While there are various methodologies of budgeting, the most commonly applied method is the incremental approach to budgeting. It is the most widely adopted approach to budgeting and despite its limitations, it is a useful approach for many established businesses. In this FAQ we will define what incremental budgeting is, why it is important to understand, and how it is performed.
What Is Incremental Budgeting?
An incremental budget is a budget that is prepared by taking the current period’s budget or actual performance and 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 the consideration of the adjustments made on 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. One of the biggest benefits of the incremental budget is that it is easy to use and less intimidating to approach. Having a basic understanding of how incremental budgeting works will help you feel more confident when entering the finance profession. If you are new to budgeting, it is also the easiest methodology to practice and understand making it good for many small business applications.
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).
One of the most important aspects of the incremental budget approach is that it is 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 cost by 3% would likely be insufficient and limit the ability of the business to achieve its desired growth target.
How To Create An Incremental Budget
One of the things that makes incremental budgets easier and less intimidating than other forms of budgeting is that the base is already established. It begins by making the assumption that 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, which typically takes a significant amount of effort and resources.
Beginning with the expenditures of the prior period, 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.
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 cost should be factored into the next period’s budget, therefore cost might go down.
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. New product lines or mixes 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 replaces 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.
Every finance department knows how tedious building a budget and forecast can be. Integrating cash flow forecasts with real-time data and up-to-date budgets is a powerful tool that makes forecasting cash easier, more efficient, and shifts the focus to cash analytics.
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 can help your team create and monitor cash flow against budgets faster and more accurately than ever before.