One of the common mistakes people make is thinking that economics is the same thing as finance. Many economics professors will attest that this leads to us getting several questions about financial planning.
The key difference is that while economics studies exchange and the institutions under which exchange takes place, finance deals more with the practical study of managing money and other assets.
So, as an economist, I won’t be planning your retirement anytime soon. But, in my time in business school and my own life, I have picked up a trick or two relating to money management.
So with that I present a simple guide for making a budget. Please note, none of this is financial advice. I’m just describing a method you can use to make a budget, and some ways of thinking someone may find helpful.
Step 1) Know Your Income
Your budget requires you to compare your income to your expenses. That means you’re going to have to know your income. But just knowing the number associated with your yearly salary or wages is not enough. Why? Two reasons.
First, unless your boss is really cool, you don’t get your entire salary paid to you on January 1st. You can’t just assume you have access to your whole salary when you plan your expenses for the month.
Second, your yearly salary number is likely not adjusted for taxes. So if your salary is $100,000 a year, you’re not going to get all that money. Some of it is going to Uncle Sam rather than your budget, and likely to state and local government as well.
So can this be fixed? Well, for me, keeping track of my income on a monthly basis is best. The issue is, I get paid every other week rather than monthly, so I have to do some math.
Since there are 52 weeks in the year, getting paid every other week means I get 26 paychecks. So I take the dollar amount I get on my paycheck after taxes, multiply it by 26 to get my annual income after taxes and other deductions are removed, then I divide that number by 12 to get my average monthly income.
Situations and preferences vary, of course. You might want to keep track of your budget on a biweekly basis. In that case, you can just use the amount on your bi-weekly paycheck.
If you work for a wage at a job with irregular hours, things are tougher. You’re going to have to make a guess on the number of hours you’re going to work. I recommend trying to take an average of your last few paychecks so long as one of them isn’t extremely abnormal. Ultimately, if you have irregular pay, it will be important to make sure you have some savings on hand to cover you when you have a smaller pay period.
So we have a number now. I use my monthly average income. Others might use bi-weekly income. But what do we do when we get that number?
Step 2) Categorize Your Expenses
For a good budget, the next thing you’re going to have to do is make categories that describe everything you spend money on. That’s right, all your spending is going to fit in some category. The number of categories you need depends on a lot of factors. My wife and I have around 27. Here are some examples:
- Cell Phone
- Date (what can I say? I’m a romantic.)
- Fun budget
- Other (Do not use this too much!)
- Auto Insurance
Again, these are not all of my categories. These are just a sample. But there’s a few lessons in this list. First, you may wonder why I separate out water and utilities. This separation illustrates a general rule that I think works well for budget categories. If you’re nearly certain of how much something will cost you, give it its own category.
Water almost always costs me the same amount every month. Our usage doesn’t fluctuate much, so I have that as its own category. This same rule applies to phone and auto insurance expenses. I know how much I need each month to cover them, so I just give them their own categories.
On the other hand, my electricity cost increases tremendously over the summer with AC, and my propane (heating) cost increases massively in the winter. These two utilities do not cost me the same every month, so I lump them together in one category and make sure I give enough to that category to cover both.
You may also notice the date and “fun budget.” Date is exactly what it sounds like, and fun is whenever I spend money just on myself. This might seem like a bit of a drag to predetermine how much you spend on these sorts of things, but it’s important to set some limits. First, it will help you to tell if you can afford the sorts of fun things you’re doing. Second, it’s a good discipline tool.
I won’t promise you’ll become a millionaire by cutting out daily coffee, but I will say you’ll have a lot less money in the future if you let yourself use it in a totally unlimited manner. This doesn’t mean there are no exceptions, but I’ll return to that later.
You might also notice an “other” budget. It’s easy to let this get out of hand. Any large expense that recurs frequently enough should not be here. The perfect item for an “other” budget is batteries. I barely ever buy them, and they’re cheap. They don’t fit in any category and don’t merit their own. To be explicit, I’ll share that I currently only put away $23 a month on “other” expenses.
Step 3) Decide How Much Income Goes Toward Each Category
So, you have an income number. Let’s say you make $50,400 a year after taxes or $4,200 average monthly. You need to allocate that $4,200 among your monthly expenses.
Of your categories you likely have:
- Things that are necessary (think groceries)
- Things that are superfluous (think vacation)
You also have:
- Things that cost the same every month (think mortgage)
- Things that fluctuate month-to-month (think gas or groceries)
The easiest way to start is to begin with categories that are necessary and cost the same every month. Say your mortgage is $1,100 (note: I live in rural Kansas where this number is not unrealistic at all). So of your $4,200, you now have $3,100 remaining.
Once you’ve done all your necessary expenses that cost the same each month, move on to your necessary expenses that cost different amounts each month. You’re going to have to give your best guess on these. For example, what did you spend on groceries last month? Try that number. For things like utilities, often companies will offer average price information for a year on their website.
Before moving on to superfluous things like vacations, you should have some amount of money go to savings each month. In theory, you want to build up an emergency savings fund on hand. Many in finance recommend having 3-6 months of living expenses in an emergency fund. So, you should put money in that category to start building it.
At this point, check how much your monthly expenses come to, and compare it to your monthly income. If monthly expenses are greater than monthly income at this point in the process, you have an issue. This means you cannot sustainably afford to pay for monthly necessities. Something has to change.
