Every year in every business, budget planning is done on priority. Incremental budgeting is the most commonly applied method to do so. While some budgeting methods are complex, incremental budgeting is simple for businesses. This budgeting approach works best in companies with a steady budget that make a few changes gradually.
Most businesses adopt this approach to budgeting despite its limitations. Let us take a deep dive into the incremental budgeting system, how it works, its example, uses, process, advantages and limitations. Read on!
The key idea behind incremental budgeting is that a new budget can be developed from the previous period’s budgeted results or actual results by making only a few slight changes. The incremental budgeting system uses the previous budget as a base, and incremental adjustments are added to the base amounts to get a new budget.
Incremental budgeting sets the current year’s budget based on the previous year’s actual results after inflation adjustments and other incremental factors. The budget processes are concerned primarily with the addition, not reduction in expenses or operations during the next financial year, as is made clear by the name “incremental” meaning an increase The incremental factors can be increased sales prices and costs of material labour and other inputs.
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For many established companies, the incremental budget system is common and favourable due to its simplistic nature with minimal effort. Generally, an incremental budget is the most effective for companies in a steep competition whose profits are stable from year to year. Usually, a mature’s business growth rate is less volatile than a new company, making incremental budgeting an easy-to-implement system within the scope of the foreseen business growth.
The approach may not be a right fit for early-stage companies with unstable profits. If your costs fluctuate from year to year, you may need another budgeting approach that you find has a product-market fit. If you are going to add a new revenue stream, increase staff, add a new office space to the official list, or make more significant changes, you may want a system other than an incremental budget.
Incremental budgeting starts by considering the expenses from the last year as estimated expenses for the current financial year. Varied amounts are added to/ these expenses based on inflation to ascertain a budget increase for the current year over the previous year. This approach functions best in large companies with set funding and small fluctuations. Many educational institutions use incremental budgeting for long-term funded projects.
The steps for incremental budgeting are as follows:
Step 1: Select the base and determine the amount towards expenses already committed
Step 2: Narrate for adjustments for the current year. Adjustments can be as follows:
Step 3: Aggregate the amount with adjustments and the base amount
Suppose Company X manufactures two products, X1 (500 units) and X2 (350 units). The total production cost for the previous year was Rs.650,000 with 70% variable costs and 30% fixed costs.
The variable cost for product X1 is 60% and for X2 40%. The company is planning to budget this year with additional information as follows:
All costs will increase by 3% due to the inflationary effect.
Operational levels will be the same.
With the increased production, X1 will be 650 units, and X2 will be 400 units.
Let’s calculate the variable costs for product X2 for the next budget for incremental budgeting.
Previous Variable Costs = 70% × 6,50,000 = Rs.4,55,000
Portion of Product X2 for Variable Costs = 40% × 455,000 = Rs.1,82,000.
Cost per unit for X2 = (Rs.1,82,000/350) = Rs.520.
Inflation Adjustment for the Current Year = 520 × (1+3%) = Rs.535.6
Total Variable Costs for Product X2 = Rs.535.6 × 400 = Rs.2,12,240.
The basis of calculation is the key difference between incremental and zero-based budgeting.
Zero-based budgeting is another commonly used budgeting approach many companies consider implementing. It is a technique for budgetary actions that allocate funds as per efficiency and necessity instead of budget history. Budget managers start from scratch and develop a budget that includes necessary expenses only to run the business. There will be no automatically added expenses to the budget.
zero-based budgeting is prepared based on values from scratch and budget managers take the base as zero. The business activities are allocated with a budget according to their importance and without considering past budget figures. Whereas, in incremental budgeting, the base is the previous year’s budget.
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It is one of the most widely used and easiest ways of constructing budgets. Let us see how efficient it is by considering its benefits:
With incremental budgeting, management can adjust the budget as necessary if the changes fall within certain parameters. Such flexibility helps companies to save resources. It protects management from making irreversible budgeting mistakes. Budget changes can be done on a small scale, and budget managers need not worry about budget gaps affecting the entire budget.
Incremental budgeting is a straightforward procedure that makes budgeting easy. It is one of the easiest budgeting approaches that does not require any special skills. It enables an individual to set a budget without specific training. Depending on the previous expenditure, only inflation or incremental changes are required to prepare new budgets. Moreover, it requires less preparation time with lesser preparation costs.
Incremental budgeting is suitable for companies with stable businesses and operations. For example, the expenses incurred on office supplies in a year are unlikely to change hugely from the previous year. Therefore, considering actual expenses incurred in the last year as a base and adding a small amount due to the inflationary effect develops a reasonable estimate for the next fiscal’s expenses.
One of the key budgeting goals is to maintain consistency at all levels of a company. Resultant budget managers can link their budget estimates across all departments. This is possible with incremental budgeting. It makes it possible to create a budget for upcoming years by adjusting figures as required or preferred. This consistency helps management to avoid budgeting errors and allows businesses to establish clear objectives.
One of the main benefits of the incremental budgeting method is that it provides greater transparency into budget figures. In addition, management can look into the effects of budget shifts and know if there are any flaws in their budgeting process. This budgeting approach will reduce internal rivalry as it considers incremental changes for every department equally from one year to the next. There will be no dispute among departments for the budget.
Typically, the incremental budgeting method accounts for incremental figures only in budgeted items and does not account for reductions. Therefore, the funds may be used disproportionately for unwanted items. Budget managers consider inflation or incrementally based on assumptions and may take budget adjustments for granted without justification. There may be expenses that do not reoccur, but the budget for the current year will follow the previous figures and still include this overspending.
This type of budgeting might suppress new ideas and innovations because the next budget is based on previous data. So there is little scope to fund wholly new concepts or activities. As a result, this budgeting approach deters implementing innovative ideas and promotes a backward-looking approach. Historical data is the basis of incremental budgeting. Therefore, it is hard to adapt to new businesses or unique projects without previous data.
Incremental budgeting may cause a scenario called budgetary slack. It means budget managers may estimate lower revenue and higher expenses to give themselves enough slack in the budget to show favourable performance. In other words, the budgetary slack effect can bring about a “disconnect from reality” to make the budgets look good on paper.
Incremental budgeting can not benefit companies where business operations change quite often.
These are the incremental budgeting advantages and disadvantages that help businesses to decide on adopting this approach. Based on incremental budgeting pros and cons, make the right decision as per your business type.
One of the significant advantages of the incremental budget is that it is an uncomplicated approach. It is the simplest method to apply if you are new to budgeting. Its ease and effectiveness make it fit for small businesses and large, well-established businesses alike. It is preferred by most mature businesses that have little variance in their variable costs. Thus, the incremental approach is one of the most widely adopted budgetary approaches even in the modern business environment. While there are a few limitations, its use is practical when considering tangible and measurable factors. For example, labour costs can be adjusted every fiscal year by increasing the Consumer Price Index (CPI). Compare the factors associated with incremental and zero-based budgeting and budget efficiently with a clear understanding of your business needs.
Ans: Generally, incremental budgeting is best applied if the company’s budgets will be stable in the long term, with slight modifications. In other cases, it is advised to employ more sophisticated budgeting methods.
Ans: Incremental budgeting is one of the traditional approaches whereby managers prepare budgets by taking the actual performance of previous budgets as a base.
Ans: Incremental budgeting is used by companies with established business models whose cost variance is less likely to happen. On the other hand, a zero-budgeting approach is when the budget is built from scratch and can be used by new companies.
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