Although there are a variety of budgeting approaches, the incremental approach is the most commonly employed. It is the most popular budgeting method, and despite its flaws, it remains a viable strategy for many small businesses and large organizations to reduce costs. In this post, we will comprehensively review the incremental budgeting definition, its essential aspects, and how it is implemented.
What is incremental budgeting?
An incremental budget is created by starting with the budget for the current period or actual performance and then adjusting it incrementally. Usually, this is done by using the budget from the year before and making changes to account for any cost increases.
It is common practice to utilize the inflation rate as a guide for the adjustment factor when establishing total budgets. This is done following the incremental budgeting method. On the other hand, other businesses assess the adjustment variables for each budget line item in a unique way.
This varies from the second primary way of budgeting, known as zero-based budgeting, in that each expense is not required to be scrutinized and justified; instead, it is adjusted to account for forecasts for the forthcoming period. That is not to say that incremental budgets do not analyze revenue and spending; on the contrary, they achieve operational stability.
One of the most common misconceptions about incremental budgets is that because they are easier to implement, very little thought is given to the adjustments made to them. The essential contrast is that costs are not analyzed and justified in new budgets; instead, the business’s current expenditures are believed to be valid and required before proceeding. This is not the case, and a significant amount of time and effort should be put into considering the budget changes made in the previous quarter.
Pros and cons of incremental budgeting
It is possible to argue that this budgeting strategy is the most commonly used in contemporary business settings. Even though it has a lot of advantages and favorable variances, incremental budgeting methods also have several disadvantages. Some of the significant advantages and disadvantages of incremental budgeting include the following:
Incremental budgeting pros
Businesses may find incremental budgeting useful for a variety of reasons, including the following:
Ease of use
Incremental budgeting is one of the easiest methods of budgeting. It does not involve complex calculations because it predicts the future budget based on the current period’s budget. Furthermore, the budgeting technique necessitates the formation of only a few assumptions. Lastly, the method is easy to use, which saves time for the organization’s management team during the budgeting process.
Stability and consistency in operations
Because they are based on numbers from previous budgets, budgets will always stay mostly the same over time.
Stability of funding
Because it is easy to estimate spending, incremental budgeting can be a powerful tool for ensuring that funding remains consistent throughout the project. Businesses working on long-term initiatives that may require funding stability could benefit from this.
Reduces internal competitiveness within the organization
Changes to the budget from the previous year’s budget are frequently assigned an identical amount of incremental change when employing incremental budgeting. As a result, departments inside a corporation do not have to compete with one another for a more significant portion of the available funding.
Incremental budgeting cons
Although its application is simple and consistent, incremental budgeting is frequently criticized for various fundamental issues. The following are some of the significant disadvantages of employing such a budgeting method:
Encourages non-sssential extra spending
When utilized incorrectly, incremental budgeting can result in unnecessary spending of more money for a conservative business environment. This is because departments within a corporation tend to spend all of the money in a budget during one year to receive a higher amount of money during the next budgeting period. This is done to optimize profits over the prior budgeting cycle. The incremental budgeting principle states that each budget component should get a fixed annual increase. Nonetheless, it is feasible that specific departments will not require additional financing every year. However, regardless of this reality, the budgeting process will give them an increase in funding stability whether or not they need it. The budgeting process may result in unnecessary waste and may not be as efficient as it may be.
It stifles innovation
This incremental budget model may be a barrier to creating new ideas and hindering progress. Because new budget periods are constructed using the same parameters as the prior period’s budget, there is very little room in the budget to fund completely new ideas or endeavors. As a result, creating an incremental budget impedes the execution of creative ideas and contributes to developing a conservative climate within the organization.
Does not evaluate the consequences of modifications or other external factors
This is one of the significant disadvantages of incremental budgeting. The essential assumption of developing incremental budgets is the continued stability of the company’s operations. Because of this, budgets often can’t adjust to changes that may happen because of things that didn’t happen as planned or because of the situation.
There is little motivation for a thorough review
The stability of incremental budgets provides no incentive for firm management to analyze budgets to generate cost reductions through more efficient spending. Because they don’t have a budget review system, they are more likely to make mistakes and waste money by making wrong assumptions.
How to create an incremental budget?
One of the key reasons incremental budgets are considered more straightforward and less terrifying than other budgeting techniques is that the foundation has already been established. It begins with the assumption that the company would continue to operate within the limits of the previous periods’ budgets. Because of this, it is no longer necessary to thoroughly analyze how much each department spent, which would usually take a lot of time and money. It is calculated using the incremental budgeting formula. Consider the scenario of a company that paid out $400,000 in salary to its employees the previous year. The following year, they plan to give those employees a ten percent raise and hire six new employees, each with a starting salary of $25,000 per year.
The above is one of the examples of incremental budgeting. It shows how incremental budgeting works. Every line item in the budget, beginning with the previous period’s expenses, is revised with incremental adjustments following some of the major features of incremental budgeting for the upcoming period. The elements may increase or decrease the revenue growth depending on the conditions.
Many educational institutions have a widespread misconception that subsequent budget revisions are not considered since the incremental budget does not thoroughly examine the costs involved. This is false, and each line item should be carefully considered. For example, any investments made the year before that should lead to lower production costs and sales prices should be included in the current budget for the next period. This means that costs may go down if they are re-evaluated.
Following any necessary revisions to the previous period’s expenditures to align with the budgetary slack of the same budget for the upcoming period, the next step is to forecast revenue using the same procedure. It is essential to look at any new product lines or combinations and see what effect they will have. It is also crucial to conduct an extensive analysis to predict growth rates proportional to the company’s size and age.
The main advantages of incremental budgeting are simplicity and consistency in every fiscal period. Nonetheless, this budgeting technique may have unfavorable long-term repercussions and risk-taking.
Companies operating in today’s fast-paced business world have potentially significant limits due to this budgeting method’s conservatism, the method’s inflexibility, and the resulting inability to adapt to internal and external changes. Because of these constraints, the approach cannot adapt to changes, except only minor changes in cash flow over multiple years.
In general, the incremental budgeting method assumes that the company’s budgets will remain unchanged over the long-term budget period, with only modest incremental amounts carried forward into the long-term funded projects. In other cases, more advanced budgeting procedures are strongly encouraged in future periods.