A Note on the Benefits of Aggregate Evaluation of Budget Proposals

Abstract

ABSTRACT Budgeting admits significant management control problems due to information asymmetries within organizations. We extend the Antle, Bogetoft and Stark (1999) principal agent analysis of budgeting, performing comparative statics on the potential benefit of bundling projects. Bundling projects confers a type of diversification benefit similar to portfolio diversification. We find this benefit is maximized at intermediate levels of profitability. The rationale for this finding is that at high levels of profitability the control problem is trivial and at low levels of profitability individual evaluation is necessary to screen for only the most profitable projects. For similar reasons bundling is most beneficial at intermediate levels of slack potential. We further find that when bundling is strictly beneficial to the principal its benefit is decreasing in the correlation between the projects' profitability. The intuition for this finding is (positive) correlation diminishes the diversification benefit found with aggregation. Finally, we sketch a setting with heterogeneous projects that differ with respect to ex ante profitability. We demonstrate that the benefit of aggregation is decreasing in project heterogeneity. The intuition is that when projects are sufficiently heterogeneous the ability to tailor the contracts to the individual projects dominates the diversification benefits.