Incremental budget

What Is Incremental Budget?

Incremental budgeting is a financial management approach where a new budget is prepared by taking the current period's budget or actual performance as a baseline and then adding or subtracting incremental amounts to account for anticipated changes. These adjustments typically reflect factors such as inflation, expected growth, or new initiatives. This method falls under the broader category of budgeting techniques and is known for its simplicity and the stability it offers to an organization's financial planning process. Unlike more radical budgeting methods, incremental budgeting assumes that the existing operations and associated costs are generally acceptable and will continue into the next period, requiring only marginal modifications. It provides a sense of funding stability by allowing departments to anticipate consistent resource allocation.

History and Origin

The concept of budgeting, in a rudimentary form, can be traced back to ancient civilizations like Mesopotamia, Greece, and the Roman Empire, where records of agricultural output and distribution were kept to manage resources²⁵. However, the modern form of budgeting, particularly in a governmental context, began to take shape in England around 1760 when the Chancellor of the Exchequer presented the national budget to Parliament to control public spending²⁴. In the United States, governmental budgeting was initiated by President William Howard Taft in 1911, laying a foundation for its adoption in the business world²³.

As organizations grew in complexity, so did their need for financial planning and cost control. Incremental budgeting emerged as a pragmatic and straightforward method, building upon existing financial frameworks. This approach became prevalent due to its ease of implementation, especially in large and stable entities where drastic changes to existing expenditure were less frequent. It became a traditional method for many businesses and government agencies, serving as a precursor to more dynamic budgeting systems that would develop later.

Key Takeaways

• Incremental budgeting uses the prior period's budget as a starting point, adjusting it for minor changes.
• It is valued for its simplicity, consistency, and the predictable adjustments it allows for.
• This method can perpetuate inefficiencies and discourage innovation if past spending is not critically reviewed.
• It is commonly applied in stable environments, such as government agencies and large, established organizations.
• Adjustments often account for inflation, anticipated growth, or specific, minor new expenditures.

Formula and Calculation

Incremental budgeting does not rely on a complex mathematical formula in the traditional sense, but rather a straightforward adjustment process. The basic premise involves taking the previous period's budget and applying incremental changes.

The general approach can be represented as:

Where:

• Previous Budget: The actual expenditures or approved budget from the most recently completed period.
• Incremental Adjustments: Additions or subtractions based on anticipated changes. These changes can include:
  • Inflationary increases: Accounting for rising costs of goods and services.
  • Volume changes: Adjustments for increased or decreased activity levels.
  • New initiatives/projects: Funding for new programs or expansions.
  • Efficiency gains/cuts: Reductions due to identified savings or forced cuts.

For example, if a department's expenditure for the last year was $100,000, and a 3% increase is anticipated due to inflation and a 2% increase for a new, small project, the incremental adjustment would be 5%. The new budget would then be $105,000. This process makes financial planning relatively simple.

Interpreting the Incremental Budget

Interpreting an incremental budget primarily involves understanding the deviations from the previous period's financial allocation. Since the fundamental assumption is that existing operations will continue, the focus shifts to justifying the "increment" or "decrement." If a department requests a significant increase, the justification needs to clearly outline the new initiatives, increased operational demands, or external factors like inflation that necessitate the additional funds. Conversely, a proposed decrease might indicate efficiency improvements or discontinued activities.

The interpretation also involves assessing whether the small, year-over-year changes align with the organization's broader strategic planning and organizational goals. While the method provides stability, a lack of deep scrutiny in the incremental budgeting process can obscure underlying inefficiencies or missed opportunities for more significant cost reductions or strategic reallocations. Managers should evaluate if these incremental shifts are sufficient to support future growth or necessary adjustments in a dynamic market.

Hypothetical Example

Consider a small manufacturing company, "Widgets Inc.," that uses incremental budgeting for its annual financial planning. For the current fiscal year, the marketing department had a budget of $200,000.

For the upcoming fiscal year, the finance team and the marketing department collaborate on the incremental budget. They identify the following anticipated changes:

1. Inflation Adjustment: A general inflation rate of 3% is expected to impact all operational costs.
2. Increased Digital Advertising: The company plans to increase its spending on digital advertising by an additional $5,000 to reach a wider online audience.
3. Trade Show Reduction: Due to a shift in strategy, the company will attend one less trade show, resulting in a saving of $2,000.

Here's how the incremental budget would be calculated:

• Previous Year's Marketing Budget: $200,000
• Inflationary Increase: $200,000 * 0.03 = $6,000
• Increased Digital Advertising: +$5,000
• Trade Show Reduction: -$2,000

New Marketing Budget Calculation:
$200,000 (Previous Budget) + $6,000 (Inflation) + $5,000 (Digital Advertising) - $2,000 (Trade Show Reduction) = $209,000

The new marketing budget for Widgets Inc. would be $209,000. This example demonstrates how the incremental budget builds upon the previous year's figures with relatively minor, justified adjustments, providing a predictable and stable budget for the marketing department's operations. The process allows for easy tracking of changes and ensures accountability for the increases or decreases.

Practical Applications

Incremental budgeting finds its most practical applications in environments that value stability and predictability, often where operations are mature and changes are gradual.

