Budget lapse describes the practice of limiting the use of monetary budgets to a specific period of time, usually a fiscal calendar year or quarter. This mechanism provides a better way to monitor the spending of allocated budgets by providing a finite time horizon for spending activities and is an important performance measure for the organization. By rewarding budget compliance, it influences and controls employee spending behavior and is an essential cost management tool.
Budget lapse also ensures that resources made available for a certain period of time are used in that period. If a company defines a five-year medium-term strategy with projected annual growth targets and allocates budgets accordingly, the consumption of these budgets must follow the original plan to ensure that this strategy is supported. Over- or under-spending of budgets by individual business units can affect strategy due to existing organizational dependencies. Also for multi-year programs, the allocation of annual budgets can provide an early indication of cost overruns and provide useful information for management decisions.
However, this practice can promote undesirable behavior from employees. The fact that unspent budgets expire can prompt managers to spend the remaining budget at the end of a period on unnecessary items because of “use it or lose it” thinking. Another option could be to provide the remaining funds to other business units that may need the funds. While this is the better alternative, it would distort the operating results of the beneficiary business unit and could lead to incorrect management decisions.
However, the main reason for completely using up allocated budgets may be the underlying budget planning process. Many companies consider the amount spent in previous periods as the basis for future budgets. If an allocated budget is not used in the current period, it can lead to a smaller budget in the future. Given the uncertainty of future spending needs, managers will tend to use the existing budget to be in the best possible position in the future, with the largest budget possible. Even for growing companies, the impact of any budget cuts will trigger such reactions. Assuming a company plans to grow by 5% in the coming year, the annual budget can be defined as the amount spent in the previous year plus an additional 5% increase. Managers who are aware of this simplified budgeting method may fear that they may receive future funds that are smaller than the expected growth rate and therefore feel motivated to use up the allocated budget. As these examples show, budget lapses combined with a simplified budgeting process do not seem to support frugality. In addition, such processes would justify cost increases over time in line with revenue increases, although a commensurate cost increase may not be warranted. Even during periods of constant growth, operating costs can vary or even decrease (eg due to higher start-up costs, step costs) and must be carefully analyzed.
However, there are ways to avoid these pitfalls. One option is to monitor spending patterns and require additional approval and justification for year-end spending. This measure can help reduce unnecessary spending, but ultimately managers could adjust their spending behavior to avoid year-end peaks and circumvent year-end restrictions. Another option is to at least occasionally change the budget planning approach for certain cost categories to a more advanced method to ‘reset’ budgets and avoid rising cost increases. External market or sector information and benchmarking activities could support this task.
In addition, the use of budget compliance as an individual performance measure in compensation management should be carefully assessed. Overspending should be avoided, penalized for the impact on profits, but an exception process should be defined and communicated for reviewing and approving additional budget needs. Underspending should not be rewarded because of potential effects on the company’s growth plans and negative consequences for employee satisfaction.
Budget decay is an important accounting function necessary for monitoring and controlling expenses and the benefits seem to outweigh the potential drawbacks. There are methods to prevent abuse and waste, but they can be costly and can still have loopholes. The better approach to creating desirable behaviors is to educate employees about the impact individual actions can have on bottom line, encourage entrepreneurial thinking, and have open communication on budget topics.
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