Incremental budgeting: Meaning, Criticisms & Real-World Uses

What Is Incremental Budgeting?

Incremental budgeting is a traditional approach to financial planning where a new budget is developed by making small, marginal adjustments to the previous period's budget. It is a method within the broader category of budgeting process or Financial Planning & Analysis (FP&A). Rather than starting from scratch, the prior year's budget serves as a baseline, and adjustments are applied to account for factors like anticipated inflation, changes in activity levels, or shifts in strategic planning. This approach emphasizes continuity and uses historical data as a primary guide for future expenditure and revenue projections.

History and Origin

The roots of incremental budgeting are intertwined with the evolution of formal corporate and government budgeting. For many decades, particularly in the mid-to-late 20th century, it became a prevailing practice due to its simplicity and the relative stability of economic conditions compared to more volatile periods. Governments, for instance, have historically relied on building budget plans based on past decisions, making adjustments for expected changes.⁷ This "backward-looking" approach was largely the norm for public sector resource allocation. The establishment of entities like the Congressional Budget Office (CBO) in the United States, created by the Congressional Budget and Impoundment Control Act of 1974, formalized aspects of the federal budgeting process, often involving an incremental approach to analyzing proposed spending against existing baselines.⁶ Similarly, international bodies such as the Organisation for Economic Co-operation and Development (OECD) have developed frameworks for good budgetary governance, which, while promoting sound fiscal policy, have observed the prevalence of budgeting practices that build upon previous periods.⁵

Key Takeaways

Incremental budgeting uses the previous budget as a starting point, making minor adjustments for the new period.
It is generally considered the simplest and least time-consuming budgeting method.
The approach promotes stability and reduces internal conflict by typically allocating similar increases across departments.
It may encourage inefficient spending and discourage innovation, as departments might spend their full allocation to justify a similar or larger budget next year.
External factors like economic shifts or market disruptions can significantly challenge the effectiveness of incremental budgeting.

Interpreting Incremental Budgeting

Interpreting incremental budgeting involves assessing the proposed changes relative to the prior period's budget and understanding the rationale behind those increments. Rather than scrutinizing every line item from scratch, the focus is on the marginal increases or decreases. Analysts evaluate whether the proposed increments are justified by factors such as anticipated inflation, changes in operational volume, or new projects.

For example, if a department requests a 5% increase, the interpretation focuses on why 5% is needed, not necessarily on the entire budget amount itself. This allows for quick reviews and helps maintain continuity in financial management. However, it also requires careful variance analysis to identify deviations from planned increments and to understand underlying performance issues.

Hypothetical Example

Consider a small manufacturing company, "Alpha Components," preparing its budget for the upcoming fiscal year. In the current year, the marketing department's approved budget was $100,000. Under an incremental budgeting approach, the marketing manager might propose a 3% increase for the next year, citing expected inflation and a slight increase in advertising costs.

Here’s a step-by-step breakdown:

Current Year Budget: Marketing Department = $100,000
Proposed Increment: 3% increase
Calculation: ( $100,000 \times 0.03 = $3,000 )
New Budget: ( $100,000 + $3,000 = $103,000 )

The marketing department's budget for the next year would be $103,000. This process is straightforward and relies heavily on the previous period's figures as the baseline, with minimal adjustments. The justification would primarily focus on the need for the additional $3,000, rather than a full re-evaluation of the entire $103,000. This method streamlines the budgeting process for Alpha Components.

Practical Applications

Incremental budgeting is widely used across various sectors, including corporate finance, government agencies, and non-profit organizations, primarily due to its simplicity and ease of implementation.

