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Review of Accounting Studies

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01-09-2010

Flattening the organization: the effect of organizational reporting structure on budgeting effectiveness

Authors: R. Lynn Hannan, Frederick W. Rankin, Kristy L. Towry

Published in: Review of Accounting Studies | Issue 3/2010

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Abstract

This study investigates whether increasing a superior’s span of control improves the effectiveness of the budgeting process. We characterize the superior’s utility function as consisting of utilities for norm enforcement and wealth, leading the superior to reject profitable projects believed to contain excessive slack. We develop theory to predict that superiors become more willing to reject projects as their span of control increases. Further, subordinates anticipate superiors’ behavior and reduce slack as span of control increases. Experimental results are consistent with these predictions. As span of control increases, superiors show a greater willingness to reject projects that they believe contain excessive slack, and subordinates submit budgets with less slack. The net result is that superiors earn more profit per subordinate under an expanded span of control. Our study suggests that increasing span of control can improve the effectiveness of the budgeting process, an important component of most firms’ control environments.

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Although there are instances in which slack may be beneficial to the organization—for example in encouraging strategies that require innovation and experimentation or as a means of protection against the downside of an uncertain future (Merchant and Manzoni 1989; Van der Stede 2000)—in our setting slack is harmful because it represents the appropriation of rents by the subordinate.

For expositional purposes, we refer to the owner and manager as the superior and subordinate, respectively.

In our setting, each subordinate proposes exactly one project. Therefore, increasing the number of subordinates simultaneously increases the span of operations (i.e., number of projects) controlled by the superior.

Several experimental studies in accounting also investigate participatory budgeting in a multi-agent setting (for example, Waller and Bishop 1990; Chow et al. 1994; Fisher et al. 2002). However, these studies do not manipulate the span of control and thus do not provide evidence on the effect of span of control on budgeting effectiveness.

We assume that the superior is the residual claimant of the surplus. While we recognize that, in the organizational setting, there may be one or more hierarchical levels between the superior and the actual residual claimant, this technicality does not change the intuition of our analysis. That is, assuming that the superior is employed under a performance-based contract, the hierarchical setting implies that the superior is a partial claimant of the residual. Further, to the extent that the superior can limit the subordinate’s rent, it leaves more residual from which the superior can appropriate rents.

In Rankin et al. (2003), the experimenter acted as a third party who designed a device to ensure the superiors’ commitment. In their binding-announcement (commitment) treatment, superiors announced a hurdle cost and then subordinates reported costs. The software made the superiors’ announcements binding by automatically accepting projects when the reported cost was less than or equal to the hurdle cost and rejecting projects when the reported cost was greater than the hurdle cost. That is, the software did not allow the superiors to act after receiving the subordinates’ cost reports; hence, ex post renegotiation was essentially prohibited by an authority (the experimenter) other than the superior.

In the real world, individuals may choose to enforce social norms not only because they receive intrinsic utility from doing so, but also because there are explicit advantages associated with enforcing norms (such as the value of a reputation). In fact, research using group selection models suggests that the human tendency to punish is evolutionarily adaptive, in that it sustains cooperation, and cooperative groups are less prone to extinction than uncooperative groups. That is, the intrinsic utility for enforcing norms has evolved because there are explicit advantages to enforcing norms. In this way, the constructs of utility from norm enforcement vs. the explicit advantages of norm enforcement are closely related. However, as described in the method section, we design our experiment to isolate the effects of the intrinsic utility from norm enforcement.

We are intentionally vague in our use of the term “excessive.” What constitutes excessive slack will likely vary by institution and individual. Prior research finds that factors such as ethics (Luft 1997; Stevens 2002), fairness (Evans et al. 2001), social pressure (Young 1985), targets (Newman 2010), and the appearance of honesty (Hannan et al. 2006) affect the level of slack in subordinates’ budgets, suggesting that individual and organizational factors influence the acceptable level of slack. That is, social norms may allow for a positive level of slack. However, because the superior is the residual claimant and slack represents the appropriation of rents by the subordinate, the superior prefers less slack to more. For our purposes here, we assume that there is some acceptable level of slack and any amount greater than that is considered excessive.

