Incremental Budgeting
A method of budgeting that is based on the previous budget.
What Is Incremental Budgeting?
Incremental Budgeting refers to the method of budgeting that is based on the previous budget. Creating a new budget by making little adjustments to the existing one is known as incremental budgeting. An incremental budget starts with the budget for the current year as a baseline and makes incremental adjustments from there.
Incremental Budgeting is considered to be the most traditional and conservative form of budgeting. In this type of budgeting, Accountants usually use the previous budget as a basis for creating a new one. It is one of the many budgeting methods available in the accounting field.
To form the current budget, some items are removed and added from the previous one.
Therefore, the previous budget is an essential document that provides essential information required in the future budget.
The main benefits of incremental budgeting are simplicity and consistency. However, as was already mentioned above, this budgeting strategy may have unfavourable long-term repercussions.
In general, you should only use incremental budgeting if you are certain that the company's budgets will be steady over the long term with only minor fluctuations. It is advised to employ more advanced budgeting strategies in such situations.
Budgeting is indeed an old practice that has been around for decades. However, the evolution of the budgeting process led to the rise of different kinds of budgeting processes that companies use today.
Key Takeaways
- An incremental budget is easy to make and is considered the traditional form of budgeting. This means it does not take a lot of effort and time to make. A few people with minimal expertise can also do it.
- Incremental budgeting takes much less time to construct than other forms of budget.
- Incremental budgets are much easier to understand because of their structure and what it consists of. An Incremental budget takes input from the previous budget, which makes it easy to follow.
- There is less opportunity for conflict of interest among the stakeholders. A company is a system of several independent units that coordinate with each other to achieve one goal. These units that work together in a company are called departments.
- An Incremental Budgeting system assumes that the previous cost and projected expenditure will be needed. The main argument against this budgeting system is that it does look into the necessity of entry.
- The other problem with this traditional form of budgeting is that there is no justification for the figures. But again, this is because the numbers are inherited and are based on the previous budget.
- This budgeting system does not encourage managers to cut costs and spending.
Importance of Incremental budgeting
Budgeting is a crucial element in business and finance. It has a great bearing on the profitability and success of a business.
The budgeting process is a crucial element of management control systems. This is because it provides a method of planning, coordination, and control for a business or management. Companies from all over the world benefit from the budgeting process.
It comes as no surprise that the budgeting process is a demanding one, and the people involved typically feel uncomfortable. In addition, it should be noted that budgeting in the public sector can be even more difficult.
The reason why this is true is that Public institutions tend to have complex objectives. Therefore, the organization's objective is more difficult to determine in a quantifiable manner than the objectives of a private company.
This is true because publicly owned or state-owned organizations have different corporate governance compared to private companies.
The goals of a private company may be to maximize sales and profits for the shareholders. On the other hand, a state-owned organization like an energy company aims to make energy affordable to ordinary citizens and generate income to keep the institution alive.
Note
It can be very difficult to develop an incremental budget for Public or State-owned enterprises due to the complexity of their objectives.
Advantages of Incremental Budgets
All types of budgeting have their advantages and disadvantages.
The following are the advantages of the method.
1. Easy to make
This type of budget is easy to make and is considered the traditional form of budgeting. As a result, it does not require much effort or time. A few people with minimal expertise can also do it.
It is true because the previous company budget serves as the base for the next budget. Therefore, there is no need to start coming up with new estimates for each department because the previous budget already has the figures upon which a new budget can be developed.
2. Takes less time to develop
Incremental budgeting takes much less time to construct than other forms of budget. For instance, the Activity Based Budget is one of those budget systems that require a lot of time and effort to construct.
Therefore, this budget is usually preferred because of this characteristic. This is because companies can spend minimal time constructing a cost-effective budget. This is advantageous, especially if the company is cutting costs.
3. Easy to Understand
Incremental budgets are much easier to understand because of their structure and content, which are figures from the previous budget.
Note
An Incremental budget takes input from the previous budget, which makes it easy to follow.
4. Less conflict
There is less opportunity for conflict of interest among the stakeholders. A company is a system of several independent units that coordinate with each other to achieve one goal. These units that work together in a company are called departments.
It is because of these departments that conflicts of interest arise in a company. However, Incremental budgeting has little chance of conflict among departments because it offers consistency in the budget under the previous budget.
5. Change is visible
Incremental budgets are designed in a manner in which change is noticeable in the actual budget. This makes monitoring and auditing easy.
Example: The Sales department had a budget allocation of $230,000 in 2022 but now has a $312,000. It becomes easy to find the difference and audit it.
Disadvantages of Incremental Budgeting
Incremental budgeting also has a downside.
The following are the disadvantages of this type of budget.
1. It is based on the previous cost and expenditures.
The main flaw with this budgeting system is that it assumes that the previous cost and projected expenditure will be needed. In other words, it is assumed that the company will need the previous figures. Therefore, the main argument against this budgeting system is that it does look into the necessity of entry.
