This is the fourth in a series of six articles in which we cover how to create a budget. The previous post Use Cari$ Budget to Pull Everything Together covered how to use a spreadsheet to enter the data you’ve gathered, as well as projecting for twelve months. Here, we show you how to take the next crucial step.
If you’ve pulled together all of your income and expenses for a twelve month period, congrats! You have made considerable progress towards taking control of your finances, because now you know your financial picture. It’s like a self portrait, except in $. So, what’s next? You need to create your budget.
As a reminder, a budget is not a list of income and expenses. What you’ve done so far is to gather a few months of income and expenses and project those for one year (January to December). This is NOT your budget. Now you need to use this information to actually create your budget.
Determine your savings target
Once you decide that, and we assume it is higher than what your financial picture is currently showing, then you have two variables to change.
Either you need to make more money…don’t roll your eyes. This is an important realization. Because if we understand in dollars and cents that we simply can’t live on the income we make, we then put all our energies into finding higher income e.g. new job, getting more educated, fighting for a promotion, or getting a second (or even third) job.
But the second choice is usually the one we start with: Reduce expenses. Take a long hard look at each expense area and see how to reduce. Of course, it makes sense to tackle the largest numbers first. (Check out the post Visualize Your Expenses to learn more.) And don’t assume nothing can be done; every area can be reduced if things are desperate enough, rent, mortgages, whatever.
But the first area that generally gets reduced is the discretionary component. Which is why we lay out our budgets in Fixed and Discretionary. Taking the hatchet to Discretionary expenses is usually easy. We can always go out less, eat out less, buy less clothes, rent a movie instead of going to the cinema, use public transport occasionally instead of paying for gas, etc.
What we’ve found is most people understand the need to save but they get hung up on “how much should I save?” They just don’t know what is the right amount. The easy answer is you have to save enough to allow you to meet your retirement goals, while enjoying life in the meantime. [Update: check out the post What Are Savings? to learn more.]
Our 33/33/33 approach
Yeah, we bet you’re saying, “That sounds nice, but how do I do it?”. The truth is, this is hard to estimate because it requires thinking about events that will not happen for many years (e.g. where will you be working, what is your future income level, are you renting or owning a home, etc.) We’ll show you how to do this in other sections to come, but for now, let’s just acknowledge that the “right” amount is not easy to quantify, but while we’re trying to figure out what our future looks like, we need a financial strategy.
All 3’s. What could possibly be simpler?! All right, all right, let us explain.
We believe balance is important and things usually go astray when we depart from a balanced and “everything in moderation” approach. Think about it and you’ll identify many examples; however, this ain’t no philosophy site, so we’ll leave this idea right here. The point is, balance in financial matters is necessary as well (for example, a low level of savings now means a great life now, but a difficult retirement). Therefore, we believe most people’s budgets (yes there are exceptions) should be configured in this way:
Take your total annual take home income e.g. $36,000
- Multiply it by a third i.e. 33% equals $12,000
- Your Fixed expenses should therefore not be more that $12,000
- Your Discretionary expenses therefore not be more that $12,000
- Your targeted level of annual savings should be at least $12,000
Don’t blow a gasket! Notice we said “targeted” level of savings. Most likely you’re far away from 33% and that’s perfectly fine. The purpose of the budget is to set an annual target that eventually gets you to 33%. For example, if you currently save 5% of your take home salary, it will be silly to immediately try to get to 33%, assuming you aren’t just wasting a big chunk of money. But you can make a serious effort to get there in 2 or 3 years.
We expect many of us will be around 5-10%, most likely because Fixed expenses are too high. Whatever the reason, this 33/33/33 framework we are suggesting gives you a clear and numerical target.
Could you choose a lower % than 33% targeted level of savings? Absolutely. You have to choose what you feel comfortable with. All we are suggesting is you need to make that decision in the context of what is your retirement picture. If you have clearly mapped out what you need in retirement and as a result you estimate that you only need to save 10% of your take home salary, then go for it. BUT if you don’t have such a clear picture, then use our approach until you figure out what’s right for you.
At this point, you probably need to talk to someone and get some help with defining how to move to 33% targeted level of savings. Contact Us to if you think we can help.
Variable Income e.g. Bonuses
In the last section, we mentioned that you need to carefully consider how to treat “one-off” type income such as performance bonuses. We believe these should NOT be included in your budget because whether they are actually received and the amount is beyond your control. And the last thing you need to do is create a level of expenses that depends on an uncertain level of income.
Far too many people rely on bonuses to sustain a lifestyle, and it is an earth-shattering event when the amount they receive is less than they expected. Income that is so uncertain should just not be budgeted.
Instead a better approach is to leave that income out but also leave out big, chunky discretionary expenses e.g. vacations. It’s ok to include long-weekend beach limes in your budget, but more expensive vacations that involve overseas travel are better left out of your budget and use your bonus to fund those purchases.
Also important is DON’T SPEND ALL OF YOUR BONUS. We recommend that you save half and spend half. Trust us, you’ll enjoy the amount you spend a lot more (guilt-free spending) because you’ll be feeling a certain level of pride that you are managing your finances.
Sales and Other Variable Commission Income
But what about those of us that earn sales commissions for example? It’s regular-ish income but the amount received varies.
You have no choice, these have to be included in your projected income, but just be careful. It’s better to under-budget than over-budget it. Meaning, project the LEAST amount you think you’ll make, and then make your expenses fit this lowest level. Then you’ll only have potential upside if you make more than you projected, and no disappointment and stress from earning less.
Interest and Dividend Income
As mentioned, a few of us may have investments that provide a return in either interest or dividend. And we’re not talking about the pittance interest you earn on your bank balances. We’re talking about interest on fixed deposits, bonds, etc.
You may be tempted to include this income in your budget but we suggest to leave it out. We believe your budget is to help you decide how much you should save from what you earn from working. Interest and dividends arise because your money is now working for you. If you include this in your budget, you can easily start to spend it. But this income should remain untouched so it can build your net worth.
If you’ve followed our advice step-by-step, you’ve now created your budget. Well done! Keep at it and beware of problems you could encounter. We explore these in Live Freely Within Budget: Avoid These Problems.
Have you tried our 33/33/33 approach yet? We’d love to hear about your thoughts or experiences in the comments below!