Incremental budgeting is a longstanding, data-driven approach to budgeting. But is it driving your business in the right direction?
Learn about the hidden dangers of incremental budgeting and how innovative approaches can push your business forward faster.
Incremental budgeting has been around for a century.
It’s one of several business budgeting methods that have evolved from Budgetary Control, written in 1923 by James O. McKinsey, founder of McKinsey & Company.
It’s difficult to say who first created a financial plan for a business, but you could reasonably call McKinsey the “father” of modern business budgeting. After all, his book is thought to be the first ever written on the subject.
While he’s not widely credited for it, McKinsey was also among the first in the business to take what in today’s business parlance is called a “data-driven” approach to the task of budgeting.
One of the key tenets of McKinsey’s method was that financial forecasting and budgeting should be based on past performance – what we modern-day finance folks call “actuals.”
He believed that combining the data from past budgets with revenue expectations, expenses, and other financial variables could help guide decision-making. This inherently data-driven approach and McKinsey’s concept have built the foundation for incremental budgeting, a method that builds the budget for the upcoming period (usually a year) by making small adjustments based on the previous period's budget or actual performance.
One of the chief advantages of incremental budgeting is its simplicity.
It’s quick to develop and easy to implement because the budget doesn’t change much throughout the period. However, for SaaS companies, incremental budgeting imposes a number of pretty hefty costs. While most of the downsides to incremental budgeting are well known, there are a few that remain obscured by its ease. But these pitfalls can harm SaaS businesses in particular.
This article reveals those costs and proposes an alternative approach to budgeting that will help SaaS companies accelerate the achievement of their strategic goals.
Using an incremental approach, the budget is typically updated once a year.
What is the incremental budgeting approach?
The previous year’s budget is the starting point, and each line item is adjusted using one of two approaches:
Neither approach requires any complex calculations, and, for the most part, both eliminate any need to do a budget analysis. And because the changes are incremental, this method gives you a relatively stable budget over time. These characteristics make incremental budgeting attractive to many types of businesses, SaaS companies included.
However, it’s a method ill-suited to most SaaS companies. Here’s why:
These are the more obvious problems.
Let’s look more closely at the deeper, more subtle ways they threaten your business.
It’s true that incremental budgeting doesn’t have to eat up your time, but if you’re just adding a percentage to your previous budget, the future budget will lack accuracy.
But let’s say you can afford to spend some time on thoughtful analysis to create a more accurate annual budget.
The problem is that the budget you’re starting with was based on a forecast you made many months ago. While your budget may be static on paper, in reality, it’s anything but. Shifting priorities, unexpected expenses, and market fluctuations – these and other changes in the business keep SaaS finances in constant flux throughout the year.
To understand and incorporate the lessons learned over the last 12 months, you have to analyze a year’s worth of data all at one time. That means you not only have to capture all the changes in what you spent vs. what you planned to spend during that time, but you must also understand why they occurred.
This is an enormous task.
It’s not easy to remember the context around each and every budget variance, especially after several months. It might be easier if you’ve done some variance analyses along the way. But if you haven’t, you’ll have to recreate the past 12 months, piecing all those changes together again in order to make informed decisions for the new budget.
Picture this…
Let’s say that in January, your sales and marketing (S&M) budget included a line item with funding for two industry events. Then, you learned about a new event in July. The decision was made to sponsor a booth and send staff to that third event, which exceeded your budget by $10,000.
As a result, your original forecast is off in terms of your cash, revenue, and expenses, making it much harder to know whether you should increase the budget for events in the coming year. Your previous forecast was clearly inaccurate, so how do you decide?
Thinking through the rationale for adding that extra event might help. The problem is the decision was made months ago, and the people who made it may not be available. Now, you have to do even more work to determine whether it makes sense to increase the budget for events.
And this is just one line item on your S&M budget. You still have more to work through there, plus your engineering, customer success, and other budgets to figure out.
This example illustrates how the work required to create an accurate incremental budget can easily consume several weeks of your finance team’s time. It also explains why so many companies limit their analysis, opting instead to simply add some percentage to each of the line items in the previous budget.
For companies that want a reasonably accurate budget forecast, the most obvious cost associated with incremental budgeting is the enormous amount of time it takes. The true cost, however, is much larger.
