Pros and Cons of Incremental Budgeting for Your Business
To be honest, I am not a fan of incremental budgeting. I think it is ineffective in many ways. It does not respond to rapidly changing circumstances and causes waste. To be fair, there are advantages of using incremental budgeting, which we can explore. I also give some real-life examples of how the application of incremental budgeting is done so that you can make up your own mind about it.
What Is Incremental Budgeting?
Incremental budgeting is a technique of using a previous budget from a prior period to create a new smart budget based on marginal changes. It is useful as an option for online budgeting tools but not always the best approach.
An example of incremental budgeting is the annual increase in Social Security payments to retirees based on a calculation of the previous year’s cost-of-living increase. In 2022, Social Security payments increased by 8.7% due to an increase in the cost of living.
When using this formula, the budget for Social Security payments for 2023 takes the existing payments made during 2022, which will continue, and adds 8.7% to that total amount. Then, any new payments for 2023 are added, and any payments that are terminated are deducted. This calculation is a very simple one and results in the total amount of Social Security payments that will be budgeted for 2023.
On the surface, this seems like a reasonable way to budget for the annual Social Security payments, except it is very easy to demonstrate how flawed this system is by simply investigating how the cost-of-living increase is calculated.
In 1973, laws passed to allow for an annual cost-of-living adjustment (COLA) to Social Security payments and Supplemental Security Income (disability payments). The COLA rules allow benefits to keep up with any inflation.
The formula for calculating COLA comes from increases in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The CPI-W is calculated each month by the Bureau of Labor Statistics. The percentage increase in the CPI-W from the average for the third quarter of the current year is compared to the average from the third quarter of the last prior year when a COLA was applied.
The Consumer Price Index (CPI) is based on a basket of goods from 200 categories divided into eight groups: food/beverages, housing, transportation, communication/education, medical care, apparel, recreation, and other goods.
The U.S. Bureau of Labor Statistics (BLS) surveys thousands of American households to find out what they paid for consumer items in the basket of goods.
All of this surveying and calculating sounds reasonable until we think it through. It is a national average. However, people live in cities and states where the cost of living is substantially different between locations.
For example, the New York's cost of living is 129% higher than the national average. The cost of living in Mississippi is 16.7% lower than the national average. Using a national average CPI is not a reflection of consumers' actual costs in different parts of the country.
Incremental Budgeting Advantages
Incremental budgeting appeals to accountants for the following reasons:
simplicity
It is very easy to apply an incremental calculation such as adding 5.9% to a Social Security payment. If localized differences are not important to consider, a budget for 2021 can simply be adjusted upwards by 5.9% for 2022, and theoretically, everything will remain the same. Using this method, budgeting for the following year based on a previous one is very easy to do.
Consistency
Using the budgetary figures from a previous year and adjusting them with a simple marginal calculation offers a consistent budget that keeps pace with inflation. The problem is that any errors or faulty budget projections made in the first year that the budget was prepared will be passed forward every year thereafter.
Stability
Incremental budgeting creates a smooth, stable progression of budgetary figures that makes it easy to project expenses. This works well for projects that are funded over multiple years to allocate the budget equally over the entire period.
Reduces Infighting Over Budget Allocations
When the only change for an organization’s budget is the application of a marginal incremental calculation, there is no need for departments within an organization to fight over budget allocations. Departmental rivalries and competition over budget allocations are removed.
Incremental Budgeting Disadvantages
Despite the simplicity, consistency, stability, and reduced infighting, incremental budgeting has many flaws. It is not a desirable method used by accountants for the following reasons:
Wasteful Spending
Incremental budgeting creates a feedback loop that promotes wasteful spending. Since the upcoming year’s budget depends on the previous year’s expenditures, there is a tendency to rush to spend any remaining unspent budget allocation before the current year's expiration.
Department heads know that they will get an increase in the budget next year based on what they spent this year. They are encouraged to spend everything they have in the current year, whether the expenditures are justified or not. This budgetary structure usually results in a rash of spending towards the end of the current fiscal year to eliminate any remaining budgeted funds.
Another problem is that some departments may not need a budget increase if the circumstances changed from the prior year. If a department gets money that it does not need, these funds can be wasted.
Reduces Efficiency
There is little reward for cost-cutting improvements if the budget will automatically increase each year. If the money saved by applying a more efficient process is taken from the following year's budget, there is little incentive to operate more efficiently.
Discourages Innovation
Incremental budgeting does not allow room for new initiatives because there is no provision in the budget to add new categories or projects. The lack of resource allocations for innovative projects causes an organization to become stagnant when it comes to implementing new ideas. Incremental budgeting creates a constraint on innovation.