• Government Agencies: Many government bodies, from local to federal levels, frequently employ incremental budgeting. This is because public services tend to be ongoing, and large portions of their budgets are tied to existing laws and commitments. For instance, the U.S. Government Accountability Office (GAO) regularly reports on federal spending, which often reflects incremental increases in various departments and programs year over year. In fiscal year 2019, the federal government obligated over $586 billion through contracts, an increase of more than $20 billion from the previous year, with spending on services for national defense as a significant driver²². This method helps maintain consistent public service delivery and allows for predictable adjustments to departmental allocations.
• Large Corporations: Established large corporations with stable business models and extensive departmental structures also use incremental budgeting. It allows for consistent resource allocation across numerous divisions without requiring a complete overhaul each budget cycle. This simplifies the budget preparation process and helps maintain operational continuity.
• Educational Institutions: Universities and school districts often utilize incremental budgeting due to their relatively stable core activities and predictable annual changes, such as adjustments for faculty salaries or minor program expansions²¹.
• Non-Profit Organizations: For non-profits with consistent programs and funding streams, incremental budgeting can be an efficient way to manage their finances and ensure the continuation of their services.

While its simplicity makes it attractive, the effectiveness of incremental budgeting in dynamic environments is often debated.

Limitations and Criticisms

Despite its widespread use, incremental budgeting faces several significant limitations and criticisms:

• Perpetuation of Inefficiencies: A primary criticism is that incremental budgeting assumes the previous budget is efficient and accurate¹⁹, ²⁰. This can lead to the continuation of outdated spending patterns and inefficiencies being carried forward year after year without thorough review¹⁶, ¹⁷, ¹⁸. Departments may not have an incentive to reduce costs if they know their budget will simply be adjusted from the prior year's level¹⁵.
• Discourages Innovation and Flexibility: Because new budgets are based on past figures, there is often little room for financing entirely new ideas or activities, potentially stifling innovation and growth¹⁴. This approach works best in stable environments and may not provide the flexibility needed in rapidly changing industries or during periods of significant organizational transformation¹³.
• Lack of Comprehensive Review: Incremental budgeting can lead to complacency, as it doesn't necessitate a thorough evaluation of all expenses¹². Managers may not feel compelled to justify existing costs, only the incremental changes¹¹. This can result in "budget creep," where small, unchecked increases accumulate over time, potentially leading to overspending⁹, ¹⁰.
• Potential for "Spend It or Lose It" Mentality: Departments might be incentivized to spend their entire allocated budget, even if unnecessary, to avoid having their budget reduced in the next cycle, based on the assumption that unspent funds indicate less need⁸. This can lead to wasteful spending at the end of a fiscal period.
• Limited Analytical Depth: The method's focus on minor adjustments may not provide the deep analysis required to uncover significant cost-reduction avenues or to optimize resource efficiency⁷. This can restrict an organization's capacity for strategic capital allocation.

These drawbacks highlight why organizations in dynamic industries or those seeking significant operational improvements often explore alternative budgeting methods that demand a more rigorous examination of all expenses. ACCA Global, a professional accounting body, notes that incremental budgeting "assumes that all current activities and costs are still needed, without examining them in detail"⁶.

Incremental Budget vs. Zero-Based Budgeting

Incremental budgeting and zero-based budgeting (ZBB) represent two fundamentally different approaches to financial planning, particularly in their starting points and the level of scrutiny applied to expenses.

Incremental budgeting relies on historical data and assumes that past expenses are a reasonable guide for future needs, making minor adjustments for inflation or known changes⁵. This provides stability and is easier to implement, often leading to predictable cash flow projections.

In contrast, zero-based budgeting requires that every line item in the budget be approved, rather than just changes from the previous year. Managers must justify every expense from a "zero base," demonstrating its necessity and alignment with organizational goals for each new budget cycle. Peter Pyhrr developed ZBB in the 1970s, and it gained prominence as a tool for cost reduction and increased accountability⁴. While more labor-intensive, ZBB can lead to greater efficiency and more strategic resource allocation by forcing a comprehensive review of all activities³.

FAQs

Q1: What is the main advantage of incremental budgeting?
The main advantage of incremental budgeting is its simplicity and ease of use. It saves time and effort compared to other methods because it builds on existing financial frameworks with minor adjustments, leading to consistency and stability in financial planning.

Q2: Can incremental budgeting be used for personal finance?
While more commonly associated with businesses and governments, the underlying principle of incremental budgeting can be applied to personal finance. An individual might take last month's spending as a baseline and adjust it for expected changes like a raise, a new recurring bill, or a planned large purchase. However, for a detailed financial overhaul, other personal budgeting strategies might be more effective.

Q3: Does incremental budgeting account for inflation?
Yes, incremental budgeting does account for inflation. The "incremental amounts" added to the previous budget typically include adjustments for factors like inflation, anticipated increases in sales prices, and costs².

Q4: Is incremental budgeting suitable for all types of organizations?
No, incremental budgeting is not suitable for all types of organizations. It is best suited for stable organizations, educational institutions, and government bodies that experience minor year-over-year variations¹. Organizations in rapidly changing industries or those undergoing significant transformation may find its lack of flexibility and tendency to perpetuate inefficiencies a disadvantage, requiring a more dynamic approach to financial management.

Q5: How does incremental budgeting relate to management accounting?
Incremental budgeting is a tool within management accounting that helps organizations with internal planning, control, and decision-making. Management accounting focuses on providing financial and non-financial information to internal users to aid in operational and strategic choices, and incremental budgeting is one method for developing future financial plans based on historical data and expected changes, contributing to aspects like performance metrics and profitability tracking.