Types of budgets - Historical figures 2.2.4

Historical figures - budget initially based on the figures from previous period (year)

Extrapolation - means assuring that past trends will continue into the future. It must be used with care because changes in business conditions may require adjustments to be made.

For an existing business it may be best to produce a budget based on previous figures, such as last year's sales and costs. This approach uses extrapolation to model the next year's targets

• As the product moves through its life cycle, it places different demands on budgets, for example less adverting may be needed.
• Allowances need to be made for inflation, to ensure estimates are correct
• Sales figures can be unpredictable 
• Costs may not be the same
• Economic variables such as the business cycle can affect budget figures
• Unforeseen events such as the euro crisis can affect budgets. 

A historical budget is realistic in that it is based on actual results, HOWEVER, circumstances may have changed (e.g. new products, lost customers, credit crunch. Additionally, this type of budget does not encourage efficiency, instead it encourages the business to be "spending up to the budget" to ensure a reasonable allocation in the next period. It leads to a "spend it or lose" mentality.

This type of budget can be adjusted in line with actual outcomes and is linked to the ability to meet outcomes.

Advantages of historical budgeting

• The budget is stable and change is gradual.
• Realistic as it is based on actual results
• Managers can operate their departments on a consistent basis.
• The system is relatively simple to operate and easy to understand.
• Conflicts should be avoided if departments can be seen to be treated similarly.
• Co-ordination between budgets is easier to achieve.
• The impact of change can be seen quickly.

Disadvantages of historical budgeting

• Assumes activities and methods of working will continue in the same way.
• No incentive for developing new ideas.
• No incentives to reduce costs.
• Encourages spending up to the budget so that the budget is maintained next year.
• The budget may become out of date and no longer relate to the level of activity or type of work being carried out.
• The priority for resources may have changed since the budgets were set originally.
• There may be budgetary slack built into the budget, which is never reviewed-managers might have overestimated their requirements in the past in order to obtain a budget which is easier to work to, and which will allow them to achieve favourable results.