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On a Spending Spree: The Real Effects of Heuristics in Managerial Budgets

May 19, 2023

At the Gupta Governance Institute 16th Annual Corporate Governance Conference held on April 14 2023, Paul Décaire, Assistant Professor of Finance at the Arizona State University, showed that rigid budgeting rules reduce investment efficiency and increase wasteful spending, especially in large and complex firms.

Key insights

  • Delegated budgeting is a common approach to resource allocation used by U.S. firms to manage the large number of operating decisions they face every day. This includes setting budget targets and rigid fiscal year deadlines. By investigating advertising expenditure, the study shows that managers that are running a budget surplus raise their spending by 44% four weeks before the budget reset deadline. In contrast, managers that are close to the budget constraint early in the fiscal year, drop spending by 46% in the four weeks before the budget reset and resume it after the budget deadline has passed.
  • The spike in spending near the reset deadline is associated with a decline in the effectiveness of advertising, as measured by the impact on sales, market penetration, and customer reach. Advertisement projects funded in the last month of the budgetary cycle generate 62% less revenue, achieve 39% less market penetration, and cost 52% more. In contrast, the sharp decline in spending for managers close to their budget constraint lead to foregoing project opportunities until the budget is reset, no matter how good the investment option is.
  • The negative impacts of delegated budgeting are more pronounced in firms with more hierarchical layers between the CEO and the employees engaged in daily operations, in firms with a greater number of product divisions, and in firms with a higher proportion of lower-rank employees compared to upper management. CEOs with multiple external board appointments, CEOs approaching retirement, and CEOs with low insider ownership stakes also appear to increase the negative effects of budget rigidities.

Summary of Complete Findings

A central role of top management is to allocate a firm’s capital to the best investment opportunities. Due to the large number of resource allocation options, firms typically delegate day-to-day decisions to midlevel managers with pre-determined spending budgets. Managerial spending budgets are anchored on round amounts, remain persistent in nominal terms over time, and often carry special provisions such as a mandatory review of any overage expenses or a recapture of the remaining funds at the fiscal year-end. The benefit of such annual budgets is that they endow mid-management with control rights, impose a clear budget constraint, and reduce monitoring costs associated with the approval of day-to-day expenses. However, the limitation of such a simplified framework is that it hardly incorporates the complex dynamics of a firm’s investment opportunities, which should be the ultimate focus of capital allocation decisions. Investment opportunities vary greatly over time, do not come in round amounts, and arise independently of the remaining budget balances and fiscal year deadlines.

This study finds that the divergence between rigid rules in capital budgets and dynamic investment opportunities reduces investment efficiency and generates frictions. Such frictions manifest in wasteful spending around fiscal year deadlines and lead managers to forego attractive investments that unexpectedly arrive late in the budget cycle when the manager is close to their budget constraint. This behavior is more prevalent in complex and large firms where spending is difficult to monitor.

The researchers analyze one of the largest types of corporate budgets - namely, advertising expenditures - using daily transaction-level data on the allocation of nearly $400 billion across 3.4 million itemized expenditures by 347 publicly traded firms in the 2010–2019 period. On average, firms in the United States spent $294.8 billion per year in advertising in that period, which represent 20.5% of the budget US firms allocated to capital expenditures per year. Advertising budgets are largely fixed within the year, follow fiscal year deadlines, and remain sticky in nominal terms, with the majority of executives (62%) reporting minimal year-over-year budget adjustments. The study focuses on understanding the impact of such budgetary rigidities on investment spending and the efficiency of capital allocation.

First, the researchers show that managers raise their spending sharply during the final four weeks before the budget reset deadline. As a result, the average expenditures in the final budgetary month spike by 44%, but only if the manager is running a budget surplus relative to the previous year’s realized expenditures. In contrast, when managers appear to reach their budget constraint early in the fiscal year, expenditures drop sharply for the rest of the budgetary cycle, with an average decline of 46% in the pre-deadline month. This decline persists irrespectively of investment opportunities and leads to underinvestment relative to industry peers until the manager’s budget reset date. Investment recovers sharply at the onset of a new budget cycle.

