When I started my first real budget as an adult, the concept was not difficult. I knew I had to track my spending and keep myself from paying more than necessary for expenses I could control in order to fix my financial situation. To reverse the trend of increasing debt every month, I came up with a simple spending plan that suited my needs.
Although the software I was using to manage my personal finance — at that time, a free version of MoneyDance, though I also experimented with GnuCash — categorized my expenses into at least twenty categories. Like I discussed with J.D. Roth from Get Rich Slowly on this past Sunday’s podcast, complicated budgets don’t work as often as simple plans that break spending down into the most core components.
J.D. is a fan of the Balanced Money Formula of budgeting, which is an overall approach of spending 50% of your after-tax expenses on “needs,” 30% on “wants,” and 20% on “savings.” These ratios serve as a goal that one can strive to reach eventually, much like the ideal weight I’m slowly working towards today. But this is not a full budgeting solution. It lays the groundwork, but you need to examine your spending with a little more detail, possibly asking yourself and answering a few questions.
What constitutes a need or want? Some areas of spending can be reason to be needs when they may actually be wants, and what one person wants may be something another family needs. For an entrepreneur whose business relies on access to the internet, this is a need — and a business expense. Is a cell phone a need or a want? What about a smart phone versus a basic phone? Where does charity fit into the picture?
You will likely find that some expenses are partly needs and partly wants. Food is necessary for survival, but is dining out every week the only option for keeping a family alive?
Even once questions like the above are answered, budgeting hasn’t really started. You cannot effectively budget without tracking your finances and knowing what you are spending — and what you could spend in the ideal “low expense” world — within a variety of real, meaningful categories. If I didn’t create a category for my rent expenses when I budgeted, I may not have worked to reduce that expense at a time I really needed to keep my expenses low. If I didn’t focus specifically on the amount of money I spent on food, I wouldn’t have been able to reduce my spending at restaurants, fast-food and otherwise.
There is an essential list of categories that you need to budget for when you’re looking to reduce your expenses due to an inability to save for the future. The key is finding the balance between a plan simple enough to maintain motivation while detailed enough to have a meaningful effect. Looking at just your wants, needs, and savings is good for tracking your budgeting success, but in practical terms, you’ll need to determine specific categories.
When considering budgeting, I like to refer back to Maslow’s Hierarchy of Needs and my college Introduction to Psychology course. Physiological needs come first, including food, water and shelter (rent or mortgage, for example), and clothing. Sex is also a physiological need, but budgeting money to spend for sex might be beyond the scope of financial needs.
Once physiological needs are covered in the budget, you need to think about safety needs. Health insurance is probably towards the top of this list, despite the fact that most people don’t budget for insurance — they rely on an employer to just deduct an amount from a paycheck. Insurance is an oft-forgotten line item in a budget, perhaps due to the need for simplification or due to a lack of consideration. Also in the safety category, but arguably a physiological need as well, are the utilities that cost money, like providing power to your home. Humans survived for many thousands of years without electricity, though, so I would not rank this as high as shelter and food. Nevertheless, it’s important for living in modern society.
All other categories and the other levels in Maslow’s hierarchy could be considered wants. Education, gift-giving, dining out, and entertainment should be part of your budget. Love and belonging, esteem, and self-actualization are the higher levels in the pyramid-shaped representation of the hierarchy. The expenses below apply to everyone within the household and do not include taxes. Debt repayment, savings, and investing aren’t on this list, though they play important roles in budgeting. They might be suited to be placed under the 20% “savings” banner, while the below categories focus on the “wants” and “needs” of the Balanced Money Formula.
Level 1: Physiological Needs
- Housing: rent or mortgage payments
- Basic sustenance: groceries, cooking and water
- Clothing: non-designer brand essential wear
Level 2: Safety Needs
- Power (electricity, gas)
- Basic telephone service
- Insurance: health, home, and life
- Vehicle or other transportation
- House repairs and maintenance
- Expenses related to operating your business
Level 3: Love and Belonging
- Charitable contributions
- Spending time with friends and family
Level 4: Esteem
- Work-appropriate clothing
- Education and professional development
- Dining out
- Fitness beyond basic health needs
Level 5: Self Actualization
- Internet, if not needed for generating income
- Vacations, non-essential travel
What do you think of the above list? Should anything be added or moved to a different hierarchy level?
Updated December 22, 2011 and originally published May 10, 2011. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.