Using Different Budgeting Procedures to Coordinate Principal/Agent-Relationships

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 production related 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