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Budgeting for Growth: Pros and Cons of Incremental Budgeting

Budgeting is the guardrail for business success. The path for growth goes through the budgeting process, making it incredibly important to match the right one for your company’s vision. There are dozens of types and components of budgets, from zero-based to value proposition and everything in between.

According to a Clutch survey, more than half of small businesses didn’t have an official documented budget for 2020. Having a new business with not enough resources to hire full time finance professionals to create the budget can be very damaging. No matter what size the business is, or how fast it changes, creating a clear and documented budget is vital for future growth. Incremental budgeting is one of the basic and traditional methods and can be good for those who don’t have a lot of time to create a budget from scratch.

What is Incremental Budgeting?

Incremental budgeting is commonly referred to as the traditional method of budgeting. Although it can be the simplest one to create, there is one big problem particularly for small businesses: It is based on the previous year’s numbers.

The budget is prepared by taking the current period’s budget or performance data as a base, and adding incremental amounts for the new period.

Incremental budgeting is the most “free thinking” type, as you can add or subtract anything into the plan. An increase in sales, a rise in inflation, or higher labor costs can all be factored in, and even lowering the budget for downsizing or a cash crunch are legitimate actions to take in incremental budgeting.

Benefits of Incremental Budgeting

  • If it ain’t broke don’t fix it. The old saying fits incremental budgeting perfectly. If last year’s budget was successful, and the business succeeded in reaching all of its goals with good profitability, then why change the process? Other than adding new budget increases or small tweaks here and there, the old base is working fine so keep going at it.

  • Incremental budgeting usually takes the least amount of time to plan out. By taking the previous year’s budget and adding on expected changes, the entire process can take far less time than other budgeting methods, such as zero-based budgeting. For small or medium sized businesses, especially those whose finance teams are not yet up to scale, or only work part-time, less resources and keeping it simple can be very important in the beginning stages.

  • In addition to being quick and relatively easy to create, it is also easy to understand. Without complex charts and financial terms that most people outside of the team wouldn’t fully comprehend, a simple budget will help the entire company be on the same page. No matter the job description, understanding the company’s financial goals will help create a thriving business culture, especially amongst SMBs.

  • Lastly, the impact is easy to see across the organization. If the budget increased by $100,000 to implement a new marketing ad campaign, then the results are tangible and easy to see. If salaries were increased by 5% then all of the employees can trace it back to the budget. This prevents conflict, as a consistent approach is adopted throughout the organization.

If there are so many benefits to incremental budgeting then why not use it year in and year out across every size companies?

Just like every type of budgeting system, incremental budgeting has its drawbacks as well:

Cons of Incremental Budgeting

  • Its biggest advantage is also its biggest disadvantage. Saving time is a huge bonus but it means that less time is spent reviewing the old budget. If something is working great then perhaps it doesn’t need to be changed completely, but if there is a chance to improve, then why not take that step? As long as the time and resources are there, then reviewing the previous budget can add even more efficiency and value to a great organization and incremental budgeting might prevent that growth.

  • Furthermore, the one who makes the budget does not need to justify the previous costs or the additional budgeting aspects that were added on. If it can be proved that an additional project is needed, then the funding will be approved whether it is the best option or not. Incremental budgeting looks backwards instead of forwards and doesn’t always create the most efficient way of setting goals.

  • Another disadvantage is that it doesn’t produce enough incentive to reach performance targets and goals for the managers of different departments. Goals are often set from the previous year (with an additional percentage based on the budget increase). Managers have another year of experience under their belt and the ability to increase output, but will be discouraged to set goals significantly higher than previous years. This can create a lackadaisical attitude and stunt the company’s growth.

  • Similar to goals, there is also no advantage for managers to reduce spending. If they can produce results within a certain budget and the company is happy, then the vast majority won’t take the initiative on their own to reduce costs. If anything, they will be motivated to spend all of their budget, because if they don’t use it all and the company consistently uses incremental budgeting, then they know that next year they will receive less.

  • Lastly, incremental budgeting might encourage managers to name a budget that is higher than they actually need in order to be praised when they finish under the line. If they would name a low budget and work hard to finish at that mark, then they probably would not be rewarded. Unfortunately, the mindset in that scenario is: “you just did the job that you were supposed to”.

When does Incremental Budgeting Fit Best?

As stated in the pros and cons, incremental budgeting is great for some companies, but also can hold many back. Many budgeting experts agree that there seems to be a thin line for those who should use it. One major concern is that it doesn’t fit public organizations or non-profits, due to the fact that their budget doesn’t represent the goal of increasing profit. A hospital, whose goal is to increase to 7 hospital beds per 1000 people, or a non-profit raising money for soup kitchens, will both have a hard time using incremental budgeting, while private, for-profit organizations would thrive.

Another obvious problem is that companies without the budget or time for a finance team are the ones most tempted to use last year’s budget. Yet, ironically small companies are constantly changing and need to be more forward thinking with their costs. Therefore, small to medium size companies who have a stable cash flow and strong executive leadership with managers who they can rely on would be the best fit for incremental budgeting. Large companies or those low on time and financial help can implement it in different ways as explained below.

Applying Incremental Budgeting

If you have decided that incremental budgeting is the best option then how do you go about applying it? Depending on the size of the company, or the level of involvement with other executives, the finance team (if there is one at this stage), or even regular employees, there are a few ways to do it. While these 3 levels of involvement are relevant in any budgeting scenario, they are of particular importance during incremental budgeting. This is due to the nature of how the budget is based on previous reports and how quickly it is completed.

Top Down- For executives who have difficult decisions to make (such as a turnaround), or in the case where there are a lot of relatively new employees, then top down might be the best way to create the budget. Managers simply follow the goals and impose budget targets for activities and costs, making the process short and to the point.

Bottom up- When the opposite is true, meaning enough time, high trust with employees, and room for growth among stability, then bottom up has even more potential. Executives more or less take the input from employees and make the decisions based on that. This takes away many of the elements of incremental budgeting (as the suggestions might be completely different from the previous year's budget), however there is room for combining incremental budgeting within a bottom up approach.

Negotiated- This is a mixture of bottom up and top down. Similar to bottom up, it makes incremental budgeting become relative. Many companies find this to be best, as the executives set the goals, but still leave room for feedback and improvement. In the right scenario, everyone walks away feeling satisfied and with attainable goals.

In summary, incremental budgeting is great in certain situations, specifically for SMBs. In addition to all of the different types of budgeting and how to go about implementing them, there are other steps to take to make budgeting smoother and more detailed. Companies such as DataRails have created an FP&A platform for automating and consolidating spreadsheets in order to create the best possible budgeting and forecasting scenarios. This is perfect for SMBs using incremental budgeting, as with a few clicks, all of your previous data can be consolidated into one report, providing more time to analyze, and giving you the tools to personalize next year’s budget.

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