While the following article may be very basic, it is meant to be a jumping off point to a series of articles on personal budgeting. It’s for those people who may be new to personal finance, for those of us who were never taught properly early in life, and for those that find ourselves in a situation where it is important to get our financial lives under control. Lets jump right in, shall we?
So what is budgeting anyways? In the simplest of terms, it is a plan for what to do with your money.
Budgeting vs. Frugality
I think a lot of people new to personal finance often confuse the concept of budgeting with living cheaply a.k.a. being frugal. What most people don’t understand is that these two concepts are not mutually exclusive. It is quite possible for someone to live on a budget while spending extravagant amounts of money. It is also possible for someone to live very cheaply within the means of their income, but not have any kind of a budget at all. And while the two are not the same, having a budget and sticking to it does tend to cause most people to make better decisions regarding their own financial behaviors, which tends to include becoming a more frugal shopper.
Lets take a look at the official definitions of these two concepts just to make sure we are all on the same page:
budget – 1) an estimate, often itemized, of expected income and expense for a given period in the future. 2) a plan of operations based on such an estimate. 3) an itemized allotment of funds, time, etc., for a given period. 4) the total sum of money set aside or needed for a purpose.
frugal – 1) economical in use or expenditure; prudently saving or sparing; not wasteful. 2) entailing little expense; requiring few resources; meager; scanty.
As we can see from these definitions, living a life resigned to clipping coupons and eating rice and beans for every meal does not mean you are budgeting, it just means you are being very frugal.
Types of Budget Methods
While the basic definition of a budget is pretty simple, the act of budgeting can be as easy as a few line items jotted down on a scrap of paper or it could be an incredibly complex spreadsheet with all kinds of complicated formulas, equations, and pivot tables. Also, It should be noted that the more complex the budget is does not necessarily mean it is better.
Do you want to know what THE best budget method is? It is the one that you’ll actually use and stick to.
There are all types of methods for creating a budget which I’ll discuss in a a moment, but first I want to be clear that the act of making a budget really isn’t going to solve your financial problems unless you actually use that budget on a regular basis and track your actual spending against it. Because your budget is a plan, it only works when you stick to the plan.
Monthly Budget Forecasting
When most people first create a budget, they typically start by listing out their monthly income and estimated expenses into categories on a spreadsheet. They then project or forecast those spending figures out into future months. The idea with this method is that you are playing the “what if” game, as in what if I earn this amount of money and only spend this amount each month, then where does that get me financially in X amount of months?
A simple example of this type of budget forecast would look something like this:
While this forecasting method is useful as a starting point, most people just end up setting it aside somewhere on their computer never to be seen again while they go back to their current spending habits. As mentioned above, when you forecast you are dealing in a “what if” scenario where you are not necessarily taking into account your actual expenses.
Budget vs. Actual Variance Analysis
For a budget to truly help you financially, you’d need to keep track of actual expenses and compare them to the budgeted amounts so that you can at least see where the problem areas are in your financial life. Then you adjust your behavior the following month to try to match the budget.
This type of comparison between the budgeted amounts and actual amounts is called the variance, which is just a fancy way of saying the difference between two amounts. Here’s a quick definition in terms of budgeting and accounting:
- variance – the difference between a budgeted, planned or standard cost and the actual amount incurred/sold. Variances can be computed for both costs and revenues.
This type of budget vs actual variance setup would look something like this:
In this example, there are three columns which show the amount budgeted, actual expenses, and the variance or difference for each monthly expense category. This is a budget that is actually useful because we can see areas where we overspent (the numbers in the red brackets), then make adjustments either to the budgeted amounts or our spending habits. The point is, rather than playing the “what if” game, we are now creating awareness of our own financial behavior in which better decisions can be applied to the future.
Another example of this type of budgeting and expense tracking can be seen in the popular online financial management website, Mint.com. While I personally don’t use Mint for its budgeting feature it is a good start for creating a budget to track your actual spending against. It also has the nifty feature of automatically importing your transactions from your banks and credit cards which is used to calculate your actual spending amounts; although there is some work involved on your part to categorize the expense transactions.
