Cost uncertainty and budget overspending: A safety-first perspective

Abstract

In this study we model a cost center manager's decision about how to achieve a required level of output. The spending plan that the manager adopts is expected to result in successful performance, but at an uncertain cost. The uncertainty associated with the spending plan is inversely related to the expected cost. The analysis presented in this article suggests that a manager who exhibits Safety-First behavior and wishes to avoid large budget deviations is more likely to exceed what he or she perceives to be the overspending limit rather than the underspending limit. That manager will tend to incur costs in excess of the budget. This mathematical result has an intuitive appeal; a manager is willing to pay a certain “risk premium” to avoid the risk of large budget deviations and accompanying adverse consequences. This result has implications for both performance evaluation and budget setting, particularly in the public sector. Under the circumstances that we describe, using budgets in evaluating managerial performance may be misleading. Another application of our study relates to the “budget creep” phenomenon and how, under particular circumstances, its size can be reduced.