Most people’s eyes glaze over at the mention of a budget. And with good reason – it is a dull topic. I’m not going to sit here and try to sugar coat it. Doing a budget won’t be the most fun you can have with your clothes on; it won’t make you more sexually attractive and it probably won’t even give you a warm fuzzy feeling. In fact, it may well make you downright depressed. But if that is the case then you are exactly the person that needs one the most.
“…done correctly a budget will put you in control of your finances…”
Most people have a vague notion of what a budget is, but very few people actually have one or understand what a powerful financial tool they can be. If done correctly a budget will put
you in control of your finances. It will help you make more informed spending decisions and it will make you feel a whole lot better about those decisions because you’ll be fully aware of your financial situation and of the implications of your decisions.
If you are a contractor, self-employed, freelance or any other variant of worker who is not in the permanent full time employment of someone else then a budget is especially important for you. Your income is likely to be less stable and certain than a full time permanent employee, so it is vital that you understand your outgoings and how long you can last without income before you need to start making cutbacks. This goes equally for anyone thinking of leaving the stability of permanent full time employment for the exciting world of being your own boss. If you are considering making that leap, whatever you do, make sure you do a budget (and a business plan) first. Then you’ll know how long you can survive without income and you’ll understand where you can make cutbacks and what you can cut if needs be. Part of your business plan will be a budget for your company. That is vital. Here was are looking at a personal business plan, however the concepts are totally transferrable.
So how do you go about it?
The first think to do is understand what you currently spend your money on. Fortunately in the digital world we now live it this is easier than it’s ever been. People used to take out lumps of cash from the cashpoint and then wonder where it had all gone. Now with contactless and smart phone payment options and internet banking it is easy to get a pretty comprehensive list of all of your transactions. It’s best to gather transactions for a full 12 months. That way you know you’ve included Christmas, everybody’s birthdays, large annual payments such as insurance, car tax and holiday’s and also the different seasons as these can affect your spending.
Once you’ve gathered a year’s worth of transactions the next step is to analyse the transactions and actually start to build the budget. How you do this depends on how tech savvy you are. My personal preference is a spreadsheet. You won’t need to do anything to advanced on the spreadsheet, so if you are a novice don’t be deterred. If you’re super geeky you may want to build an SQL database but I really think that would be overkill. If you’re someone who is intimidated by technology the money advice service has a free tool here
that is very simple to use. Anyone can use this tool, but the downside is you need to enter each cost category manually, which requires categorising and summing your transactions first, which could take a while.
Analyse your past 12 months
Ok, so you’ve got your years’ worth of transactions, what now?
The first step is to sort the transactions into broad categories. There is no real right and wrong way to do this, but you need enough categories to be able to get some insight from the data, but not too many to make it to fiddly. Probably somewhere between 10 and 20 is about right. Common examples might be:
· Household utilities
· Eating out
· Coffee out
· Other entertainment
· Car and transport
· Health and Self Care
· School fees
Categorisation is the key to this exercise, but don’t worry if it takes a bit of trail and error. If you find some categories have nothing in them, ditch them. And if you find some categories have too much in them, split them. You’ll always have ‘Other’ costs that don’t fit neatly anywhere else. But if your ‘other’ category gets to big you need to think a bit harder about some new specific categories to shift those ‘other’ costs into.
If you are doing this on a spreadsheet the easiest thing to do is list the transactions down the left and the categories across the top. Then for each transaction you put the value paid in the column corresponding to its category, and the sum the column to give the total for the year for each category.
To make sure every transaction is present, but none are there twice, take your bank balance at the start of the period, add your income, minus all of your expense categories and this should should give you your bank balance at the end of the period. If it doesn’t you have missed or double counted something.
You’ve now finished the boring bit; this is when the fun starts!
“…don’t beat yourself up about the fact that you spend twice as much on coffee on the way to work as you do on gifts for your partner…”
Have a look at all of the expense category totals. Do any shock you? Do any make you feel a little queasy? The important thing to do here is not beat yourself up about the fact that you spend twice as much on coffee on the way to work as you do on gifts for your partner. And you spend twice as much again on beer at the pub. This is the power of the budget. It is an opportunity to put these things right.