Neoclassical economics generally equates diminishing marginal utility for wealth with risk aversion because they both arise through the concavity of the utility function. However, Rabin (2000) argues that the notion of risk aversion does not arise solely from the concavity of the utility function, and thus the two are separate theoretical constructs. Consistent with this notion, Horowitz et al. (2007) find evidence of diminishing marginal utility for wealth in a laboratory setting with small stakes and no risk.

As described in the Appendix, the utility may increase at an increasing, decreasing, or constant rate.

Experiments in ultimatum game settings (Kagel et al. 1996; Coats et al. 2009) show that, although individuals are willing to reject offers they suspect to be unfair, they are more willing to do so if they know the offers are unfair. This finding is consistent with our characterization of the utility for enforcing a social norm as increasing in the certainty that a norm has been violated.

Prior budgeting experiments (and dictator games in the experimental economics literature, for example., Forsythe et al. 1994) find that, even when the superior cannot reject the funding request, subordinates report less than the maximum cost (Evans et al. 2001; Hannan et al. 2006; Newman 2010). While individual preferences such as these would not likely interact with span of control in a setting, such as ours, in which the superior has final authority for accepting the project, they could influence reporting behavior in a setting in which the subordinate has final authority. That is, if an increased span of control also increases the total amount of a superior’s potential earnings, subordinates may build more slack in their reports in order to create a more equitable distribution of payoffs between themselves and the superior.

For more on the use of the strategy method see Kagel and Roth (1995).

We selected one period for payment in order to eliminate wealth effects of superiors’ earnings from previous periods on their decisions in subsequent periods. That is, paying for all periods would likely have resulted in greater rejections in the later periods, potentially reducing the interpretability of our results. A consequence of our design choice is that it potentially imposes risk on the superiors because, when they accept a project, they are essentially entering a lottery for wealth rather than receiving wealth for certain. As more projects are accepted each period, the expected wealth from the lottery increases, but, assuming diminishing marginal utility for wealth, the marginal utility associated with each project acceptance decreases. Although slightly more complex than the model we present in developing our hypotheses, a diminishing marginal utility for expected wealth from entering a lottery is consistent with our theory.

We also ensure that differences across conditions are not due to perceived informational differences by requiring participants to demonstrate that they understand the independence of cost draws in the pre-experimental quiz.

Statistical tests have been replicated using nonparametric methods, with inferentially identical results.

Recall that the payoff potential is held constant for the superior between the payoff-adjusted low span and the high span conditions. Therefore, we consider this the more relevant comparison for tests of Hypothesis 1. Note that all values in the payoff-adjusted low span of control condition are made comparable by dividing by three.

Another alternative for testing H1 is to use the mean of each superior’s rejected cost reports as the dependent measure. This alternate measure is potentially biased in favor of H1, because it is affected by the pattern of reported costs and the average reported cost is lower in the high span condition (as predicted by H2 and reported in Table 2). H1 is supported using mean rejected cost report as the dependent variable when comparing the high span and low span conditions (p < 0.02, one-tailed) and is supported at a marginally-significant level when comparing the high span and payoff-adjusted low span conditions (p < 0.09, one-tailed).

In both conditions the mean highest accepted cost is greater than the mean reported threshold. We attribute this behavior to superiors believing that they will be tougher ex ante than they actually are ex post.

Nine superiors in the low span condition and eight in the payoff-adjusted low span condition did not reject any projects. We treated these observations as missing values in the tests reported in Table 1. Inferences do not change if missing values are replaced with a conservative estimate of the lowest rejected amount. That is, we estimated the upper bound for these nine superiors as the highest accepted cost plus one. This is a conservative estimate because it biases the upper bound downward in the low span conditions, which works against finding support for Hypothesis 1. Using this conservative estimate, results are inferentially identical.

Tests in which the acceptance decision (yes/no) is the dependent variable are based on Probit regressions.

