Many of us avoid budgeting as if it were the plague. After all, do you really want to know that 30% of your take-home pay is going to restaurant meals? Yet preparing, analyzing, and monitoring your personal budget are essential steps for successful personal financial planning. After defining your short-term financial goals, you can prepare a cash budget for the coming year. Recall that a budget is a short-term financial planning report that helps you achieve your short-term financial goals. By taking the time to evaluate your current financial situation, spending patterns, and goals, you can develop a realistic budget that is consistent with your personal lifestyle, family situation, and values. A cash budget is a valuable money management tool thathelps you:
1. Maintain the necessary information to monitor and control your finances
2. Decide how to allocate your income to reach your financial goals
3. Implement a system of disciplined spending as opposed to just existing from one paycheck to the next
4. Reduce needless spending so you can increase the funds allocated to savings and investments
5. Achieve your long-term financial goals
Just as your goals will change over your lifetime, so too will your budget as your financial situation becomes more complex. Typically, the number of income and expense categories increases as you accumulate more assets and debts and have more family responsibilities. For example, the budget of a college student should be quite simple, with limited income from part-time jobs, parental contributions, and scholarships and grants. Expenses might include room and board, clothes, books, auto expenses, and entertainment. Once a student graduates and goes to work fulltime, his or her budget will include additional expenses such as rent, insurance, work clothes, and commuting costs. For most people this process does not become simpler until retirement.
The Budgeting Process
Like the income and expense statement, a budget should be prepared on a cash basis; thus, we call this document a cash budget because it deals with estimated cash receipts and cash expenses, including savings and investments, that are expected to occur in the coming year. Because you receive and pay most bills monthly, you’ll probably want to estimate income as well as expenses on a monthly basis. The cash budget preparation process has three stages: estimating income, estimating expenses, and finalizing the cash budget. When you’re estimating income and expenses, take into account any anticipated changes in the cost of living and their impact on your budget components. If your income is fixed not expected to change over the budgetary period then increases in various expense items will probably decrease the purchasing power of your income. Worksheet 2.3, the Cases’ “Annual Cash Budget by Month,” has separate sections to record income (cash receipts) and expenses (cash expenses) and lists the most common categories for each.
Estimating Income
The first step in preparing your cash budget is to estimate your income for the coming year. Include all income expected for the year: the take-home pay of both spouses, expected bonuses or commissions, pension or annuity income, and investment income interest, dividend, rental, and asset (particularly security) sale income. When estimating income, keep in mind that any amount you receive for which repayment is required is not considered income. For instance, loan proceeds are treated not as a source of income but as a liability for which scheduled repayments are required. Unlike the income and expense statement, in the cash budget you should use take-home pay (rather than gross income). Your cash budget focuses on those areas that you can control and most people have limited control over things like taxes withheld, contributions to company insurance and pension plans, and the like. In effect, take-home pay represents the amount of disposable income you receive from your employer.
1. Maintain the necessary information to monitor and control your finances
2. Decide how to allocate your income to reach your financial goals
3. Implement a system of disciplined spending as opposed to just existing from one paycheck to the next
4. Reduce needless spending so you can increase the funds allocated to savings and investments
5. Achieve your long-term financial goals
Just as your goals will change over your lifetime, so too will your budget as your financial situation becomes more complex. Typically, the number of income and expense categories increases as you accumulate more assets and debts and have more family responsibilities. For example, the budget of a college student should be quite simple, with limited income from part-time jobs, parental contributions, and scholarships and grants. Expenses might include room and board, clothes, books, auto expenses, and entertainment. Once a student graduates and goes to work fulltime, his or her budget will include additional expenses such as rent, insurance, work clothes, and commuting costs. For most people this process does not become simpler until retirement.