“…This is the power of the budget. It is an opportunity to put these things right….”
Having looked at your past 12 months spending you now have an idea of how much you actually
spend. Now you get to think about how much you think you should spend in each category. How much do you want
to spend? It is also important at this point to set a savings goal.
A savings goal is especially important if you are contracting, or you are thinking of moving into contracting. If this is the case it might be useful to think of your savings goal in terms of your cash burn rate. Your cash burn rate is just how much you spend in a given period, so your monthly or weekly cash burn rate is just your year’s total costs divided by 12 or 52.
You might decide that in order to move into contracting you want a ‘war chest’ of at least six months. So now you know that based on current spending this would be six times your monthly cash burn. This may be a good buffer to see you through any bumps in the road.
Now is the time when you might need to start making some hard decisions.
Your income is X. Your savings goal is Y. Therefore you can afford to spend X – Y = Z. The problem is based on your last 12 months you are spending 1.5 times Z. This means you need to cut a third of your spending! Obviously for everyone this will be slightly different, and if you are already saving more than your goal congratulations, you’re in a very select group who gets to go home early.
“…this is where doing a budget is a very powerful tool to drive changes in behavior that will make your life better…”
For the rest of us, this is where doing a budget is a very powerful tool to drive changes in behavior that will make your life better. Think about it – before you did this you had no idea
that your daily coffee on the way to work was costing you £600 a year. But now that you do, you have a choice, you can keep wasting £600 a year at Costa, or you can wait an extra 15 minutes and have a Nespresso when you get to work. What you decide to do is entirely up to you. But now you are armed with the information to make decisions not only on what your savings goals should be, but on how (or if) you will reach them.
This is likely to be a somewhat painful and entirely iterative process. You’ll probably look at what your currently spending, start trimming the low hanging fruit, and find that this doesn’t get you anywhere near your savings goal. Then you’ll realize you may have to make some hard decisions.
It is important at this point to really think about the consequences of the decisions you make here. Are they realistic? Will they make you miserable? How will you achieve them? It is all about living within your means. But also it is about finding ways you can do it that will not make you to unhappy. If the cuts you make are too painful you will not stick to them.
This may be a good time to be creative. If you spend too much on gym membership why not
clean out the garage and buy some free weights? If you spend a fortune at Costa maybe invest in a nice espresso machine for home (Don’t get Nespresso, the coffee costs a fortune).
As a side note, if you are married it is important to undertake this exercise as a couple. The cost of divorce is much greater than any savings you’ll make by unilaterally cutting her drinking with mates, or his salon treatments.
In a lot of way, everything you’ve done so far is the easy bit. It’s all academic if you don’t put it into practice. The key to sticking to it is being aware, as you go, how much you are spending in each of your categories. You could update your spreadsheet each night with your days spending. But this takes discipline, and let’s be honest – if you had that you probably wouldn’t need a budget! This is not meant to be an attack. It’s just realistic. Modern life is busy. No one has time each night, or even each week or each month to analyse their spending at then beat themselves up about having spend too much. Life is too short for that.
A better option is to automate everything. You do this by setting up a separate bank account for each of your key discretionary spending categories. Then work out how much you want to spend each week or month in each category and set up a standing order for that amount from your main bank account. Either get a debit card for each account, or have them set up on your phone so that when you make a payment in each cost category it comes out of the correct account. That way you’ll always know when you’ve over-spent because you’ll run out of money in that account.
This strategy can work well, but it is important to put a bit of thought into your categories and how you are going to do it. You don’t want to have too many categories and too many cards or it’ll drive you mad, and again, you won’t stick to it.
It is vital with all of this is to think realistically about how it will actually work in real life. You need to make sure you set up something to you will stick to. And if you find you are not sticking to it don’t just give up. Think about why you’re not sticking to it and if there are any tweaks that can be made so that it can work.
I said at the beginning that this won’t give you a warm fuzzy feeling or increase your attractiveness to potential partners. The truth is I was managing expectations. Achieving your savings goals, or making real progress towards them for the first time ever, will give anyone a warm fuzzy feeling. And there is nothing sexier than a person of means.
“…there is nothing sexier than a person of means…”