Pros and Cons of Budget Lapsing

Budget lapsing describes the practice of restricting the use of monetary budgets to a certain period, typically a fiscal calendar year or quarter. This mechanism allows for a better way of monitoring the spending of assigned budgets by providing a finite time horizon for spending activities and is an important organizational performance measure. By rewarding budget compliance it influences and controls employee spending behavior and is an essential tool for cost management.

Budget lapsing also ensures that funds provided for a certain period of time are being used during that period. If a company defines a 5-year mid-term strategy with expected growth targets by year and assigns budgets accordingly, the consumption of these budgets needs to follow the original plan to ensure this strategy is supported. Overspending or underspending of budgets by individual business units might impact the strategy due to existing organizational dependencies. Also, for multi-year programs, the assignment of yearly budgets can provide an early indication of cost overruns and provide beneficial information for management decisions.

However, this practice might promote undesirable employee behavior. The fact that unspent budgets expire, might encourage managers to spend the remaining budget on unnecessary items at the end of a period due to “use it or lose it” thinking. Another possibility could be that remaining funds are provided to other business units that might need the money. Although this is the better alternative it would falsify the operating results of the benefiting business unit and could lead to incorrect management decisions.

The main reason for completely consuming assigned budgets might however be the underlying budget planning process. Many companies consider the amount spent in previous periods as baseline for future budgets. If an assigned budget is not used in the current period this might result in a smaller budget in the future. Given the uncertainty of future spending needs, managers will tend to use the existing budget to be in the best possible position, with the largest budget possible, in the future. Even for growing companies the impact of possible budget reductions will lead to such reactions. Assuming a company plans to grow 5% during the next year, the yearly budget might be defined as spent amount in previous year plus an additional 5% increase. Managers that are aware of this simplified budgeting method might fear that they could receive future funds that are smaller than the expected growth rate and therefore feel motivated to use up the assigned budget. As these examples show, budget lapsing combined with a simplified budgeting process doesn’t seem to support thriftiness. In addition, in the course of time such processes would justify cost increases in accordance to company revenue increases although a proportional cost increase might not be warranted. Even during constant growth periods, company costs might vary or even decrease (e.g. due to higher initiation costs, step costs) and should be carefully analyzed.

However, there are possibilities to avoid these pitfalls. One option is to monitor spending patterns and to require additional approval and justification for year-end spending activities. This measure might help to reduce unnecessary spending but eventually managers could adjust their spending behavior to avoid year-end peaks and bypass year-end restrictions. Another option is to change the budget planning approach for certain cost categories to a more sophisticated method at least once in a while to ‘reset’ budgets and avoid spiraling cost increases. External market or industry information and benchmarking activities could support this task.

Furthermore, using budget adherence as an individual performance measure in rewards management needs to be assessed carefully. Overspending should be avoided penalized due to the bottom line impact, however an exception process should be defined and communicated for reviewing and approving additional budget needs. Underspending should not be rewarded due to potential effects on company growth plans and negative impact on employee satisfaction.

Budget lapsing is an important accounting feature that is required for monitoring and controlling expenditures and its benefits seem to outweigh potential disadvantages. There are methods to prevent misuse and waste, however they can be costly and might still allow for loopholes. The better approach for creating the desired behavior is to educate employees on the impact individual actions could have on the company results, encourage entrepreneurial thinking and have an open communication on budget topics.