Incremental Budgeting is a type of budgeting method that uses either the previous year’s budget or the actual results to prepare the new budget. Under this method, a company makes marginal changes to the previous year’s budget or the actual results to come with a budget for the current period.
Though it is a simple approach, most professionals don’t recommend it. Such a type of budgeting is suitable for companies with fix funding needs or with little changes.
- Why go for Incremental Budgeting?
The Theory of Budgetary Incrementalism (by Aaron Wildavsky in the 1960s) is the basis of incremental budgeting. The theory assumes that department heads are responsible for the budget process and that the budget is revised annually with an increment. This theory remained popular until 1984.
Why go for Incremental Budgeting?
Management goes for incremental budgeting if it does not want to spend too much time preparing budgets. Also, businesses go for this approach if they don’t feel the need to carry thorough re-evaluation of the operations.
One can say that lack of competition in the segment is one major reason inspiring companies to go for this approach. Since there is no competition, a company doesn’t feel the urge to do anything extra. So, it continues with a similar budget.
Easy to implement
Being easy to implement is a major reason why businesses go for this approach. Also, it does not require a lot of detailed analysis like other budgeting techniques.
Incremental Budgeting favors the programs or projects that require funding for multiple years. The approach ensures that the funding keeps flowing to the program.
This approach makes sure that the departments operate on a consistent basis. Also, it leads to fewer conflicts if all the departments are treated similarly.
Easy to see the impact of change
Budgets are mostly the same year after year under this approach. But, if management makes any change made to it, one can easily identify it by comparing it with earlier budgets.
Leads to extra spending
This is the biggest disadvantage of this approach. It is a known fact that each department tries to get as much as it can to fund its operations. So, if incremental budgeting is in use, the department will try to spend as much money as they possibly can to ensure that they get a similar amount for the next budget.
Don’t consider changes
This approach assumes that everything stays the same as last year with minimum changes. Thus, it fails to take into account the changing circumstances.
Managers, when using this approach, factor in little revenue growth but more expenses. They do this to ensure they always get favorable variances.
No review of the budget
When a similar budget is carried forward next year, those who review the budget have little incentive to carry out a comprehensive check. This leads to inefficiencies rolled into the new budget as well.
Different from actual
When a company uses a previous year’s budget for the new budget, the difference between the budget and actual results increases. For instance, the budget for year 1 was $1000, but actual spending was $1800. On the basis of incremental budgeting, the year 2 budget could be $1100, but actual spending was $2000. In this way, if the budget and actual spending don’t match, the difference may widen.
Waste of resources
Suppose the previous budget allocates a certain sum to a specific business unit. Then, the new budget will also allot funds to the same unit even if the unit doesn’t need it or needs a lesser amount.
Hampers potential growth
As the budget allocates funds in a similar way year after year, it often gets difficult to get funds for the new activities. This leads to a conservative business environment that kills innovation and risk-taking.
Based on unreal assumptions
This budgeting method assumes that there is no need to analyze the objectives and activities of the department. Also, it also assumes no significant change in policy and financing approach.
Overall, it can be said that though incremental budgeting is easy to implement, it has the potential to destroy the business in the long term. To avoid such a fate, a business must thoroughly analyze its income and expenses (both current and future) and make the budget accordingly.