What is incremental budgeting? Is it good for your business?
What is incremental budgeting?
Every year, annual budget planning takes place in every business.
It is commonly seen that as time passes, managers tend to fall into the habit of repeating a similar budget allocation year after year and slightly adjusting the figures to account for inflation. This is one of the widely used, easiest, and most comfortable ways of setting budgets.
But how efficient is that?
Incremental budgeting is the process of setting the current year’s budget based on last year’s budgeted allowance or actual performance after adjusting for inflation and other incremental factors.
It is one of the most traditional methods of budgeting. To last year’s actual results, only incremental amounts are added for the new budget period. These incremental amounts are added on account of things like inflation, or planned increases in sales prices & costs of inputs such as material and labor. And the budget processes are designed in such a way that they are concerned primarily with the increment (and hardly decrease) in operations or expenditure which would occur during the next fiscal year. (source)
Suppose a university has a substantial amount in its budget for employee salaries. Assume that staff salaries totaled $560,000 in a given year. When preparing the budget for the coming year, the management believes that they will be hiring two new members to teach languages, each on a salary scale of $40,000 (before any pay raises) and that all employees shall be given a 5% raise in pay. Now, assuming that the new employees would be paid at increased levels, the salary budget for the next year shall be $672,000 [($560,000 + $40,000 + $40,000) x 1.05].
Apparently, this kind of budgeting is quick and easy. No detailed examination is carried out for the amounts already spent and thus, they are accepted without any questioning. As we see in this example, no thorough examination is executed for the salaries already included in the existing expense of $560,000. It is assumed that the existing expenditure is justifiable. This accounts for one of the main reasons why incremental budgeting may not always yield fair costs. Nevertheless, let’s first see when is it most suitable and why is it sometimes seen as a good method of budgeting.
Process of incremental budgeting
Step 1: Establish the base.
Determine the amount of expenditure already committed
Step2: Account for adjustments for the next year.
Adjustments could be related to (but not limited to) the following:
- Inflation/rise in prices levels of raw materials, labor, or services
- Staff appointments and increments
- Proposed capital expenditure like an investment in plant & machinery
- External factors like changes in government legislations
Step 3: Aggregate the amount representing adjustments and the base amount.
Why is incremental budgeting commonly used?
The application of incremental budgeting in businesses is very common and its usage can be attributed to several reasons. Some of these are:
Easy and simple process: Incremental budgeting is a quick and straightforward procedure. This enables a person with no accounting training to create a budget. Moreover, less preparation time equals lower preparation costs.
Limited data analysis: Because the data is readily available, only a limited amount of quantitative analysis is required. Managers are not frequently required to spend large amounts of time dealing with analysis or review of budgets. (source)
Reasonable in some circumstances: Incremental budgeting is appropriate to use in certain cases, especially where there is stability in operations. In a stable business, for instance, the expenditure incurred on office supplies in one year is unlikely to fluctuate considerably in the following year. Hence, taking actual expenditure in the previous year as a base and adding a small amount for inflation sets a reasonable estimate for next year’s expense.
Prevention of conflict: Because a consistent approach is used throughout the organization, it prevents conflict between departmental managers.
Easy to figure out reasons for the change: The impact of change can be seen quickly. For example, an $112,000 increase in employee costs in the aforesaid example can be quickly traced back to the hiring of two new members and a 5% pay increase because everything else in the salaries budget stayed unchanged.
Problems associated with incremental budgeting
Even though incremental budgeting is a very simple way of setting budgets, it may not always be a good idea to blindly add on a specific percentage to last year’s budget. Let’s find out why.
Inefficiencies in business: It develops an attitude of wasteful spending, thus, leading to cost inefficiencies in a business. If actual figures for the current year include overspends as a result of a reason not likely to reoccur, the budget for the following year would still include this overspend again. This shall lead to carrying forward of past inefficiencies, along with a rise in spending in the coming years. (source)
There is no challenge: Managers are not encouraged to challenge themselves and the costs of their departments. Since no one looks at the existing expenses, they are unlikely to change.
It cultivates a sense of limitedness: Incremental budgeting encourages managers to spend up to the maximum amount allowed in a budget, under the impression that if they don’t do this, they won’t have as much money to spend in the next year. Thus, organizations may spend unnecessarily to ensure that they get the same or a larger allowance next year.
It is merely based on assumptions: It assumes that all current activities and costs are still required, without examining them in depth. In the example stated above, we know that the university’s management has budgeted for two new teachers. But how carefully did they look into whether both of such new teachers are actually needed or not? It might be the case that, with some minor changes in time schedules, the university could manage with only one new teacher. There is no critical assessment of current costs of $560,000. That is why it is also said that incremental budgeting looks backward rather than forward.
It may cause uneconomic activities to continue: Because of incremental budgeting, a company may overlook any unprofitable activities and continue with them on a year-on-year basis. For example, even though it might be cheaper to outsource a component, a business may continue to manufacture it in-house. Since incremental budgeting does not deep dive into cost-benefit analysis, it results in ignorance of unprofitable activities.
Not suitable for changing circumstances: Incremental budgeting does not suit companies where a change in business operations takes place quite often.
Difficulty in assessment: There is no proper analysis to substantiate the amount of increment done in a budget from last year.
It ignores true costs: Incremental budgeting ignores the true cost drivers that cause an expense to increase or decrease. It does not take into account the cause and effect relationship between activities and their costs. But there is one such technique of budgeting that thoroughly analyses every activity and its related costs. This technique is known as activity-based budgeting.
Did you know? Incremental budgeting is often used as a synonym of traditional budgeting.
How can these problems in incremental budgeting be resolved?
One approach that overcomes the limitations of incremental budgeting is zero-based budgeting. Instead of using the previous year’s figures as a foundation to build a budget, zero-based budgeting requires all costs to be specifically justified by the benefits expected from them. If a cost is not justifiable, it does not find a place in the budget.
In traditional incremental budgeting, departmental managers justify only variances from the previous year, assuming that the “baseline” is automatically approved. On the other hand, in zero-based budgeting, every line item of the budget must be approved, rather than just modifications. It necessitates a thorough re-evaluation of the budget request, beginning with zero.
As a result, all budget line items begin with a balance of zero, as opposed to incremental budgeting, where they all begin with a balance at least equal to the previous year’s budget or expenditure.
Budget items that do not support the attainment of organizational goals can be removed from the budget framework, or new ones may be added. Thus, preparing a budget using the ZBB approach can eliminate the tendency of incrementing. (source)
Zero-based budgeting attempts to achieve an optimal allocation of resources to the parts of the business that need them the most. It accomplishes this by compelling managers to justify every activity in their department, knowing that unless they do so, their department’s budget will be zero. If they are unable to do so, they are not given any resources, and their work is halted.
An organization develops a questioning attitude by forcing managers to ask themselves questions like:
- Is the activity actually necessary?
- What happens if the activity comes to a halt?
- Is the current level of provision adequate?
- What other options do you have for carrying out the activity?
- What should the cost of the activity be?
- Do the anticipated benefits outweigh the anticipated costs?
The system of incremental budgeting is usually criticized for not being efficiency-based and seems to transfer the problem of the previous year onto the next year because of the use of the same parameters on a year-on-year basis. But still, the system is used extensively in government organizations and in some private companies too because of its simplicity.
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