Incremental budgeting is budgeting based on slight changes from the preceding period's budgeted results or actual results. This is a common approach in businesses where management does not intend to spend a great deal of time formulating budgets, or where it does not perceive any great need to conduct a thorough re-evaluation of the business. This mindset typically occurs when there is not a great deal of competition in an industry, so that profits tend to be perpetuated from year to year.
There are several advantages to incremental budgeting, which are as follows:
- Simplicity. The primary advantage is the simplicity of incremental budgeting, being based on either recent financial results or a recent budget that can be readily verified.
- Funding stability. If a program requires funding for multiple years in order to achieve a certain outcome, incremental budgeting is structured to ensure that funds will keep flowing to the program.
- Operational stability. This approach ensures that departments are operated in a consistent and stable manner for long periods of time.
There are several downsides of incremental budgeting that make it a less than ideal choice. The issues are:
- Incremental in nature. It assumes only minor changes from the preceding period, when in fact there may be major structural changes in the business or its environment that call for much more significant budget alterations.
- Fosters overspending. It fosters an attitude of "use it or lose it" in regard to budgeted expenditures, since a drop in expenditures in one period will be reflected in future periods, too.
- Budgetary slack. Managers tend to build too little revenue growth and excessive expenses into incremental budgets, so that they will always have favorable variances.
- Budget review. When the budget is carried forward with minor changes, there tends to be little incentive to conduct a comprehensive review of the budget, so that inefficiencies and budgetary slack are automatically rolled into new budgets.
- Variance from actual. When the incremental budget is based on a prior budget, there tends to be a growing disconnect between the budget and actual results.
- Perpetuates resource allocations. If a certain amount of funds were allocated to a specific business area in a prior budget, then the incremental budget assures that funding will be allocated there in the future, too - even if it no longer needs as much funding, or if other areas require more funding.
- Risk taking. Since an incremental budget allocates most funds to the same uses every year, it is difficult to obtain a large funding allocation to direct at a new activity. Thus, incremental budgeting tends to foster a conservative maintenance of the status quo, and does not encourage risk taking.
In short, incremental budgeting results in such a conservative mindset in a business that it may actually be a noticeable driver in destroying a company over the long term. You should instead engage in a thorough strategic re-assessment of a business when constructing a budget, as well as a detailed investigation of expenditures. The result should be significant changes in the allocation of funds from period to period, as well as targeted operational changes that are intended to improve the competitive position of a business.