Perhaps the most traditional approach towards budgeting is incremental budgeting. It starts the budgeting process with historic or past data, analyzes the variances, and makes adjustments for the future period.
Apart from variances in previous budgets, any allocations for inflation in costs are also adjusted. As with any traditional budgeting approach, incremental budgeting is also prepared for yearly budgets.
It’s a more static or rigid approach in nature, which calls for the achievement of targets within the set parameters or allotted resources.
As historic forms the basis of incremental budgeting, it may be difficult to apply for new businesses or unique projects without past data.
Suppose Blue Water Co. produces two products P1 (500 units) and P2 (350 units). The total costs of production for last year were $ 650,000. Estimating 70% variable costs and 30% fixed costs.
Product P1 consumed 60% of the variable costs and P2 consumed 40%. The management is planning for next year budget with additional information:
- All costs will rise by 3% due to inflation
- Operational efficiency levels are likely to remain the same
- Increased production is estimated as: P1 = 650 units and P2 = 400
Required: for product P2 the variable costs for the next budget with incremental budgeting approach.
Previous Year costs: Variable Costs = 70% × 650,000 = $ 455,000.
Portion of Product P2 for variable Costs = 40% × 455,000 = $ 182,000.
Cost per unit for P2 = (182,000 ÷ 350) = $ 520.
Inflation Adjustment for next year = (520) × (1+3%) = $ 535.6
Total Variable costs for Product P2 = 535.6 × 400 = $ 212,240.
Budgeting serves various purposes to any business, most prominently control, performance measurement, and communication. Each budgeting approach has its benefits and limitation.
The traditional incremental budgeting approach offers several benefits such as:
- One of the easiest approaches that do not require any special skills
- Depending on the past data, only inflation or incremental adjustments are needed to prepare new budgets
- Easier to understand and implement for the operational managers
- Suitable for organizations with stable and consistent production levels
However, as with any theoretical approach this method also serves its limitations:
- Operational managers take inflation or “incremental” adjustments for granted without justification
- Does not challenge the operational managers to achieve targets beyond set goals
- Does not emphasize on removing inefficiencies
- As there is no detailed activity based scrutiny of the past data, previously held inefficiencies in operations may continue
- Easier to manipulate for the operational managers if the rewards and performance are appraised on the incremental budget indicators
Budgets serve valuable purposes for any organization, for public service sectors the performance appraisals are often non-financial metrics. In such scenarios, an incremental budgeting approach may seem more feasible.
It offers a simplistic approach and easier evaluations that suit the public sector organization as their key performance indicators are often qualitative in nature.
However, the incremental budgeting approach does not suit rapidly changing manufacturing facilities, which have to adjust often to the market changes.