Comparing Incremental and Zero-Based Budgeting

Budgeting processes are important landmarks in an organization’s financial year. They include reflection on the recent past and predictions about the period ahead, and they determine the resources available to each department and team for a set period.

One way and another, there’s a lot of weight placed on budgeting, led by the company’s Financial Planning and Analysis (FP&A) team. For this reason people tend to look for the “perfect” fit for their budgeting needs, whether that’s top-down versus bottom-up or incremental budgeting vs zero-based budgeting.

In this article we’ll explore the differences between incremental budgeting vs zero-based budgeting, compare pros and cons, and see that in reality, companies may be best served by a hybrid approach.

Incremental Budgeting

Incremental budgeting is so called because all changes are made incrementally. The base of a new budget will always be the one from the period before. This is usually done on an annual basis, but in some cases incremental budgeting is also employed in a rolling budgeting format as well.

The previous budget becomes a sort of template for the new one, as the assumption is that most of what is there will be kept, with changes made only in areas where things are predictably likely to change.

The incremental changes can be up or down. For instance, it might be that certain employees will need to receive a raise as part of the new budget, compared to their salaries in the previous year, so the budget for the departments they are in would need to increase to accommodate that. On the other hand, it might be that rents or utilities in the city where the company has its headquarters have decreased, in which case the parts of the budget that reflect those costs can be reduced.

Incremental budgeting makes it easy to build in small shifts for known changes, without having to calculate complicated knock-on effects across an entire budget. In a time in which inflation is changing regularly, this can feel particularly attractive, for example.

Zero-based Budgeting

Zero-based budgeting takes its name from the fact that the budget starts out with a clean slate – from zero, so to speak.

In contrast to incremental budgeting, zero-based budgeting doesn’t take the previous period into account. Instead, each department looks at their proposed activities, goals and needs and builds a budget based on those, justifying each line item by tying it to a clear requirement.

In zero-based budgeting, managers and department heads are encouraged to consider cost-efficient ways of planning and carrying out their objectives. In many companies, as part of the zero-based budgeting process, teams include more than one possible version for certain parts of their suggested activities.

For example, the baseline budget may be for continuing the level of service as it has been provided until now, while there may also be other options proposed for additional levels of service, additional campaigns, etc.

Incremental Budgeting Vs Zero-based Budgeting

Which makes more sense for your company, or your department, when you’re considering the question of incremental budgeting vs zero-based budgeting? Often this question is one that faces a finance team, particularly whichever finance function is responsible for leading the company-wide budgeting process.

The answer depends not on “which is better” but on what is the best fit for your company and its needs at this time.

Advantages of Incremental Budgeting

If you’re a business in an industry where things don’t change very much and any changes can be accommodated in a budget with small shifts, and if you’re confident in your current approaches and practices, incremental budgeting might be the best fit for you.

Incremental budgeting might be right for you if these advantages sound persuasive:

It’s easy to understand, as a process
It’s relatively easy to carry out
It’s fast
It reflects the historical reality of the business
There is space to make changes based on predictable shifts or on lessons learned from the past

Disadvantages of Incremental Budgeting

Incremental budgeting isn’t right for everyone. Some reasons to avoid it include:

It can encourage inefficiency, because the budget from the previous period is assured; there’s no need to look for ways to improve processes
It can encourage wasteful spending, because departments know that if they don’t spend all their budget before the close of the period, they might be given less next time
It can make it more difficult for companies to adjust to major changes in their industry, the company or the wider world
It makes it easier for organizations to ignore external factors that may impact their business and costs during the year
It encourages budgetary slack, with managers building in extra budget so they can avoid going over budget and consistently appear to be coming in under budget

Advantages of Zero-based Budgeting

If you’re in a company where you need to focus on cutting costs and increasing efficiency, or an industry in which things are changing quickly and it’s impacting your expenses, zero-based budgeting might be the right match for your needs. Advantages include:

It encourages efficiency, because managers have to justify expenses
Because rationale is clearly thought through and expressed, it’s easier to make changes on the fly if you need it during the period ahead
It encourages a clear breakdown of costs and expected revenue, making budget variance analysis easier during the year, which in turn makes course correction during the year easier if necessary
It encourages companies to make relevant data transparently accessible to managers, so that they can make data-driven decisions and create relevant plans to build the budget. Some companies use dedicated FP&A platforms such as Firmbase to make centralizing and leveraging budgeting data easy and intuitive

Disadvantages of Zero-based Budgeting

Zero-based budgeting has its upsides, but it comes with costs as well. These include:

It’s very time-consuming, because you’re starting from scratch
It’s labor-intensive, requiring a lot of thought and strategizing about what the plan for the period ahead might be
It’s more complex and more difficult to understand, and managers may require training in how to build a budget in this way
It relies on having information available to make financial analysis and modeling a part of the process (although to balance this, as Forrester notes, investing widely in the right technologies can make budget planning better able to empower paths to growth)
It can discourage long-term strategic thinking and planning

Break the Mindset of Incremental Budgeting Vs Zero-based Budgeting

As we’ve written before in the context of top-down budgeting versus bottom-up budgeting, incremental budgeting vs zero-based budgeting really doesn’t have to be an either/or decision.

It’s possible for companies to use aspects of incremental budgeting and aspects of zero-based budgeting, to suit their needs or to adapt the budgeting process to the different characteristics of different times or departments.

These are some examples of a hybrid budgeting approach:

Companies may typically rely on incremental budgeting, but every 3-5 years go through a process of zero-budgeting to “reset” their understanding of processes, expenses, etc. and take changes that have occurred into account.
Departments that have operating costs that are fixed outside of their control may use incremental budgeting, while departments with far more impact and autonomy over their expenses may use zero-based budgeting.
Companies that usually use an incremental budgeting approach may employ zero-budgeting when they face economic constriction and need to reduce costs and increase efficiency.

The question of incremental budgeting vs zero-based budgeting isn’t one of best practices or which method is objectively better. It’s a question of finding the approach that best fits the company’s stage, structure, culture and objectives, no matter whether that’s incremental budgeting, zero-based budgeting or some combination of the two.

Learn how Firmbase helps FP&A teams create and compare budgets, run forecasts & analyze important financial insights.