Because they involve multiple observations from each participant, the data used for the tests in this section violate the assumption of independence. To correct for this violation, we calculate robust estimators (also known as Huber-White or sandwich estimators), using the Generalized Estimating Equations (GEE) module of SPSS. This method provides estimates that are corrected for cluster-correlated data such as ours (Wooldridge 2003). We cluster on superior or subordinate, whichever is appropriate for the given test. Reported p-values are one-tailed.

We attribute the higher acceptance rate for high cost reports in the payoff-adjusted low span of control condition compared with the low span of control condition to the fact that rejection of a comparable project necessitated a greater sacrifice of wealth in the payoff-adjusted low span of control condition compared with superiors in the low span of control condition.

The substantial proportion of reported costs in the highest range (30.7% low span; 36.5% payoff-adjusted low span; 26.8% high span) does not indicate irrational behavior, because 17.7% of the actual costs fell within this range. Thus the subordinates had no choice but to report a high cost.

We statistically examine this profitability difference in an ANOVA, in which superior profit is the dependent variable, experimental condition is a between-subjects independent variable, and period is a within-subjects independent variable. P-values are the results of planned contrasts.

This increase in profit is the result of rent extraction, in that the subordinate profit is lower in the high span condition than in either of the low span conditions (both p < 0.06 one-tailed), but total surplus is not significantly different across any conditions (all p > 0.50).

The actual thresholds were determined by randomly selecting, without replacement, eight thresholds from the population of thresholds observed in periods 5–8 of Experiment 1. The resulting thresholds range from 20 to 24, with a mean of 23.9. Participants are informed that the mean threshold is approximately 23 but receive no information about the distribution of the thresholds. The same set of eight thresholds is used for all participants in Experiment 2.

In addition to the effects due to monitoring and norm enforcement, other effects of increasing the span of control are likely to exist. For example, increasing the span may affect information asymmetry, competition, peer pressure, relative performance evaluation, or motivation (as suggested by Williamson’s (2008) finding that giving managers more decision autonomy motivates them to work harder). Further, some of these effects may be nonlinear or even nonmonotonic.

This characterization is consistent with Fehr and Gachter (2000), who find that the magnitude of punishment is related to the magnitude of the norm violation.

Because the utility for enforcing social norms is additively separable by subordinate, it is not convex or concave across subordinates. However, additive separability does not preclude convexity or concavity for a particular subordinate. That is, while we expect the utility for enforcing a social norm to increase with the magnitude of the violation, it may increase at an increasing, decreasing, or constant rate. We are aware of no theory to predict the specific form of this function. If we were to specify a convex or concave function, additive separability would be achieved by applying the exponent before the summation. This would not affect our predictions.

Although we demonstrate this effect assuming a social norm of fairness, it is generalizable to other norms, such as honesty. We use fairness because Rankin et al. (2008) conclude that fairness explains superiors’ rejection decisions better than honesty when superiors can reject projects. Likewise, although we assume that a = b = 1, the effect is generalizable for any positive level of b. That is, as long as the superior receives some degree of satisfaction from preventing subordinates from incorporating excessive slack in their budgets, the threshold for project rejection increases as the span of control increases. Finally, the effect is generalizable to nonlinear forms of a utility for enforcing social norms.

The percentage of observations in which all three proposals were accepted by a superior (20.3%) is lower than the percentage of proposals that were accepted overall (59.9%), which was reported when we discussed the distributions of acceptance rates.

Across these four periods, the 16 superiors in the high span condition accepted 1 of the 3 projects 18 times, 2 of the 3 projects 33 times, and all 3 projects 13 times.

Technically the utility from wealth is from a change in wealth. For simplicity, we use the term “wealth.”

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Title: Flattening the organization: the effect of organizational reporting structure on budgeting effectiveness
Authors: R. Lynn Hannan
Frederick W. Rankin
Kristy L. Towry
Publication date: 01-09-2010
Publisher: Springer US
Published in: Review of Accounting Studies / Issue 3/2010
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-010-9132-5

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