Today’s SaaS CFOs and their finance teams are being asked to provide insights to drive business forward. When they’re spending all their time reconstructing the past to build an accurate budget for the future, there’s little bandwidth left for other types of analyses that would offer higher-level insights.
If you stick with an incremental approach to budgeting, updating the budget only once a year, your finance team simply cannot work to its full potential, and ultimately, your business will suffer for it.
You could try to strike a balance between accuracy and time. To do this, you have to decide where you should focus your efforts, devoting more time to the analysis of the most important line items and making best guesses on the rest.
No matter how you approach it, though, there’s always a tradeoff with annual incremental budgeting in terms of accuracy. Generally, the less time it takes, the less accurate it becomes.
Creating an annual incremental budget can easily consume 2-3 months of a finance team’s time, and all too often, the resulting budget is outdated almost as soon as it’s finalized.
The most obvious problem with such a process is the amount of time it takes. Long lead times are usually needed because most SaaS businesses still use spreadsheets for their financial planning and analysis (FP&A).
CFOs and finance teams have access to the data they need, but they end up spending an enormous amount of time pulling it from different source systems and then compiling and formatting it for the budgeting process.
They also have to confirm the accuracy of the data, which typically requires multiple emails back and forth with different data owners to work through all the questions that inevitably arise.
We’ve already mentioned the opportunity costs associated with such a time-intensive process. But there’s another problem that creates the question, why even budget in the first place?
We’re not suggesting that budgeting doesn’t matter – only that when you update your budget just once a year, it loses most of its value as a tool for guiding your spending. Companies budget because they need to know if they have enough money to keep the lights on.
The problem with incremental budgeting is that in SaaS, change is a constant. When it takes more than two months to finalize your budget, it’s a pretty good bet that the data you used to build it is already outdated or soon will be.
This simple fact renders your budget obsolete.
The moment a decision is made to spend money on something that wasn’t in the budget – like sponsoring that extra event, for example – your forecast becomes even more inaccurate.
We all know that an accurate forecast means an accurate budget. While CFOs and other finance professionals strive for accuracy in all things, with incremental budgeting, that often remains an elusive goal.
As a finance professional, you’ve probably learned that budget variances are a fact of life. Of course, you try to minimize them, but at the end of the year, if you find your actuals exceeded your targets, that probably doesn’t feel like a big problem.
For example, who’s going to take issue with a favorable budget variance? No, the forecast wasn’t accurate there, but it worked out well in the end.
But what about the other side of that?
If your forecast was larger than your actuals, that likely means you spent more money than you needed to in different areas, perhaps even hiring additional people based on the expectation of higher revenue. Now you have an unfavorable variance that calls into question your ability to forecast.
Other than some minor changes here and there, you only update your budget once a year with this approach. So where does that leave you when you discover a new, but expensive, opportunity that you want to jump on? Like that extra event in July, you didn’t know about when you created your budget at the beginning of the year.
In our earlier example, we assumed you were able to find the money somewhere to pay for that, and it resulted in a huge variance. But it would have been better if you’d known about it when you were creating your budget.
Decisions are always better when they are driven by data. Making informed decisions allows companies to take advantage of emerging opportunities and respond to unexpected shifts in the market.
With incremental budgeting, your decisions are data-driven, but the information they’re based on is a static point in time that probably no longer reflects your current reality when new opportunities and threats arise. Given how dynamic the SaaS industry is in general, it makes you wonder why any SaaS company would still use incremental budgeting.
Let’s return to the history of budgeting to answer that question.
When McKinsey wrote the book on budgeting, his ideas became the basis for incremental budgeting, which was soon widely adopted, particularly by large companies that had achieved a relatively “steady state” in which their cost structure and revenue had become fairly predictable.
Of course, it was only natural for smaller companies to look at what the “big guys” were doing and follow suit. That’s how incremental budgeting became so widely adopted.
However, revenue and expenses are generally far less stable in small companies, especially in SaaS. Today, SaaS CFOs realize that incremental budgeting doesn’t make sense for a company in startup mode because everything changes all the time. It simply doesn't make sense for startups to do incremental budgeting unless they want to grow extremely slowly. And which startups want that?
Adopting a rolling budget is absolutely a step in the right direction. We think everyone should be using a rolling budget because they’re more accurate by design and provide the flexibility to pivot when you need to.
Think about the example above where you went over your event budget by $10,000 sponsoring that extra event. Now, fast forward to the next time you’re creating your budget. You’re using a rolling budget, and your forecast is updated every month or quarter based on the previous month or quarter’s actuals.