Corporate Finance: Many businesses, especially stable ones, use incremental budgeting to manage their annual financial planning. It allows for quick adjustments based on expected economic changes or minor shifts in operations. It is often favored for routine departmental budgets, such as administrative or maintenance costs, where significant changes are not anticipated. This helps in maintaining cost control without extensive re-evaluation.
Government Budgeting: Public sector entities often employ incremental budgeting. The federal budgeting process in the United States, for instance, frequently builds upon existing appropriations, with agencies requesting marginal increases for new initiatives or to cover rising costs. The Congressional Budget Office (CBO) plays a role in providing cost estimates for proposed legislation and analyzing the President's budget, which typically reflects incremental changes from prior years.
*⁴ Non-Profit Organizations: Non-profits also utilize incremental budgeting to manage predictable operating expenses. For example, a charity might base its next year's administrative budget on the current year's actual spending, adjusting for anticipated increases in office supplies or staff salaries.

While effective in stable environments, its rigidity can be a drawback during periods of rapid change. For instance, the COVID-19 pandemic highlighted the limitations of traditional budgeting methods, prompting some organizations to consider more agile approaches better suited for dynamic environments.

³## Limitations and Criticisms

Despite its widespread use, incremental budgeting faces several criticisms regarding its potential to hinder efficiency and innovation.

One major drawback is that it can encourage "spending up to the budget." Departments might consume their entire allocated budget, even if not strictly necessary, to ensure they receive at least the same amount—or an increment—in the following period. This behavior can lead to wasteful expenditure and a lack of incentive for cost control or finding efficiencies.

Anot²her limitation is its backward-looking nature. By relying heavily on past figures, incremental budgeting may fail to adapt to significant changes in the operating environment, market conditions, or organizational priorities. It can perpetuate inefficiencies or outdated processes by simply rolling them forward with minor adjustments, rather than forcing a comprehensive review. This makes it challenging to reallocate resource allocation effectively to new, higher-priority areas or to respond to unexpected challenges. Critics argue that it can stifle innovation and proactive strategic planning because it doesn't necessitate a fresh look at departmental needs or the justification of every expense. Furth¹ermore, it can obscure true needs, making it difficult to perform meaningful performance measurement or establish clear accountability for financial outcomes.

Incremental Budgeting vs. Zero-Based Budgeting

Incremental budgeting differs fundamentally from zero-based budgeting (ZBB) in their starting points and underlying philosophies.

Incremental budgeting begins with the previous period's budget and applies small adjustments. It assumes that existing activities and spending levels are justified and only requires justification for changes or increments. This makes the process simpler and less time-consuming, focusing on continuity and marginal adjustments. Organizations using this method typically project future needs based on historical trends and current economic conditions, aiding in straightforward forecasting.

In contrast, zero-based budgeting requires that every line item of the budget be justified from scratch, as if the budget were being built for the first time. No prior assumptions about existing spending are carried forward. Each department must justify its entire budget request annually, demonstrating the need for every dollar. While far more laborious and time-intensive, ZBB aims to eliminate wasteful spending and optimize resource allocation by aligning all expenditures directly with current organizational goals and priorities.

The confusion between the two often arises because both are methods of financial management that aim to control costs. However, their approaches to achieving this goal are diametrically opposed: one builds upon the past, the other starts anew.

FAQs

Why do organizations use incremental budgeting?

Organizations often use incremental budgeting because it is straightforward, easy to implement, and less time-consuming than other methods. It provides stability and continuity by building on previous budgets, which can simplify the budgeting process for departments.

What are the main disadvantages of incremental budgeting?

The main disadvantages include potentially fostering wasteful spending (as departments might spend their full budget to secure future allocations), a lack of motivation for cost control, and a tendency to perpetuate inefficiencies. It can also make it difficult to adapt to significant market changes or reallocate resource allocation effectively.

Is incremental budgeting suitable for all types of organizations?

Incremental budgeting is generally more suitable for stable organizations in predictable environments where costs and operations do not fluctuate significantly. It may be less effective for organizations undergoing rapid growth, facing significant market changes, or those that need to drastically reallocate resources and focus on efficiency.

How does inflation affect incremental budgeting?

Inflation is a common factor considered in incremental budgeting. Budgets are often increased by a certain percentage to account for rising costs of goods, services, or salaries due to inflation, ensuring that the purchasing power of the allocated funds remains relatively consistent.