Incremental budgeting is a type of a budgeting process that is based on the idea that a new budget can best be developed by making only some marginal changes to the current budget. In other words, with incremental budgeting, the current budget is used as a base to which incremental assumptions are added or subtracted from the base amounts to determine new budget amounts. Among all budgeting methods, incremental budgeting is commonly considered as the most conservative approach.
Note that there is no standard formula to determine the applicable marginal changes in the budgeting process. The marginal changes are typically determined using certain assumptions that are based on previous budgeting and expenses.
Advantages of Incremental Budgeting
Incremental budgeting can be appealing to companies for a number of reasons, including:
Incremental budgeting is the easiest budgeting approach. Since it uses the budget for the current period to project the future budget, it does not require complex calculations. Also, only a few assumptions are required in the budgeting method. Finally, the method’s simplicity allows the company’s management to save time on the budgeting process.
2. Consistency and operational stability
The dependence on the figures from the budgets of previous periods ensures that the budgets remain fairly consistent and relatively stable over time.
3. Funding stability
Incremental budgeting may also help ensure that funding remains stable over time, as expenses are relatively easy to project. This can be helpful for companies with projects that require funding for multiple years.
4. Reduces internal rivalry
Incremental budgeting generally allocates equal incremental changes to the budget from one year to the next. Thus, departments within a company are not forced into a position of competing with each other to obtain a larger portion of the budget.
Despite its simplicity and consistency, incremental budgeting is frequently criticized for a number of underlying flaws. The primary potential disadvantages of such a budgeting method are as follows:
1. Promotes unnecessary spending
Incremental budgeting can result in unnecessary spending for a company. The reason behind this is that the departments within a company generally tend to spend all the money that they’ve been allocated in a budget one year in order to obtain a greater amount of money in the next budgeting period. Incremental budgeting takes the position of increasing each part of the budget by a certain amount each year. However, some departments may not, in fact, need more money each year – but they will be allotted an increase anyway, simply because that’s how the budgeting process works. In this way, the budgeting process may be wasteful and less than optimally efficient.
2. Discourages innovation
This type of budgeting may discourage the production of innovative ideas and growth. Since new budgets are based on figures from previous budgets, there is a little room for the financing of completely new ideas or activities. Thus, the budgeting process discourages the implementation of new ideas and fosters a conservative business environment.
3. Fails to account for changes and external factors
The key assumption behind incremental budgets is the constant stability of the company’s operations. Therefore, the budgets are typically not responsive to potential changes that can result from unforeseen circumstances or some unanticipated factors.
4. Lacks an incentive for a comprehensive review
The stability of incremental budgets does not provide any incentives to the company’s management for reviewing its budgets with a view to realizing savings in expenditures. The lack of a review process makes budgets vulnerable to waste, inadequate assumptions, and mistakes.
Simplicity and consistency are the primary advantages of incremental budgeting. However, this budgeting technique can lead to adverse effects in the long term (as discussed immediately above).
The conservatism of this budgeting method, as well as its inflexibility and resulting inability to adjust to internal and external changes, imposes potentially problematic limitations on companies operating in today’s fast-paced business environment.
Generally, incremental budgeting is best applied only if you are confident that the company’s budgets will remain stable in the long term, with only minimal changes. In other cases, it is recommended to use more sophisticated budgeting techniques.