Incremental budgeting is an important part of management accounting based on the premise of making a small change to the existing budget for arriving at the new budget. Only incremental amounts are added to arrive at the new budgeted numbers.
Budget used for the current fiscal year becomes the base for working on the forthcoming year’s budgetary allocation. The management assumes that all departments will continue to operate at their current level of expenditure and cases where any additional amount is required will be added to arrive at the next year budgeting estimates. Cases, where expenditure may be lesser, will cause the budget reduction from the current year base amid certain assumptions.
There is no fixed formula to arrive at the incremental budget, however, there is an approach that is followed. The approach for incremental budgeting starts with an assumption that the expenditures incurred in the previous year will be the starting point of estimates for the current year. An insight into the advantages and disadvantages of incremental budgeting may help understand the concept in a better way.
Advantages of Incremental Budgeting
- This method of budgeting is very easy to implement and does not entail any complex calculations. This can be achieved for various departments without much issue as one does not need any detailed analysis irrespective of the department in consideration.
- Incremental budgeting ensures continuity of funding for the departments without much detailed analysis of funding requirement.
- Incremental budgeting approach ensures no large deviations are seen in the budget year after year as it gradually changes the budget requirement. With this type of budgeting, a company is likely to have stable budgets year on year.
- Incremental budgeting is been used as a technique by many companies to help eliminate rivalry or build the value of equality among departments as all departments are given a similar amount of increase over previous year.
- The impact of the change can be seen immediately in case of incremental budgeting.
- Incremental budgeting is suitable for companies where funding requirements are usually fixed or with little deviation.
Despite multiple advantages, incremental budgeting has its own limitations which are listed as under:
Disadvantages of Incremental Budgeting
- It usually is incremental in nature since it assumes that this years’ requirement is likely to be marginally different from the previous year. However, in reality, there may be major structural changes with respect to the company, industry or economy which may warrant much more significant budget changes.
- This approach may tend to make managers spend more as budgets may be easily available and may lead to unnecessary spending of funds which may not be warranted.
- Since this method assumes a slight change in budgetary allocations forms prior period, it assumes that method of working shall remain the same. This may lead to the lack of innovation and no incentive for managers to reduce the cost.
- Incremental budgeting subconsciously encourages higher spending so that the budget is maintained next year.
- Incremental budgeting may cause management to lead into a scenario called as budgetary slack, whereby managers tend to build lower revenue growth and higher expense growth so as to have favorable variances.
- “Disconnect from reality” is what is frequently seen in cases of incremental budgeting as actual results many times tend to be different from budgeted as budgets were based on a prior year benchmark and not on projected/forecast requirements.
- Incremental budgeting can cause perpetual resource allocation to certain departments even if they may not require them in later years. Since funds were allotted in one of the years, incremental budgeting will allocate same or similar amounts in all coming years thereby causing waste of resources or depriving other units of funding requirements.
- Since budgets allocated are more or less the same over years; it turns the business to run into conservative mode as departments or units who wish to take larger risk may not be made the required funding available as the funds may be allocated to many units which may not require.
Conclusion: To sum up, one can say that incremental budgeting though very easy to compute and implement, it comes with larger limitations. It may lead a company to get into a non-innovating conservative mindset which may not be suitable for companies in all industries.
For companies that have steady budgets which seldom change over years may very well opt for an incremental budget. However, it would be appropriate to undertake a complete assessment of funding requirement as in the case of more advanced budgeting techniques like zero-based budgeting and then arrive at the budgetary allocations in today’s dynamic industry scenario.