Historical Budgeting: How It Works

Historical budgeting is a budgeting approach that focuses on past allocations and spending. This method starts by examining previous budget periods. Then, minor adjustments are made to account for required changes, such as inflation, changing interest rates, and material cost shifts.

In essence, new allocations are based on past allocations and budget period outcomes. Historical budgeting, also known as traditional budgeting, does not take into account missed opportunities, future project merit, or other factors.

How to Approach Historical Budgeting

Historical budgeting is primarily about analysis and standardization. More often than not, the goal is to continue with the status quo. Historical information is used to make minor adjustments to allocations in hopes of capturing a similar performance level during the next budget period.

If your company decides that a historical budgeting approach is the right fit, data gathering and analysis are critical parts of the equation. Your business needs to track prior allocations and departmental spending. Additionally, researching cost-impacting trends is essential, ensuring the proper adjustments are made to account for anticipated changes.

The Types of Businesses That Could Benefit from Historical Budgeting

By and large, the businesses that can benefit most from historical budgeting are those with a long history and broad stability. As mentioned above, the approach concentrates on continuing down a set path.

Similarly, businesses with a gradual and straightforward growth path could benefit from historical budgeting, as well. Your company can ramp up allocations in accordance with the growth rate, creating a smooth upward trajectory.

In some cases, companies with highly focused operations may also find that historical budgeting is a solid fit. For example, if the business offers a single service and has no intention to expand outside of that niche, the number of total budget categories could be incredibly limited. That could make alternative budgeting methods unnecessary.

How Historical Budgeting Compares to Other Budget Approaches

Historical budgeting is on one end of the budgeting spectrum. It relies on tradition, using budgets and spending from prior years as the baseline. On the far side of the spectrum is zero-based budgeting. Under this approach, every department competes for funds. When the new budget cycle is being planned, all departments are reset to zero. Then, they have to request a particular amount and justify their request.

Usually, zero-based budgeting is far more time-intensive. However, it allows any potential project to be examined individually. In some cases, this leads to a merit-based approach, as projects with the most potential are guiding forces in budgeting decisions.

There are a few budgeting techniques that fall in the middle of those options. With activity-based budgeting, the company focuses on a specific goal, working backward to determine allocations that make that target achievable.

While it can be effective in the short term, activity-based budgeting isn’t always ideal for long. At times, it’s overly focused on a single objective. If that occurs, critical categories may be overlooked. Additionally, chance opportunities may slip through your company’s fingers because you weren’t prepared to seize them.

Value proposition budgeting is another alternative. With this, every potential line item is examined to determine how much value it provides to the company. It encourages performance-based allocations, ensuring areas that are driving positive growth or profitability and prioritized over expense categories that aren’t measuring up.

However, value proposition budgeting can cause the company to overlook less glamorous necessities. At times, this can lead to shortfalls in undesirable areas, harming critical operations simply because they weren’t viewed as profit-driving or high-priority.

The Strengths and Weaknesses of Historical Budgeting

One of the biggest benefits of historical budgeting is its simplicity. Implementing the approach is incredibly quick, predominately because it relies heavily on budgets from past years. In most cases, only slight tweaks are needed, significantly shortening the amount of time it takes to plan a budget.

Additionally, for highly stable companies, historical budgeting could meet their needs year after year. Extensive overhauls simply aren’t necessary. Instead, minor adjustments to account for costs shifts, inflation, and other known factors are all that’s required.

Another strength is that this approach relies on actual outcomes. It accounts for past spending levels specifically. Your company doesn’t have to worry about the impact of potentially overly optimistic projections, as the basis of all budgeting decisions is past data.

However, historical budgeting does have some drawbacks. It’s primarily based on the belief that business operations will continue in the same fashion. At times, it may leave little room for sudden changes, such as adapting to the impact of events like the coronavirus pandemic.

In some cases, departments may go out of their way to spend their total allocation even if it isn’t necessary. Often, this is a defensive move designed to ensure their budget won’t be cut the following year, something that can occur when a historical budgeting approach is the norm.

Historical budgeting also eliminates any incentives for cost-cutting. Again, cost reductions could lead to budget cuts moving forward. Due to that, departments may avoid cost-saving measures to keep their budgets intact.

Further, historical budgeting doesn’t allow for quick shifts in priorities. It relies heavily on a “business as usual” mindset instead of one driven by innovation and growth. As a result, some potentially beneficial developments may be stymied solely because the budget doesn’t account for needed advancements within a particular department. Similarly, it could disincentivize creativity and new ideas, as employees know that the budget won’t be adjusted to make exploration possible.

Is Historical Budgeting Right for Your Business?

Ultimately, whether historical budgeting is the best fit for your business depends on your needs, preferences, structure, and other factors. Explore the various options, compare them to your goals, and see if one is the ideal match.

If not, consider blending multiple approaches together. In some cases, the best fit is a custom one, so don’t be afraid to break free of the mold if that will better meet your needs.

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