The Budgeting Process
Like the income and expense statement, a budget should be prepared on a cash basis; thus, we call this document a cash budget because it deals with estimated cash receipts and cash expenses, including savings and investments, that are expected to occur in the coming year. Because you receive and pay most bills monthly, you’ll probably want to estimate income as well as expenses on a monthly basis. The cash budget preparation process has three stages: estimating income, estimating expenses, and finalizing the cash budget. When you’re estimating income and expenses, take into account any anticipated changes in the cost of living and their impact on your budget components. If your income is fixed not expected to change over the budgetary period then increases in various expense items will probably decrease the purchasing power of your income. Worksheet 2.3, the Cases’ “Annual Cash Budget by Month,” has separate sections to record income (cash receipts) and expenses (cash expenses) and lists the most common categories for each.
Estimating Income
The first step in preparing your cash budget is to estimate your income for the coming year. Include all income expected for the year: the take-home pay of both spouses, expected bonuses or commissions, pension or annuity income, and investment income interest, dividend, rental, and asset (particularly security) sale income. When estimating income, keep in mind that any amount you receive for which repayment is required is not considered income. For instance, loan proceeds are treated not as a source of income but as a liability for which scheduled repayments are required. Unlike the income and expense statement, in the cash budget you should use take-home pay (rather than gross income). Your cash budget focuses on those areas that you can control and most people have limited control over things like taxes withheld, contributions to company insurance and pension plans, and the like. In effect, take-home pay represents the amount of disposable income you receive from your employer.
Estimating Expenses
The second step in the cash budgeting process is by far the most difficult: preparing a schedule of estimated expenses for the coming year. This is usually done using actual expenses from previous years (as found on income and expense statements and in supporting information for those periods), along with predetermined shortterm financial goals. Good financial records, as discussed earlier, make it easier to develop realistic expense estimates. If you do not have past expense data, you could reexamine old checkbook registers and credit card statements to approximate expenses, or take a “needs approach” and attach dollar values to projected expenses. Pay close attention to expenses associated with medical disabilities, divorce and child support, and similar special circumstances. Whether or not you have historical information, when preparing your budget be aware of your expenditure patterns and how you spend money. After tracking your expenses over several months, study your spending habits to see if you are doing things that should be eliminated. For example, you may become aware that you are going to the ATM too often or using credit cards too freely.
You’ll probably find it easier to budget expenses if you group them into several general categories rather than trying to estimate each item. Worksheet 2.3 is an example of one such grouping scheme, patterned after the categories used in the income and expense statement. You may also want to refer to the average expense percentages given in Exhibit 2.3. Choose categories that reflect your priorities and allow you to monitor areas of concern.
Your expense estimates should include the transactions necessary to achieve your short-term goals. You should also quantify any current or short-term contributions toward your long-term goals and schedule them into the budget. Equally important are scheduled additions to savings and investments, because planned savings should be high on everyone’s list of goals. If your budget doesn’t balance with all these items, you will have to make some adjustments in the final budget. Base estimated expenses on current price levels and then increase them by a percentage that reflects the anticipated rate of inflation. For example, if you estimate the current monthly food bill at $500 and expect 4% inflation next year, you should budget your monthly food expenditure next year at $520, or $500 $20 (4% $500). Don’t forget an allowance for “fun money,” which family members can spend as they wish. This gives each person some financial independence and helps form a healthy family budget relationship.
Finalizing the Cash Budget
After estimating income and expenses, finalize your budget by comparing projected income to projected expenses. Show the difference in the third section as a surplus or deficit. In a balanced budget, the total income for the year equals or exceeds total expenses. If you find that you have a deficit at year end, you’ll have to go back and adjust your expenses. If you have several months of large surpluses, you should be able to cover any shortfall in a later month, as explained later. Budget preparation is complete once all monthly deficits are resolved and the total annual budget balances. Admittedly, there’s a lot of number crunching in personal cash budgeting. As discussed earlier, personal financial planning software can greatly streamline the budget preparation process.