If this is the case, I can’t give too much advice. Situations vary wildly enough that there’s not a one-size fits all for this case. Obviously, lowering expenses for necessities or raising income is a fix in one sense, but this is easier said than done. Technically, you could take on debt to cover the gap, but this is not a sustainable long-term strategy and would be very costly because of compound interest.
If your income is greater than your expenses at this point, you can distribute the rest to your various superfluous budgets. Even small amounts are better than nothing. I looked at the history of our budget, and, at one point early in our marriage, my wife and I put away $20 per month for our date budget. It wasn’t much, but setting aside money for fun things is important if you can afford it.
If, after you fill all your superfluous categories, you still have extra, I recommend throwing it back into savings to build that emergency fund.
Step 4) Doing the Budget
So we have our categories, and we have how much income is going toward each category each month (or every two weeks if you did it that way). Now what?
Well, budgeting is a process. It’s no good if you just write it down. You have to stick to it. There are lots of ways to keep track of your income and expenses. You could use pen and paper or fancy software. I use an Excel spreadsheet. I have a column for each budget category. It looks something like this:
Again, I have a lot more columns because we use 27 categories, but it’s the same idea. Under the column headings I add income and deduct expenses. So, at the end of the month, I add my average monthly income broken up by categories. So let’s say for mortgage we have $1,100, Gas we’ll have $100, and everything else we’ll just say is X dollars for simplicity. So when the month ends I add a row that looks like this:
Each month to add income I just copy that row, insert a new row farther down in the budget, then paste the same information.
Next you have to include your expenses. I do this manually in the spreadsheet. Every couple of weeks I pull up my bank account and card statements, and I input those expenses as a negative number. So let’s say I look at my statements and see my mortgage payment was deducted, and I had three transactions where I purchased $30 worth of gas each time. Then we’ll say a second month ends and I get to put income in. The budget now looks like this:
So the first line is the first month’s pay. The second line is the deduction for the mortgage payment and one of the gas payments. Lines three and four are deducting the next two gas payments. Line five is a new month of pay. Technically you could just add the three -$30 gas purchases together, but keeping them separate helps if you want to double-check yourself later.
Finally, at the bottom of the spreadsheet I use a basic SUM function to add up all the income and expenses. I make sure to insert rows above this line so I don’t have to constantly redo it. You can do this part differently depending on how you are doing the accounting, but the point is you want a running total of all your income and expenses in each category.
Some Last Things
- Over-Budgeting: If you notice a category has a running total that is growing over time (you only spend $90 per month every month but you budgeted $100) you should feel free to adjust this eventually. I’d put the extra $10 a month in savings. Be careful though. Certain categories are more expensive in certain times of the year, so don’t adjust budgets down when you know something is cheaper than usual.
- Under-Budgeting: When a category goes negative, it means you’ve taken more expense than income in that category. If it only happens once, and you have money in the savings category which is greater than the gap, it’s no big deal. But if this happens every month and the negative balance grows, you’ll need to adjust that budget up.
- Average vs. Actual: When I do an average monthly income, I’m technically not working with exact numbers. At the end of the year, things will balance out, but, during the year, my budget will be slightly different from reality since months have different numbers of days. So long as you have decent money in your “savings” category, this is no issue. But, if this concerns you, you may be better off adding your exact bi-weekly pay (if that’s how often you’re paid).
- Double-Checking: How do you know you haven’t messed up? Well, if the running total of all your categories put together is pretty close to your bank account balance (preferably a little less if you want to be conservative), then you’re probably doing fine. I usually err on the side of caution and make sure my bank balance is a little greater than my running total for all categories.
- Emergencies: Trying to make an emergency category is futile for obvious reasons. The cost and frequency of emergencies is unknown. I use my savings account for all big, unavoidable, unexpected costs.
- Exceptions: It’s hard to plan a surprise trip for your wife with strict adherence to this sort of system. For me, the best solution to this is, again, savings. Assuming you already have an emergency fund built up, you may find excess savings to be a good way to do this. But exceptions are just that—exceptions. Be careful to not make your savings an “anything goes” category even if you have enough.
- Extra Money: If you get paid money you didn’t budget for, put it where you need it most. Maybe one budget has very low funds, or maybe your emergency fund is still lacking. The only caution when it comes to extra money is to be careful assuming you’re going to get it. For example, professors often have the chance to get extra pay for teaching extra classes, but it would be a mistake for me to rely on that money if it’s not certain that the university will have enough students demanding another economics course.
- Too Much Savings?: So let’s say you’ve built up an emergency fund that you’re happy with, and your savings balance is still growing. Should you just let it grow? Many would advise against this. Cash is a financial asset, but, like any asset, it has downsides. The upside is it can help you out quickly in a pinch. One major downside with cash is inflation. As prices rise, the purchasing power of the money you have in the bank goes down. So keeping too much on hand could mean losing significant wealth. Instead, many would recommend investing in other assets which do better during periods of inflation (stocks are a common choice). In fact, even if inflation is 0%, stocks tend to have a positive return which would mean money in the bank is losing relative to stocks. Another option with this money is to pay extra on debts (like a mortgage) to give you a guaranteed return in the form of less future interest.
Catalyst articles by Peter Jacobsen | Full Biography and Publications