Companies that use incremental budgeting tend to develop very inflexible business processes that become rigid operational rules constructs, which are difficult to change. There is a tendency to do things the same way as they have always been done before, despite potential process improvement opportunities.
Increase Risk from Changes Caused by External Factors
Incremental budgets promote stability and do not consider external factors that may be disruptive of a company’s business model. Using incremental budgeting methods, large enterprises might be caught off-guard when a startup creates an industry disruption. The larger enterprises may lose significant market share before they have a chance to respond to the changes in market dynamics.
Unforeseen events and factors that appear, which are not anticipated, can throw a larger enterprise off course. Some companies may be able to re-tool, re-allocate budgets, and respond. Others may react with too little effort and be too late to forestall their demise.
Missing Insights
When using incremental budgeting, there is no incentive to conduct a comprehensive budgetary review to hunt for insights into how to improve operations. This frequently results in continuing to work with incorrect assumptions about operations, increased waste, and multiplies the damages caused by mistakes.
Complacency in Corporate Governance
The stability of incremental budgets might cause corporate governance to be neglectful in investigating problems with operations. A long-term, slowly-changing, negative trend may be ignored for a very long time until it builds up to a level that causes a major disaster.
The Danger Of Incremental Budgeting For Governments
A typical and traditional budgetary approach for governments is to use incremental budgeting. Before any new annual budget is prepared, the first thing to do is to come up with the base foundation for the budget calculations. This base level contains the foundational amounts used to make the new budgetary allocations.
This typically means there is an increase. For instance, an allowance for a budgeted expenditure is based on the previous year’s budgeted allowance plus an increased amount to cover any expected price increases. For many governments, this process supports an ever-increasing budget with no attention paid to improving operational efficiencies, cost-savings, or budget allocations that are made based on key performance indicators. Budgets developed in this way have a tendency to never go down; they always seem to increase.
Case Study on the U.S. Military Spending Budget
An example of the problem with incremental budgeting is shown by the ever-increasing military spending budgets of the United States. This happened during the decade following September 11, 2001 (9-11). After the 9-11 event, military spending increased by 50% over the next decade, when adjusted for inflation. In comparison, non-military spending increased by only 13.5% during the same period.
There was a tendency by the Pentagon to simply ask for more money based on an incremental addition to the previous year’s budget, without much need to justify the line-item expenditures. There was significant bipartisan support to “rubber stamp” the Pentagon’s budget requests and not much opposition from either political party in either the House or the Senate.
It is interesting to note that this decade also included the period of the worldwide economic recession caused by the real estate market collapse in 2008. At the height of the economic collapse, U.S. military spending was over $600 billion a year.
Only the pressure of a major economic downturn caused the military budget to be reduced. It went back down to just over $500 billion in 2015; however, the military budget then climbed up again to reach $705 billion for 2021, which was 0.1 % greater than the 2020 budget. And the national defense total in the 2022 omnibus spending bill is $782 billion.
One can criticize this spending because it is not based on any performance metrics or efficiency. All the problems of a previous year are simply included in the budget for the next year. Using an incremental budget strategy has a tendency for these budgets to become more bloated over time, regardless of any changing circumstances. It encourages expenditures of all funds in the budget to ensure the same or slightly increased allocations for the following year.
The U.S. military budgeting system is wasteful. It lacks budgetary expertise and oversight without sufficient evaluation of any alternatives. There is no measure of the budget performance that is capable of measuring the success of implementation that results in positive societal values. Flexible budgeting is missing, and future societal cost implications are ignored. U.S. military spending is the highest in the world. It is more than the combined total of the next ten countries’ military-spending budgets.
Incremental budgeting processes are part of the cause of this dysfunction without proper checks and balances on spending. There are few performance metrics used to reduce spending and virtually no political will to make any adjustments. Based on these dynamics, I would expect this annual U.S. military spending budget to continue to grow. It is a very clear example of the failure of incremental budgeting at its worse.
Conclusion
The primary advantages of incremental budgeting are that the method is simple and consistent. Nevertheless, there are many disadvantages that may lead to adverse impacts over the long-term. This budgetary method's inflexibility and the inability to respond to external changes are problematic for governments, organizations, and companies that operate in a highly-competitive, fast-paced marketplace.
Incremental budgeting works best when applied to an organizational budget that will remain stable for the long-term and is projected to require only moderate operational adjustments with minimal changes. For most companies and organizations, the recommendation is to consider using other, more sophisticated budgeting methods.