Managers with a budget surplus near the reset deadline select the same project categories (a similar mix of advertising channels) but implement lower-quality projects. The most attractive investment opportunities for advertising expenditures (such as salient space in print media and primetime TV slots) are pre-booked 6-12 months in advance. Thus, managers with a budget surplus before the reset deadline face three options: they can spend the remaining funds on less attractive projects (effectively, leftover ads); return the unused funds to the firm; or signal a lack of investment opportunities at the risk of receiving a smaller budget next year. The study concludes that managers mainly elect to retain control over the remaining funds and expend them despite weak investment opportunities, investing in at least some projects with negative estimated net present value (NVP). Consistent with this explanation, the study also observes that managers who instead choose to finish the year with an unspent surplus tend to receive lower capital allocations in the following year.

Secondly, the researchers find that the spike in spending before the budget reset deadline is associated with a decline in investment efficiency, as measured by the impact on sales, market penetration, and customer reach. Advertisement projects funded from budgets with excess funds in the last month of the budgetary cycle generate 62% less revenue, achieve 39% less market penetration, and cost 52% more to reach the same number of viewers than other projects of the same manager in the same year but after the budget reset deadline. Such close-to-deadline projects are likely to be value destroying for a firm.

On average, advertising expenditures conducted on non-terminal months of the fiscal year generate positive return on investment: for the average dollar of advertising, firms generate $1.08 of sales in the six months following the expenditure. However, advertising efforts conducted in the last month of the fiscal year generate only $0.17 of sales over the 6 months period following the expenditure, an 84% reduction in advertising efficacy.

The price of market penetration measures how much firms must spend to reach their entire targeted population once during the month. A small number indicates that firms’ advertising is more effective at reaching firms’ targeted audience. This study finds that firms that advertise towards the end of the fiscal year spend $4.53 million more to reach their population of potential viewers once per month, a 39% decline in the efficiency of advertising expenses.

The price of viewer-hour is the price that firms pay to promote their products to one viewer for one hour. A smaller number indicates that firms can reach out to a prospective client more efficiently. Again, on average firms spend $0.74 more at the end of the fiscal year to advertise to one person per hour, a 52% reduction in advertising efficacy.

Overall, these findings indicate that when managers face rigid budget rules, they scramble to find ways to quickly spend their allocated budget amounts. In doing so, they select projects that are less efficient and that generate weaker sales.

Looking at the features of firms, the researchers find that the negative impacts of budget heuristics are stronger for firms with a higher number of layers between the CEO and the employees engaged in daily operations. This suggests that a more complex hierarchy makes it harder for upper managers to directly monitor the decisions of their subordinates. Similarly, the negative impact of budget heuristics is more pronounced the larger the number of product divisions in a firm, because it is more challenging for the CEOs to keep them all on their radar at once. Furthermore, the negative impact of budget heuristics is more severe when firms have larger subordinates-to-manager ratio, that is when the size of the upper management team is small compared to the lower ranked employees. Finally, busy CEOs with multiple external board appointments, CEOs approaching retirement, and CEOs with low insider ownership stakes also appear to increase the waste of resources associated with delegated budgeting.

Overall, the findings suggest that some form of stricter monitoring from upper management could help mitigate the negative effect of delegated budgeting. Specifically, the researchers model the impact on performance of capital rationing (where lower management makes a case for investment projects towards the end of the fiscal year). They find that rationing mitigates overspending and improves the performance of spending in the run-up to the fiscal year end. In conclusion, this study provides new insights on the benefits and pitfalls of delegating capital budgets as a practical approach to resource allocation. In doing so, it highlights that the governance of managerial incentives below executive level in a firm’s hierarchy plays a significant role in a firm’s performance.

“On a Spending Spree: The Real Effects of Heuristics in Managerial Budgets” by Paul H. Décaire (Arizona State University), Denis Sosyura (Arizona State University).

View the working paper

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