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Incremental budgeting: The worst thing you can do for your company's financial health

by , 28 January 2015
Incremental budgeting is when you take last year's budget and simply add an inflation percentage to it to adjust it for the year ahead.

This might seem like a logical approach to budgeting, but it's not.

The truth is, this could be the undoing of your entire financial plan for this year and it could lead to a massive financial loss.

Read on to discover why incremental budgeting could have such a devastating affect on your company's financial management and why you must avoid it at all costs...


If you want your company's 2015 financial plan to be successful, don't use incremental budgeting

The Practical Accountancy Loose Leaf Service lists incremental  budgeting as one of the top three budgeting mistakes business owners make. 
The problem with merely increasing last year's budget by a fixed amount is it doesn't reflect reality. 
You have to remember, inflation isn't a single number. So never treat it like this. 
The South African Consumer Price Index consists of more than 400 items. These items fall into 12 major categories of consumer expenses. Each one of these increases at a different rate.
This means your expenses won't all increase by the same rate, if at all. So, if you simply increase your forecast profits by the inflation rate, they'll be unrealistic. 
For example, let's assume you forecast your profits for 2014 as R1.4 million. 
But you had to do major repairs that cost you R210 000. This means your profits for last year decreased by 15% from your forecast amount. 
But, when you draw up your budget for 2015, you simply add 6% for inflation to the R1.4 million you forecast for last year. 
This means your profit projections for 2015 are out by a massive 21%.
As you can see, your budget won't be accurate because it doesn't reflect your company's true performance. It doesn't take into account that you didn't even achieve your projections for last year, so how can you reach ones that are 6% higher?
So how can you avoid making this massive mistake?
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When new expenses arise, no one could have imagined they would be a source of so many serious problems for your business cash flow.
Even the slightest discrepancy in your financial budget can result in you not knowing whether your business is over performing or underperforming.
This is why you need a solid financial budget for your business.

Here's what you need to do to avoid this mistake when you draw up your financial budget and plan

First, you must analyse your financial history to see the actual increases in your profits and expenses. 
Then, work out your company's average growth and inflation rate over the last three years.
Next, do some research. Find out if your expenses are going to increase because of inflation. Make sure you find the specific inflation rate for your various expenses. 
Lastly, look at any other specific factors, such as a current slump in the economy. Look at how your competitors are doing. 
From there, you can forecast what your profit and expenses for the year will be. 
This is a far more realistic way to ensure your financial budget will actually work for your company and help you avoid a massive financial loss.
PS. To make sure you do all your forecasting correctly, check out the Master Budget Series.

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