Budgetary slack is when the people involved in creating a budget deliberately under-estimate the amount of revenue to be generated or over-estimate the amount of expenses expected to be incurred during the budget period. This allows managers a much better chance of "making their numbers," which is particularly important for them if performance appraisals and bonuses are tied to the achievement of budgeted numbers.
Budgetary slack may also occur when there is considerable uncertainty about the results to be expected in a future period. Managers tend to be more conservative when creating budgets under such circumstances. This is particularly common when creating a budget for an entirely new product line, where there is no historical record of possible results to rely upon.
Budgetary slack is most common when a company uses participative budgeting, since this form of budgeting involves the participation of a large number of employees, which gives more people a chance to introduce budgetary slack into the budget.
Another source of budgetary slack is when senior management wants to report to the investment community that the business is routinely beating internal budget expectations. This cause is less likely, since outside analysts judge a company's performance in relation to the results of its competitors, not its budget.
Budgetary slack interferes with proper corporate performance, because employees only have an incentive to meet their budget goals, which are set quite low. When there is budgetary slack for multiple consecutive years, a company may find that its overall performance has declined in comparison to that of more aggressive competititors who use stretch goals. Thus, budgetary slack can have a long-term negative impact on the profitability and competitive positioning of a business.
Budgetary slack is less likely to occur when a small number of aggressive managers are the only ones allowed input into the budget model, since they can set expectations extremely high. Slack is also less likely when there is no link between performance or bonus plans and the budget.