Incremental forecast

What Is Incremental Forecast?

An incremental forecast is a financial planning approach where future projections are developed by making small, often percentage-based, adjustments to previous period's actual results or existing budgets. This method assumes that an organization's operations and external environment will remain relatively stable, allowing for a continuation of past trends with minor modifications. It is a core component within the broader field of Financial Planning and Analysis (FP&A), providing a streamlined way to anticipate future financial outcomes without a complete re-evaluation of every line item. Unlike more complex forecasting methods, the incremental forecast relies heavily on Historical Data as its foundation, making it a familiar and often straightforward tool for businesses, especially for Budgeting purposes.

History and Origin

The practice of forecasting has ancient roots, with early forms of prediction used for agricultural planning and trade in civilizations like the Babylonians and Egyptians⁷². However, modern economic and business forecasting, underpinned by statistical methods, gained prominence in the 19th and 20th centuries⁷⁰, ⁷¹. The concept of incremental budgeting, which heavily influences incremental forecasting, became widely adopted, particularly by large, stable companies. Pioneers in economic forecasting, such as Roger Babson in the early 20th century, built businesses around predicting economic activity based on discernible patterns and past performance, forming the bedrock for data-driven financial projections⁶⁸, ⁶⁹. Their work fostered the idea that business activity, much like weather, followed cycles that could be anticipated, leading to the development of methods that made small adjustments to established figures rather than starting anew⁶⁷. This approach simplified the forecasting process and provided a sense of predictability in turbulent economic times⁶⁵, ⁶⁶.

Key Takeaways

• An incremental forecast builds upon previous financial results or budgets by applying minor adjustments.
• It is known for its simplicity and ease of implementation, making it a popular choice for stable organizations.
• The method assumes a continuation of existing operations and market conditions.
• It provides a consistent and predictable view of future financial needs and Financial Performance.
• While efficient, it can overlook the need for a comprehensive review of expenditures and may discourage innovation.

Formula and Calculation

The incremental forecast does not adhere to a single complex mathematical formula but rather involves an adjustment process applied to prior period figures. The calculation is typically straightforward, taking a previous period's actuals or budget and applying an incremental increase or decrease.

For example, for a specific expense line item:

Or for revenue:

Where:

• Previous Period's Expense/Revenue: The actual cost incurred or revenue generated in the prior period, or the budgeted amount from the prior period.
• Adjustment Percentage/Growth Rate: A percentage increase or decrease applied based on anticipated changes due to factors such as inflation, market conditions, or policy changes⁶⁴.

For instance, if a company's Expense Management for marketing was $100,000 last year, and they anticipate a 5% increase due to inflation and planned activities, the incremental forecast for the marketing budget would be: $100,000 * (1 + 0.05) = $105,000⁶³. This process is repeated across all relevant line items, such as Revenue Forecasting, fixed costs, and variable costs, to build a complete future projection⁶².

Interpreting the Incremental Forecast

Interpreting an incremental forecast primarily involves understanding that it reflects a projection based on the premise of consistency and gradual change. When reviewing an incremental forecast, stakeholders should look for the percentage changes applied to each line item and the underlying assumptions that justify those changes. A higher-than-usual incremental adjustment might signal anticipated market shifts or new initiatives, while a flat or slightly increased forecast suggests stability in operations and Resource Allocation.

Since the incremental forecast is built on historical patterns, its accuracy depends on the stability of the operating environment. It provides a benchmark for evaluating Financial Performance by allowing for easy comparisons between budget periods⁶¹. Deviations from the incremental forecast necessitate a closer look at the factors driving the variance, helping management understand if performance is better or worse than expected.

Hypothetical Example

Consider "TechSolutions Inc.," a software company preparing its annual budget for the upcoming fiscal year. Historically, their primary operating expense has been Research & Development (R&D).

Last year's R&D expenditure: $5,000,000

TechSolutions Inc. decides to use an incremental forecast approach. Management anticipates a 4% increase in R&D costs due to expected salary increments and a slight expansion of their development team.

Step-by-step calculation for the R&D incremental forecast:

1. Identify the baseline: Last year's R&D expenditure of $5,000,000.
2. Determine the incremental adjustment: A 4% increase.
3. Apply the adjustment:
   $5,000,000 * 0.04 = $200,000
4. Calculate the new forecast:
   $5,000,000 + $200,000 = $5,200,000

So, TechSolutions Inc.'s incremental forecast for R&D expenditure for the upcoming year is $5,200,000. This straightforward adjustment helps maintain Financial Stability and aligns with the company's Strategic Planning to grow steadily without radical shifts in spending. They would apply similar incremental adjustments to other budget line items, such as sales and marketing, administrative costs, and revenue projections, to form their complete financial plan.

Practical Applications

The incremental forecast method is widely applied across various aspects of business and financial management due to its simplicity and stability.

