Difference Between Incremental and Zero-based Budgeting

Key Difference – Incremental vs Zero-based Budgeting
 

Budgeting is an important exercise carried out by organizations to assist planning for the future. Budgeting provides a basis to compare results with, evaluate performance and to take corrective actions for the future. Incremental and zero-based budgeting are two widely used methods for budget preparation. The key difference between incremental and zero-based budgeting is that while incremental budgeting adds an allowance for changes in revenues and costs for the upcoming year by taking the current year’s budget/actual performance, zero-based budgeting prepares the budget for the next year from scratch by estimating all results disregarding the current performance. 

CONTENTS
1. Overview and Key Difference
2. What is Incremental Budgeting
3. What is Zero-based Budgeting
4. Side by Side Comparison – Incremental vs Zero-based Budgeting
5. Summary

What is Incremental Budgeting?

An incremental budget is a budget prepared using the previous period’s budget or actual performance as a basis with incremental amounts added for the new budget. The allocation of resources is based upon allocations from the previous accounting year. Here, the management assumes that the levels of revenues and costs incurred during the current year will also be reflected during the next year. Accordingly, it will be assumed that revenues and costs incurred during the current year will be the starting point for estimations for the next year.

Based on the results of the current year, an allowance will be added to the next year’s budget that takes into account possible changes in selling prices, associated costs and effects of inflation (general rise in price levels). This is a much less time consuming and convenient process compared to zero-based budgeting. However, incremental budgeting is criticized for a number of limitations as per below. The main drawback of this type of budgeting is that it carries forward the current year’s inefficiencies into the next year. Furthermore,

• Since this method assumes a slight change in budgetary allocations from the prior period, it is assumed that working method will remain the same. This may lead to a lack of innovation and no incentive for managers to reduce the cost.

• Incremental budgeting may encourage increased spending so that the budget is maintained next year

• Incremental budgeting may cause management to lead into ‘budgetary slack’, whereby managers tend to build lower revenue growth and higher expense growth to obtain positive variances

What is Zero-based Budgeting?

Zero-based budgeting is a system of budgeting in which all revenues and costs must be justified for each new accounting year. Zero-based budgeting starts from a ‘zero base’ where every function within an organization is analyzed for its respective revenues and costs. These budgets may be higher or lower than the budget of the previous year. Zero-based budgeting is ideal for small scale companies due to its detailed attention to cut costs and to invest scarce resources effectively.

Zero- based budgeting has also gained much popularity during recent times due to the swift changes in business environment and markets. Incremental budgeting assumes that future will be a continuation of the past; however, it is questionable if this is fairly accurate. The forecasts and results of the prevailing year can change drastically during the upcoming year. Therefore Zero-based budgeting is preferred by many managers to draft effective budgets.

This approach requires managers to provide explanations and justify all the revenues and costs for the upcoming year; thus, it is a very economic focused method. Waste can be eliminated by identifying and discontinuing non-value adding activities. Since a new budget will be prepared each year it is very responsive to the changes in the business environment.

Despite the advantages, Zero-based budgets are difficult to prepare and extremely time-consuming where senior managers of all departments should provide explanations justify all the expected results. Zero-based budgets are also criticized for been overly focused on short-termism, thus tempting managers to cut costs that may negatively affect in the future.

Figure 01: Iran Budget Process – Budgets are prepared by both companies and governments

What is the difference between Incremental and Zero-based Budgeting?

Summary –  Incremental vs Zero-based Budgeting

The difference between incremental budgeting and zero-based budgeting depends whether the management prefers to use the previous budget as a basis for the new budget or to prepare it independent of past outcomes. Both systems have their respective advantages and disadvantages. Irrespective of using an incremental or zero-based approach, if revenues and costs are effectively justified, budgets can be used to obtain promising results. Which type of budgeting system to be used is up to the discretion of the management since budget reports are internal documents that are not governed and regulated by accounting bodies.

Reference:
1. “Examples of Zero-Base Budgeting.” Chron.com. Chron.com, 20 Sept. 2011. Web. 15 Mar. 2017.
2. “Incremental Budgeting – Meaning, Advantages, and Disadvantages.” EFinanceManagement. N.p., 23 Dec. 2016. Web. 15 Mar. 2017.
3. Pankajtpareek Follow. “9159001 Zero Base Budgeting A And Performance Budgeting.” LinkedIn SlideShare. N.p., 23 Aug. 2009. Web. 15 Mar. 2017.

Image Courtesy:
1. “Iran Budget Process” By SSZ – Own work (CC BY-SA 3.0) via Commons Wikimedia

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