Efficiency and Applicability of Participative and Authoritative Budgeting Systems

In principal-agent relationships incentive problems follow from divergent objectives and information asymmetries. The principal can mitigate the incentive problem by using incentive schemes that align the agent's preferences with her own preferences. A further mitigation of the agency problem may result if the principal species activity schemes that limit the activities available to the agent. Examples of activity schemes of that kind refer to budgeting systems such as Zero Base Budgeting and Overhead Value Analysis, as well as to various types of standardization in an organization. The two main questions addressed in the paper refer to the applicability and efficiency of budgeting systems. A system's applicability is given by the conditions necessary for applying budgeting systems with rigid and exible activity schemes. The comparison of exible and rigid budgeting systems addresses the systems' efficiency. Rigid schemes limit the activities available to the agent and are often easier to implement. However, they suffer from the reduced exibility regarding the agent's reaction to private pre-decision information. The trade-off between implementation/agency cost and foregone exibility benefits drives the relative efficiency of exible and rigid budgeting systems. This is relevant both for participative and authoritative budgeting systems and in uences the relative benefits arising from the agent's participation in the budgeting process. Comparing the two approaches we find that communication has no value to the principal if she only tries to implement rigid activity schemes. In the paper we briefly describe the mechanisms enabling the application of activity schemes. Subsequently, we analyze a moral hazard problem based on a hidden action and hidden information situation. The agency problem is formulated with the assumptions of the LEN-model. Based on the second best activity schemes and the comparison of the expected result to the principal we derive conditions for an efficient application of exible and rig