Dealing with Deficits
Even if the annual budget balances, in certain months expenses may exceed income, causing a monthly budget deficit. Likewise, a budget surplus occurs when income in some months exceeds expenses. Two remedies exist:
The second step in the cash budgeting process is by far the most difficult: preparing a schedule of estimated expenses for the coming year. This is usually done using actual expenses from previous years (as found on income and expense statements and in supporting information for those periods), along with predetermined shortterm financial goals. Good financial records, as discussed earlier, make it easier to develop realistic expense estimates. If you do not have past expense data, you could reexamine old checkbook registers and credit card statements to approximate expenses, or take a “needs approach” and attach dollar values to projected expenses. Pay close attention to expenses associated with medical disabilities, divorce and child support, and similar special circumstances. Whether or not you have historical information, when preparing your budget be aware of your expenditure patterns and how you spend money. After tracking your expenses over several months, study your spending habits to see if you are doing things that should be eliminated. For example, you may become aware that you are going to the ATM too often or using credit cards too freely.
You’ll probably find it easier to budget expenses if you group them into several general categories rather than trying to estimate each item. Worksheet 2.3 is an example of one such grouping scheme, patterned after the categories used in the income and expense statement. You may also want to refer to the average expense percentages given in Exhibit 2.3. Choose categories that reflect your priorities and allow you to monitor areas of concern.
Your expense estimates should include the transactions necessary to achieve your short-term goals. You should also quantify any current or short-term contributions toward your long-term goals and schedule them into the budget. Equally important are scheduled additions to savings and investments, because planned savings should be high on everyone’s list of goals. If your budget doesn’t balance with all these items, you will have to make some adjustments in the final budget. Base estimated expenses on current price levels and then increase them by a percentage that reflects the anticipated rate of inflation. For example, if you estimate the current monthly food bill at $500 and expect 4% inflation next year, you should budget your monthly food expenditure next year at $520, or $500 $20 (4% $500). Don’t forget an allowance for “fun money,” which family members can spend as they wish. This gives each person some financial independence and helps form a healthy family budget relationship.
Finalizing the Cash Budget
After estimating income and expenses, finalize your budget by comparing projected income to projected expenses. Show the difference in the third section as a surplus or deficit. In a balanced budget, the total income for the year equals or exceeds total expenses. If you find that you have a deficit at year end, you’ll have to go back and adjust your expenses. If you have several months of large surpluses, you should be able to cover any shortfall in a later month, as explained later. Budget preparation is complete once all monthly deficits are resolved and the total annual budget balances. Admittedly, there’s a lot of number crunching in personal cash budgeting. As discussed earlier, personal financial planning software can greatly streamline the budget preparation process.
Dealing with Deficits
Even if the annual budget balances, in certain months expenses may exceed income, causing a monthly budget deficit. Likewise, a budget surplus occurs when income in some months exceeds expenses. Two remedies exist:
- Shift expenses from months with budget deficits to months with surpluses (or, alternatively, transfer income, if possible, from months with surpluses to those with deficits).
- Use savings, investments, or borrowing to cover temporary deficits. Because the budget balances for the year, the need for funds to cover shortages is only temporary. In months with budget surpluses, you should return funds taken from savings or investments or repay loans. Either remedy is feasible for curing a monthly budget deficit in a balanced annual budget, although the second is probably more practical. What can you do if your budget shows an annual budget deficit even after you’ve made a few expense adjustments? You have three options, as follows.
- Liquidate enough savings and investments or borrow enough to meet the total budget shortfall for the year. Obviously, this option is not preferred, because it violates the objective of budgeting: to set expenses at a level that allows you to enjoy a reasonable standard of living and progress toward achieving your long-term goals. Reducing savings and investments or increasing debt to balance the budget reduces net worth. People who use this approach are not living within their means
- Cut low-priority expenses from the budget. This option is clearly preferable to the first one. It balances the budget without using external funding sources by eliminating expenses associated with your least important short-term goals, such as flexible or discretionary expenses for nonessential items (e.g., recreation, entertainment, some types of clothing). This chapter’s Money in Action feature can help you find easy ways to spend less
- Increase income. Finding a higher-paying job or perhaps a second, part-time job is the most difficult option; it takes more planning and may result in significant lifestyle changes. However, people who can’t liquidate savings or investments or borrow funds to cover necessary expenses may have to choose this route to balance their budgets.
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