The example budget from Mint would look something like this:
As you can see, it is a similar concept to the budget vs. actual variance analysis we discussed previously. This Mint example has the same three columns: budgeted amount, actual expense, and what’s left over; except that this budget is graphically displayed in a different way. The left hand column with the green tracking bars indicates the actual amounts spent, the middle column displays the budgeted amount and the far right column shows the variance (what’s left).
Zero Based Budgeting
My personal favorite budgeting method which I believe to be the most useful is called a Zero Based Budget which some people also refer to as a Zero Sum Budget. This method is one that has become quite popular for personal budgeting and advocated by many personal finance gurus like Dave Ramsey as one example.
While I won’t get into the nitty gritty details of Zero Based Budgeting in this article, I will give you the basic idea of the process and two popular systems that follow the zero based budget method.
Essentially, a zero based budget is one where every dollar of income is budgeted towards a specific expense category so that there is a zero balance remaining. It is important to note that this method does not mean that you spend all your money, it just means that you are giving every dollar of actual income a specific job. Some dollars go towards rent, some dollars go towards food, some dollars go towards savings, and so on. The basic principle is that the bottom line is always zero, since any overspending in one budgeted category must be adjusted by decreasing the budget in another category to make sure there is never a negative or positive sum for the entire budget.
Another main principle of the zero based budget is that you only budget the money that you actual have. There is no forecasting or projecting with income that is anticipated, there are no “what if” games, you only work with the money you have access to.
Envelope Budget System
One system that Dave Ramsey often recommends for zero based budgeting is the envelope budget system. This system is very easy and doesn’t even require you to make any complicated spreadsheets.
The basic idea is you get a bunch of paper envelopes and label them with your different expense categories like rent, groceries, utilities, etc. Then every time you get paid, you take that money in cash and split it up into your different envelope categories based on what your estimated expenses will be. Then when you need to buy something you only take the money from the envelope category for that particular expense, that’s it. If you want to buy something in a particular category and there is no money in the envelope, then you can’t buy that thing until new income comes in and is allocated to that envelope category.
This is a great system for those who have a hard time controlling their spending on debit and credit cards. Being forced to only pay for things in cash from specific budgeted envelope categories tends to be a great reality check for those people who constantly find themselves spending more than they earn.
You Need A Budget Software – YNAB
While the envelope budget method is a good system, the one main drawback is that it is a cash based system in a world that is increasingly digital. This can be a problem if you buy items online or pay bills online.
Since I tend to consider myself part of the 21st century, I like to embrace the convenience and efficiency of digital payments, which is why I use a zero based budgeting software called YNAB, which is an acronym for You Need A Budget.
An example of a YNAB budget would look something like this:
Again, I’ll save the details for another article which gives a better overview of the YNAB software, but in the above image we can see the typical parts of a budget such as expense categories, budgeted amounts, actual amounts, and variance. However, we also have a big box at the top which shows the amount “Available to Budget” which should always show a zero if we are following a zero based budgeting approach. Should any new income come in, that amount that is available to budget will increase in which case it is your job to give every one of those dollars a job or a plan within your budget.
What is Budgeting Going To Do For You?
We’ve gone over some basic concepts in terms of what budgeting is as well as some different types of methods and systems for creating a budget, though there are plenty more. However, the point of this overview on what is budgeting, is meant to be both a quick introduction to budgeting and to drive home the importance of having a “plan” for your own personal finances.
Just like anything in life, it is usually better to go into a situation with a well thought out plan, and even though life may throw you curveballs from time to time, you’ll fare much better when you have those contingencies built into your plan. The same sentiment is true for dealing with your money, especially if you are the type of person who is currently living paycheck to paycheck and/or in some sort of debt. If you have a plan for dealing with your money, aka a budget, then at least you’ll be prepared for when life throws you a financial curveball.
This is just the first article of a series on personal budgeting. If there is anything in the above article that is not clear, doesn’t make any sense to you, or have questions about; please ask in the comment form below and I will do my best to clear things up.