• Corporate Budgeting: Many established companies use incremental forecasting as the basis for their annual Budgeting cycles. It is particularly prevalent in organizations with relatively stable Cost Structure and predictable revenue streams, as it simplifies the process and allows for efficient Resource Allocation⁵⁹, ⁶⁰.
• Operational Planning: Departmental managers often use incremental forecasts to plan their operational expenses and allocate resources for the upcoming period. This ensures continuity and avoids significant disruptions to ongoing activities⁵⁸.
• Performance Monitoring: The incremental forecast provides a baseline against which actual financial results can be compared. This facilitates Variance Analysis, helping identify deviations and understand the drivers of financial performance⁵⁷.
• Government and Non-Profit Organizations: These entities often operate with relatively fixed funding and established programs, making incremental forecasting an effective tool for managing public funds and consistent service delivery.

In modern Financial Planning and Analysis, while new technologies and methodologies are emerging, the need for robust financial models remains critical⁵⁵, ⁵⁶. CFOs are increasingly leveraging AI and data analytics to enhance forecasting accuracy, but the fundamental principles of understanding past performance, which underpins incremental forecasting, remain relevant⁵³, ⁵⁴.

Limitations and Criticisms

Despite its widespread use and perceived simplicity, the incremental forecast approach has several limitations and criticisms:

• Encourages Unnecessary Spending: A primary criticism is that it can lead to "budgetary slack" or "use it or lose it" mentality. Departments might spend their entire allocated budget, regardless of actual need, to ensure they receive at least the same, or an increased, amount in the next period⁵⁰, ⁵¹, ⁵². This can lead to inefficient Resource Allocation and stifle efforts towards cost reduction.
• Discourages Innovation and Efficiency: By focusing on minor adjustments to the status quo, incremental forecasting may discourage a thorough review of existing processes and limit the incentive for innovative ideas or significant operational improvements⁴⁸, ⁴⁹. It does not inherently challenge whether current spending is optimal or if new, more efficient approaches exist⁴⁷.
• Fails to Account for Significant Changes: The fundamental assumption of stability in incremental forecasting makes it less suitable for dynamic environments or during periods of rapid market shifts, economic downturns, or technological disruptions⁴⁴, ⁴⁵, ⁴⁶. It may not adequately incorporate the impact of major external factors, such as shifts in Economic Indicators or unforeseen events⁴², ⁴³.
• Perpetuates Inefficiencies: If a prior budget contained inefficiencies or outdated assumptions about the Cost Structure, these can be carried forward year after year through incremental adjustments, leading to a waste of resources in the long term⁴⁰, ⁴¹.
• Lack of Justification: Because it builds on the previous period, there is often less emphasis on providing detailed justification for each line item in an incremental forecast, as the numbers are inherited³⁹.

Critics argue that while forecasting and planning are crucial for decision-making, an over-reliance on static, incremental approaches can hinder a company's agility and responsiveness in a dynamic business world³⁷, ³⁸. This conservative approach may impede a business's capacity to identify cost-reduction opportunities and maximize resource efficiency³⁶.

Incremental Forecast vs. Rolling Forecast

The incremental forecast and the Rolling Forecast are both methods used in financial planning, but they differ significantly in their flexibility and responsiveness to changing conditions.

While an incremental forecast provides stability and ease of implementation, a rolling forecast offers greater agility and accuracy in volatile markets by continuously updating projections based on the latest information¹², ¹³. Many organizations now adopt a hybrid approach, combining the stability of a fixed annual budget with the flexibility of a rolling forecast to ensure both long-term goal setting and real-time responsiveness¹¹.

FAQs

What is the main advantage of an incremental forecast?

The main advantage of an incremental forecast is its simplicity and ease of implementation. It saves time and resources by building upon previous figures rather than starting from scratch, promoting consistency and operational stability⁸, ⁹, ¹⁰.

When is an incremental forecast most appropriate?

An incremental forecast is most appropriate for organizations operating in stable environments with predictable revenues and expenses, and where significant changes in operations or market conditions are not anticipated⁵, ⁶, ⁷. It is often used by mature businesses with established Financial Models.

Can an incremental forecast incorporate new initiatives?

Yes, an incremental forecast can incorporate new initiatives, but these would typically be treated as specific adjustments or additions on top of the existing baseline. However, it might not encourage the same level of detailed review or Risk Management for new projects compared to other methods that require a ground-up justification.

How does an incremental forecast relate to budgeting?

Incremental forecasting is a common method used to create a Budgeting plan. It takes the previous period's budget or actuals as a starting point and makes minor adjustments for the new budget period³, ⁴. This contrasts with methods like zero-based budgeting, which requires every expense to be justified from scratch.

What are the risks of relying solely on an incremental forecast?

Relying solely on an incremental forecast can lead to inefficiencies, stifle innovation, and make it difficult for an organization to adapt to significant market changes or unforeseen events. It can also perpetuate outdated spending patterns and limit the ability to optimize Key Performance Indicators¹, ².