Which forecast is going to be more accurate? The one you created 12 months ago or the one you updated in August, which included that third event? The answer here is obvious. However, a rolling budget is not in itself a panacea to all the problems commonly associated with incremental budgeting.
If you haven’t already guessed, it’s spreadsheets. For companies that rely on spreadsheets, a rolling budget can actually exacerbate the time problem. Implementing a rolling budget using spreadsheets is extraordinarily time consuming, hard to manage, and prone to error.
Given this, all the same opportunity costs associated with incremental budgeting exist when you implement a rolling budget using spreadsheets.
Here again, the time your finance team spends on this work is time they could be using to do the kind of analyses that generate key insights that drive your business forward.
On top of that, you’ll also eventually need to hire a new person to manage the effort because doing that on a spreadsheet month-to-month is a complicated and never-ending cycle.
But what if you could automate the process?
You’ve probably heard about a relatively new breed of technology that’s purpose-built for FP&A. Platforms like these provide robust FP&A capabilities, including budgeting and forecasting.
Some of this tech can eliminate the tradeoff between time and accuracy that incremental budgeting requires, allowing you to implement a rolling budget without the heavy investment of time that spreadsheets require.
With the right tool, a rolling budget becomes automatic and generative in its implementation, giving you speed, accuracy, and flexibility – all rolled into your rolling budget.
But no technology is right for every SaaS company, and in fact, spreadsheets often work just fine for small startups with relatively simple business models. However, consider these tell-tale signs that it might be time to shift to an FP&A software that will help you level up your finance function to become more strategic.
Whether you’re working with spreadsheets or are ready to move to a purpose-built FP&A tool, implementing a rolling budget is an important first step in improving your budgeting process.
Now, let’s look at how you can fully harness the power of budgeting to drive your business forward.
In the context of business, “incremental budgeting” actually has dual meaning. It can refer to how you create your budget or how you implement it, i.e., with only small, incremental changes throughout the period).
In this article, we’ve taken issue specifically with the implementation aspects of incremental budgeting as opposed to its use as a method for creating a budget. Indeed, the primary appeal of incremental budgeting is that it simplifies forecasting, although it remains time consuming if your goal is to have an accurate budget.
However, most of the problems we’ve covered here – the short shelf life and inflexibility of incremental budgets – are all rooted in the fact that you’re only updating the budget once a year.
These are implementation problems that a rolling budget solves beautifully. As for creating your budget, there are better ways to do that, too.
Over the years, newer budgeting methods have emerged to address not only some of the problems with the more traditional, incremental budgeting but also to better fit the needs of different types of businesses.
These are all well-established methods for budgeting.
You probably learned about all of them in Accounting 101. However, just as the role of SaaS finance leaders continues to evolve, so does their thinking with regard to how they can help the business grow faster and become more competitive in the market.
This is being addressed with strategic budgeting, a relatively new way of creating a budget using one of the methods in the list above. Whichever method you choose from the list above, strategic budgeting guarantees that it is aligned with your company’s larger strategic goals.
From there, you implement the plan as a rolling budget.
The three key activities involved in creating a strategic budget.
Source: Drivetrain
By marrying a more modern budgeting method with your company’s strategic plan, you can transform your budget from a static, myopic, 12-month view of your company’s finances to a visionary plan that will help you achieve stronger and more sustainable growth.
Business-as-usual budgeting won’t get you there and will cost you more than you realize.
While many of the true costs of incremental budgeting are not immediately obvious, over time, they can become a noticeable driver of demise. By the time you begin to see its negative impacts on your business, you will have lost much of the competitive edge you had, and course correction will become difficult at best or impossible at worst.
If you’re still using incremental budgeting in your business, the time to think about new methods is now. It’s hard to quantify the opportunity costs associated with inertia, but the SaaS industry is changing faster than ever in response to current economic conditions.
Whatever the true costs are, you can minimize and perhaps even eliminate unnecessary spending with an open mind and a willingness to embrace new approaches and new technology.
Ready to fine-tune your budgeting strategy? Explore this budget tracking guide, and learn more about the different types of tracking and best practices.
Edited by Aisha West
Upgrade your financial foresight, optimize planning, compare estimates with actuals, and stay ahead of changes to ensure your company's profitability.
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