In other words, it doesn't consider whether a particular entry cost or expenditure is necessary. For example, if the company had spent $300,000 on raw materials, the current budget may still reflect the exact amount without inquiring into detail.
2. There is a lack of justification for the estimates
The other problem with this traditional form of budgeting is that there is no justification for the figures. It is because the numbers are inherited and are based on the previous budget. Therefore, the numbers are assumed to be necessary even when that is not the case.
Therefore, this type of budgeting has been criticized for being wasteful and unjustified.
A good example is a company's previous cost of the marketing department. The company that uses this form of budgeting may not fully question the whole estimates of the marketing department.
3. It encourages overspending
This type of budgeting does not encourage managers to cut costs and spending. Usually, managers prefer to spend all the allocated funds fearing the consequence of remitting money.
Note
Incremental budgeting does not incentivize cost-cutting by managers. Hence, Managers tend to spend all the money they are allocated in fear of getting a lower budget allocation next time.
4. Lack of efficiency and high-performance
Incremental budgeting also tends to create a lack of high performance. This is because Managers premise their goals on previous performance. Hence, every employee feels they have achieved it all.
There is no evaluation of previous performance, current performance is based on last glory, and managers feel they deserve the addition to their budget estimates.
Note
Inefficiencies from the previous budgets are not addressed and are carried forward to the next budget. This is one of the major criticisms of this Incremental budget.
Other Types of Budgeting
Alternative to an Incremental budget, there are other budgeting systems that companies adopt. Many companies use alternative budgeting systems. Alternative budgets are common, especially at the corporate level but also in Public institutions.
These different types of budgets are unique and have special features. The alternative budgets differ from the traditional Incremental budget system and have different advantages and disadvantages.
The list of the budgets we will look at include
- Zero Budget System
- Activity Based Budget
These budgets are the evolutionary product of the traditional budget system. This means that due to the inefficiency of the Incremental Budget system, alternative budget systems were developed to meet the needs that the traditional budget could not give.
The main issue with the traditional form of budgeting is that there is no justification for the figures that grace the budget. However, since the numbers are inherited and based on the previous budget, alternative forms of budget systems have become common.
Note
Budgeting variations are derived from Incremental budgeting, which is ae traditional form of budgeting.
The following are the alternatives to this traditional budgeting system.
Zero-Based Budgeting
Zero-based budgeting is a budgeting process that starts from ground zero. There is no consideration being made to the previous budget or actual rendition. This is the opposite of traditional budgeting, which relies on previous estimates.
Therefore, all estimates start with a zero balance as opposed to Incremental budgeting, where all entries start with a proportion equal to the previous year's budget.
It has been argued that this form of budgeting process removes most of the deficiencies of this budgeting incremental in nature. Below are the benefits of Zero-Based budgeting:
- Every department's function is reviewed exhaustively, with all expenditures needing approval. In addition, all entry costs and expenditures are evaluated and are not justified by the previous budget.
- It challenges the present figures and enables employees to question the necessity of the figures.
- It is realistic because it adapts to the changes from year to year.
The disadvantages of this type of budgeting are as follows:
- It is costly. Managers require skill and training to be able to construct a budget system. This type of budget is challenging to construct.
- It takes considerable time to come up with. This is because all previous numbers are disregarded. Therefore, the budgeting team involved in the process may take some time to develop the budget draft.
Note
The Zero budget system starts with a zero balance. It starts its estimates from nothing.
Activity-Based Budgeting
The Activity-Based Budget system is another alternative to the traditional budgeting approach. As the name suggests, it includes all activities the company or institution wants to do.
The process is based on activity-costing. Activity-costing is an act of tagging a cost to an activity that is to be taken by a company. Activity-based budgeting is based on overhead activities and their concerned costs.
This budgeting system assumes that activity costs may be manageable if the magnitude of each activity is governed.
This is different compared to traditional budgeting systems, namely Incremental budgets that focus on input costs. On the contrary, Activity-Based Budgeting takes an output-based strategy.
Note
Activity-Based Budget assumes that a business is a compilation of activities.
The following are the advantages of Activity-Based Budgeting.
- The cost is questioned and evaluated contrary to the traditional budgeting style. Previous figures are not put into consideration in the current budget.
- Costs are aligned to all activities. Therefore managers need to justify the activity and its estimated costs. In this system, costs not backed by activities are not considered in the budget.
- This budget system allows for greater control of cost planning and volumes of activities. Therefore, this budget system offers greater control of cost management.
Though there are merits to the Activity-Based budget system, there are a few disadvantages:
- This budgeting is a mammoth task that requires tracking activities. The problem is there may be no traditional tracking systems.
- The lack of a tracking system may hamper tracing to activities.
- An Activity-Based budget requires managers and the team to be fully skilled and trained to construct it. Therefore, it is much more difficult than the traditional budget system.
Activity-based budget gets its figures from the activities/projects a company wants to do in the coming year.
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