1. Does merit pay create incentives for unethical conduct? Why would management use merit pay if it does in fact create such incentives?

2. Budgetary slack is one way in which the budgeting process creates incentives for unethical behavior. If the managers who create the budget receive bonuses based on their ability to meet budget goals, they may be tempted to overestimate costs or underestimate sales in order to create budget goals that are easier to reach, which increases their chances of receiving the maximum bonus.

Managers may also inflate budget values if they know they will be cut. If they overstate costs on the budget, any cuts made by the budget committee will likely result in a budget that is actually what they really desired in the first place.

Consider the following scenario. John is a new production manager. After a great deal of effort, including considerable market research, he completes his budget and submits it to his boss, Mary. Without even looking at it, she asks him what his "fudge factor" was, and which items contained the most slack. John, very surprised, responds that he doesn't use any "fudge factor," and that all his figures are honest. Mary counters by asking him how he would respond if he had to cut about 20% from his budget, as it is. She tells him that most budgets are trimmed in committee, and he had better be ready. She returns the budget to him, and tells him to come back with something reasonable.

What do you think of the actions of Mary and John? Are they ethical?

3. What is typically the starting point of the master budget? How does the accuracy of this starting point affect the remaining budgets? Should participative budgeting be used to create this starting point?