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Using different Budgeting Procedures to Coordinate Principal/Agent-Relationships

Authors/Editors: Hofmann, Christian
Published: 2003
Type: Articles in Refereed Journals (International)
ISBN/ISSN: 1439-2917
Published by: Schmalenbach Business Review
Additional information: 55, Nr. 1, S. 22-45

Abstract

Budgeting mechanisms help the CEO of a firm to restrict managerial discretion and therefore
to mitigate the firm’s agency problems. By using flexible budgets, the CEO allows the
managers to efficiently adapt their actions to changing economic conditions. Alternatively,
rigid budgets result in a more extensive restriction of the managers’ actions. Although rigid
budgets reduce managers’ flexibility to react to changing economic conditions and can
result in worse production decisions, such budgets restrict the manager’s action space
and thus are easier to implement. Therefore, depending on informational and productionrelated
conditions, rigid budgets may well outperform flexible budgets.
In this paper, we analyze a moral hazard problem resulting from a combined hidden action
and hidden information situation. We formulate the agency problem under the assumptions
of the LEN-model. We do not consider communication, i.e., we analyze authoritative
budgeting procedures. For several budgeting procedures we determine second-best compensation
schemes, show the conditions under which flexible or rigid budgets are efficient,
and determine the incremental benefits of resource-oriented budgets.