Businesses use budgeting to forecast income and expenses for the year. With a budget, individuals who manage companies’ money will have a decent of idea of how much cash they need at any time of the year to meet the company’s obligations. Personal budgets work the same way. At the beginning of the year, it’s helpful to determine a rough guideline for future spending.
Personal budgets are the most useful for people whose spending approaches or exceeds their income. For people in this situation, sticking to a plan is the most important aspect to improving financial condition. Saving for the future can only take place when the amount spent each year is less than the income earned. Otherwise, debt increases each year. A debt that grows each year is like slavery; more and more of the work you do and the money you earn goes to paying someone else rather than yourself. Additionally, interest expense should generally be unnecessary, unless the cost of debt is less than the income you are generating due to that debt.
It’s best to avoid debt and its expense as much as possible, and a budget can get someone to that point. Budgeting helped me when I quit my low-earning non-profit job. First I took an inventory of my situation and reflected on a few months of income and spending, using the free-at-the-time personal finance software Moneydance. From there, I could take some educated guesses about my future spending, targeting areas where I had to cut back until I could increase my income.
Now that I’m in a better financial position, I argue that a budget is no longer a requirement. One of the most important aspects of personal finance is to spend less than you earn. A budget gets you to that way of living. Once you’re comfortable and once you’ve limited your bad habits, a budget is not as urgent. If you’re watching your spending each month, you can easily adjust without a budget. However, if you are living paycheck-to-paycheck, a budget is going to keep you from getting behind month after month.
In a former job, I prepared “Actual vs. Budget” reports for the company. The areas of the company that provide services to the business units don’t make money from the public. There is little opportunity to earn more money for the company in these areas, so the best way to help the corporation meet its financial goals was to cut costs as much as possible. Thus, vice presidents wanted to review their performance against the budget on a monthly basis.
There is a tendency to get carried away with personal budgets. While those living on the edge of spending all their income or more should scrutinize each time they part with their funds, living one’s life chained to a spending plan is unfulfilling. If my income or savings allows for it, I want to be able to overspend. I don’t want a budget that controls me. I don’t want to feel nervous or anxious about spending money because I may be going beyond an arbitrary amount I set for myself months prior.
Therefore, a budget for someone with a solid control of their finances should be a rough guideline. There should be no punishment when spending goes over the plan as long as it’s not indicative of a troubling trend. Budgets should be adjustable. There are many times when life changes come unexpectedly. (Do you have an emergency fund?) It’s not out of the question to discard a budget and start over if circumstances dictate broad changes.
That is the point of view I have decided to take when developing my budget for 2008. I haven’t created one since 2002, and even then, I abandoned it within a year because I managed to get myself in gear within months. Nevertheless, I’ve decided to design a rough personal budget this year. My spending in the past few months has increased, mostly because I was in a position to do so and I had been putting some purchases off for years.
Each month, in addition to my balance sheets and income statements, I will publish an actual vs. budget report. This will help me identify the categories where I consistently “overspend” (according to my own guidelines). Though Quicken helps me do this now, I would say that it is simply too detailed. Rather than the 41 categories I present in my monthly report, and the many more I have in Quicken, my budget reports reduces my spending to a total of 9 non-discretionary and 5 discretionary categories.
I will post my spending plan tomorrow morning.
Image credit: Jeff Keen