Your Guide To Making A Budget

Summary/TL;DR

Most people construct and manage their budget incorrectly, leading to an unsuccessful and frustrating experience. By properly prioritizing your savings target (known as reverse budgeting), thoroughly documenting and categorizing all expenses (including “Irregular Expenses), committing to your plan, regularly tracking progress, and automating as much as possible, you will be well on your way to taming your cash flow.

Introduction

Anyone who’s tried to budget before has likely found that reality rarely matches up with what they’ve put on paper. In my experience, this is because the way that most people construct and manage their budget is incorrect.

My personal system, which I’ve found to be very successful, will be described in today’s post.

Reverse Budgeting

When most people sit down to make a budget for the first time, they begin by writing out all of their sources of income, and follow it by writing out all of their expenses. What’s left, they believe, is what they have available for “saving”. Their budgeting process, in other words, follows this pattern: Income – Expenses = Savings.

If, however, we’re budgeting to gain control over our cash flow and expenses in order to meet saving targets, then it’s nonsensical to allow our expenses to determine our savings. Instead, I prefer an approach that’s become known as “reverse budgeting”, which looks like this: Income – Savings = Expenses, where Savings = 10-20% of Income. This approach properly prioritizes our objectives and is much more likely to lead to success.

Some expenses, however, are either essential for protecting and providing for your family (such as groceries, insurance premiums, etc), or are completely unavoidable (debt payments, property taxes, etc). I call these “Mandatory Expenses”. Other expenses, which I call “Voluntary Expenses”, are either substitutable for a lower cost alternative or can be abandoned altogether without threatening household stability. For this reason, I assign every expense in our budget to one of two categories: “Mandatory”, or “Voluntary”. Our budgeting formula therefore expands to the following:

Income – Mandatory Expenses – Savings = Discretionary Income

Discretionary Income – Voluntary Expenses = Net Cash Flow

4 Steps To A Solid Budget

Step 1: Write Everything Down

Start by writing down every source of income and expense you have, the frequency at which they’re received or incurred (monthly, quarterly, annually, etc), and the amount you spend on each item.

Make sure to include what I call “Irregular Expenses”, as forgetting about these are probably the primary reason that most attempts at budgeting fail. Irregular expenses are incurred at unpredictable or irregular intervals (home and car maintenance, birthday and Christmas gifts, travel, etc). When you write the amounts you spend on these, it helps to think in annual terms. For example, on my budget, I have $3,000/yr for home maintenance and $2,500/yr for car maintenance. These expenses will be put in monthly terms in a later step.

Make sure to think of what your “miscellaneous” expenses might be. Miscellaneous expenses are irregular in nature and are intended to serve as a “buffer” in your budget for things you can’t predict that you’d need. For example, my wife and I have young children and, as anyone with children knows, it’s impossible to predict what kind of expenses I’ll incur throughout the year for them. In just the past few months, we’ve purchased new highchairs, lunchboxes, cups, cribs, beds, toys… you get the picture. We have a "miscellaneous" category of $3,000/yr for each of our children and a general "miscellaneous" category of $5,000/yr.

Finally, put all of your expenses in monthly terms.

Step 2: Categorize

In this step, you’ll categorize every expense as either “Mandatory” or “Voluntary” (using the definitions discussed above), take the sum of each category (using their monthly amounts), and use the totals as inputs to our above formula: Income – Mandatory Expenses – Savings = Discretionary Income – Variable Expenses = Net Income.

If you completed Step 2 correctly and included all of your irregular and miscellaneous expenses, you should discover that your net cash flow is far less than you anticipated. Oftentimes, it will be negative.

Step 3: Make It Work

The purpose of this step is to identify and cut waste in your current budget by minimizing voluntary expenses to reach your target savings goal and pay off debt. Voluntary expenses are a privilege – you can have more of them after you’ve put your house in order. Until that time, mandatory expenses and savings goals need to be prioritized. Start with a savings goal of 10% and work from there.

If you have debt (perhaps besides a mortgage on your personal residence), working to aggressively pay it off is one of the most impactful things you can do to improve your budget and overall financial stability. I usually recommend the following list of priorities:

1. A savings target of 10% is used to build an emergency fund

2. Redirect your savings to contribute at least up to the match on your employer’s retirement plan and put everything else towards your debt until it’s paid off

3. Work up to a savings target of 20%

Step 4: Track and Refine

Your budget, especially your first budget, will never be perfect. You will inevitably forget numerous expenses or have new ones enter the picture and have to go back through Steps 1-3. For this reason, regularly reviewing your overall budget to further refine it is essential for its long-term success. I review all expenses once per week and review my overall budget once per quarter.

 There are plenty of great budgeting apps that you can use to upload your budget into and make this step very quick and easy.

Automate Your Cash Flow

No budgeting system is complete without a cash flow system. You need to automate as much as you can to protect your budget from error and minimize the opportunities for making mistakes or exceptions. The cash flow system I use will be discussed in a future post.