An incremental budget is a budget that is prepared by using the current budget as a base and then adjusting it by incremental or small amounts.
While there are various methodologies of budgeting, the most commonly applied method is the incremental approach to budgeting. Despite its limitations, it remains a useful and relatively quick approach for many established businesses as it is based on pre-existing data.
In this FAQ we will define what incremental budgeting is, why it’s important to understand, and how it’s done.
What Is Incremental Budgeting?
An incremental budget is a budget that is prepared by taking the current period’s budget or actual performance, using it as a base, and then adjusting it by incremental amounts.
This is typically accomplished by taking the prior year’s budget and adjusting for some increase in costs.
It is common practice to create incremental budgets using the rate of inflation as a guide for the adjustment factor when creating incremental budgets. However, some businesses scrutinize the adjustment factors for each budget line item in a different way.
This deviates from the other basic approach to budgeting, the zero-based budget, in that each cost is not necessarily scrutinized and justified, but simply adjusted for expectations in the coming period.
That is not to say that expenses and revenue are not scrutinized in incremental budgets, because they are.
One common misconception is that because they are easier to approach, little thought is given to the adjustments made in an incremental budget.
This is not the case, and significant thought and effort should be put into considering the adjustments made to the prior period’s budget.
The main difference is that costs are not being analyzed and justified. It is simply assumed that all current expenditures of the business are justifiable and necessary before proceeding.
Why Is Incremental Budgeting Important To Understand?
This approach to budgeting is perhaps the most widely adopted and practiced in the modern business setting. As such, it is important to understand it so you can effectively utilize it in your own business or organization.
Having a basic understanding of incremental budgeting is expected when entering the finance profession.
Advantages of Incremental Budgeting
To help you better understand it, here are some of the most notable benefits of this budgeting method:
User-friendly
One of the biggest benefits of the incremental budget is that it is easy to use and less intimidating to approach.
If you are new to budgeting, it is also the easiest budgeting methodology to practice and understand, making it good for many small business applications.
Practical approach
While there are inherent limitations in incremental budgeting, its use is practical in that it adjusts costs by some factor that is usually tangible and measurable.
For example, labor costs might be adjusted each year by the increase in the Consumer Price Index (CPI).
Inflation is also an easily measurable approach as the company can assume that all costs were raised by the yearly inflation rate.
Ease of adoption
One of the most important aspects of the incremental budget approach is that it’s easier to adopt within large, well-established businesses.
This is because mature businesses have established costs and little variance among the variable costs they incur.
Usually, mature businesses grow at a less volatile rate than small businesses as well, making the incremental budget easy to apply within the scope of the anticipated growth of the business.
Attempting to apply the incremental budget to more volatile businesses might result in limitations being placed on the business that will prevent it from achieving the desired growth.
For example, if the goal is to grow the business by 50% YoY, then increasing fixed and variable costs by 3% would likely be insufficient and limit the ability of the business to achieve its desired growth target.
Pros and Cons of Incremental Budgeting
We’ve discussed some of the benefits of incremental budgeting above, but next, we’ll look at these (and other) pros of this method, along with potential cons.
Pros
Simplicity and Ease of Use
As mentioned above, incremental budgeting is simple to implement, requires few changes, and is relatively easy to manage. Because it uses last year’s budget as a base for the next, less time is required for analysis.
Incremental budgets tend to be more accessible and less intimidating than other forms of budgeting because their base is already established.
Stability and Predictability
This approach offers budget stability because it doesn’t need massive annual changes.
For mature businesses with relatively predictable operations, this is particularly helpful.
Efficiency
Since the basic budget has already been established, incremental budgeting reduces the time and resources otherwise required to review expenses line by line.
Less Resistance
Teams tend to have an easier time accepting and adapting to incremental adjustments than to more significant changes. This is also beneficial in terms of reducing pushback from stakeholders.
Focus on Strategic Priorities
This ‘baby step’ approach allows management to concentrate on strategic direction or new initiatives outside of the budget process without reverting to an in-depth line-by-line review of the budget.
Note that reviewing each line item is still important, but the depth of analysis tends to be less with this method.
Cons
Potential for Cyclical Inefficiencies
As most of the budget is based on the previous year’s figures, if there are any inefficiencies, they could be carried over year after year without scrutiny or elimination.
Lack of Innovation
Incremental budgeting tends to rely on minor adjustments rather than sweeping overhauls of the budget. Without this comprehensive assessment, opportunities for improvements or cost savings may be missed.
Less Adaptive to Change
Businesses in particularly volatile or quickly changing industries might need more flexibility in their budgeting. Incremental budgeting may not be the best method for managing and adapting to these changes.
Risk of Budgetary Slippage
Over time, small changes can lead to drastic budget expansions without an equivalent increase in revenue or value. This is known as “budget creep”, and it can result in inefficient resource use.
Potential for Complacency
Focusing on small changes can lead to complacency among budget managers and reduce their sense of urgency about finding efficiencies or challenging the status quo.
How To Create An Incremental Budget
At the core of the budget-building process is the assumption the business will continue to operate within the parameters of the prior period’s budget.
This removes the need for extensive analysis to be performed on the cost of each department. Otherwise, this would take a significant amount of effort and resources.
- Start with the Prior Period’s Budget: Begin with the expenditures of the prior period when you build a budget. Each line item in the budget is adjusted for some factor in the upcoming period. The factors might adjust costs up or down depending on the scenario.
- Review Each Line: One common misconception is that because the incremental budget does not scrutinize expenses heavily, little thought is put into the adjustments used in the subsequent budgets.
This is entirely false, and each line item should be given considerable thought and attention.
For example, any investments made in the prior period that should result in reduced production costs should be factored into the next period’s budget. Therefore, costs might go down.
- Forecast Revenue: Once all expenses from the prior period have been adjusted to meet the expectations of the coming period, revenue is then forecasted using the same methodology.
- Account for New Product Lines or Mixes: These factors and their impact should be taken into account and growth rates commensurate with the size and maturity of the business should be assumed.
Using Datarails, a Budgeting and Forecasting Solution
Datarails combines spreadsheets with real-time data and integrates fragmented workbooks and data sources into one centralized location.
This allows users to work in the comfort of Microsoft Excel with the support of a much more sophisticated data management system at their disposal.
Regardless of the budgeting approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
Datarails is an enhanced data management tool that will help your team create and monitor cash flow against budgets faster and more accurately than ever before.