Businesses work with plans and one of the most important planning tools in business is a budget. A budget is an operational plan for a business expressed in monetary terms. There four types of budgets that businesses can use namely zero-based budgeting, value proposition budgeting, activity-based budgeting and incremental budgeting. Incremental budgeting is our focus for this discussion.
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What is Incremental Budgeting
An incremental budget is a budget prepared using a previous period’s budget or actual performance as a basis with incremental amounts added for the new budget period. Incremental budgeting uses an interpolation of a current or previous periods budget or actual performance to derive a budget for a future period. This is a markedly different approach from other budgeting methods but it is a practice that some organisations find useful.
An example of an incremental budgeting approach is to look at working capital. If a business uses a 5 per cent increment, we can look at the working capital requirement for the previous period and increase it by 5 per cent to arrive at the new budget allocation for working capital. Assuming our previous period allocation was $100 the budgeted allocation under incremental budgeting would be $105. The same percentage would be applied to all line items in the budget to arrive at a budget for the new period. Like any method in business, it has its advantages and disadvantages.
Advantages Of Incremental Budgeting
Incremental budgeting uses a previous period’s budget or actual performance and applies the incremental percentage to it. This makes the process of budgeting very simple and does not require any complex calculations or heavy work. The greatest work involved in incremental budgeting is arriving at the incremental percentage to use thereafter the application is very simple.
Consistency And Operational Stability
Incremental budgeting provides consistent budgets over time because the process uses either previous budgets or previous performance. Where previous performance is used the incremental budget is consistent with what has been observed in practice. Compared to other budgeting methods which need to make grand assumptions about future conditions and outlook which may or may not come to be.
An incremental budget makes no changes to the proportions of allocations in a period. The incremental percentage is normally applied to every line item and as such the proportions are maintained. From a funding perspective, this makes incremental budgeting favourable. This is especially applicable where the budget is for projects that have funding requirements going many years into the future.
Reduces Internal Rivalry
As noted earlier incremental budgeting largely makes no changes to the allocation of resources year on year. This is advantageous in organisations because it prevents situations where departments or units have to compete or campaign for the allocation of resources. The is applied to all departments and their percentage of the allocation never changes. Contrast this with systems such as activity-based budgeting which would have departments submit their requirements based on the level of activity they plan to take in the period. Department heads may spend more time on petitioning for budget allocations than achieving the goals of the organisation.
Disadvantages Of Incremental Budgeting
Despite its simplicity and consistency, incremental budgeting is frequently criticized for several underlying flaws. The primary potential disadvantages of such a budgeting method are as follows:
Promotes Unnecessary Spending
Incremental budgeting applies a consistent increment across all parts of the budget and departments within an organisation. This may not always be wise as some departments may not require an increment and they may end up spending money simply because it is available. In situations such as these departments are also encouraged to exhaust their allocations within a period to appear as if they require an increment.
Without the prospect of being rewarded for it, departments in organisations that use incremental budgeting may see no benefit in innovating. If you as a department head know fully well that your budget allocation will be increased by 5% next year regardless of what happens in your department your disincentivised to innovate. Where department heads know performance is rewarded they will seek reward however incremental budgeting may encourage rent-seeking behaviour.
Fails To Account For Changes And External Factors
Organisations are affected by many external factors and one major disadvantage of incremental budgeting is that it fails to consider the impact external factors may have. An external factor may be known at the time of preparing the budget but the degree and extent its impact may have in the future unknown. In incremental budgeting, the percentage applied may not take this into account. More importantly, it may fail to take into account the different impact it has on different parts of the budget. Many businesses faced with the impact of Covid-19 and lockdowns put in place to prevent its spread looked at working online and remotely as an answer. Noble as this was the unseen impact of the effect on the incomes of their customers was greater than the benefit of setting up remote working. An incremental budget would not have been able to account for these differences.
Lacks An Incentive For a Comprehensive Review
Incremental budgeting does not encourage any review of budget performance. While in some cases actual performance may be used there is no interrogation of the actual performance to ascertain whether or not it was a good performance. Without this review, there is a risk of applying the incremental percentage where it is not necessary. Budget review is an important part of effective budgeting because it allows management to question performance and find ways to improve it. Incremental budgeting does not ordinarily provide this opportunity.
Incremental budgeting provides a simple expedient method for budgeting in an organisation. However, it is prone to weaknesses in addressing internal and external changes as well as not serving to motivate teams or departments. It is only viable in circumstances where things are expected to remain fairly stable but in the fast pace of the business world as we know it there are very few use cases for incremental budgeting.