Make a Budget #2

Jan 6, 2012 by

As we start 2012, I’m focusing several posts on Budgeting. This is No. 4 in my Budget series, and the second post covering my “6 Steps to Create a Great Family Budget.” The last post covered both Steps 1 & 2; this post adds Step 3. Click the Budget Category link on this blog’s homepage to see the entire Budget series.

My “Make a Budget” series will walk you through the 6 Steps that I think will work well to help you make a great budget. What makes a budget great? It’s not how well you forecast your fortunes or misfortunes during the upcoming year. The measure of a budget’s value is how well it helps you make better money decisions. And that’s the sort of budget my 6 Steps are designed to make.

Step 3: Estimate your family’s monthly living expenses. Break these expenses down into smaller categories under two headings: Necessary and Optional. You’ll find using a spreadsheet very handy in this step, or use one of the other free tools listed under Budget Worksheets to the right of this post.

Your categories should fit your life, but here’s a typical breakdown:

Necessary Expenses

  • Mortgage or rent
  • Car payments
  • Insurance premiums of all types (car, home, medical, life, liability)
  • Groceries
  • Utilities (electricity, natural gas, water/sewer, trash pick-up, basic telecom service)
  • Gasoline, transit fare
  • Essential clothing
  • Home repairs and maintenance
  • Vehicle repairs, maintenance, and annual fees
  • Property tax (if not part of your mortgage payment)
  • Household necessities (cleaning supplies, toiletries, paper products, bedding, etc.)
  • Out-of-pocket medical care and prescriptions

Optional Expenses

  • Eating out
  • Alcohol & cigarettes
  • Clothing beyond what’s Necessary
  • Vacation, travel
  • Cell phones
  • Gym membership
  • Recreation & hobbies (hunting, woodworking, embroidery, antiquing, etc.)
  • Entertainment (movies, music, opera, plays, nightclubs, museums, etc.)
  • Home & yard improvements
  • Home decorating, furnishings
  • Subscriptions
  • Tools
  • Cash charitable contributions
  • Gifts
  • Computer software/hardware and other electronics

Why Separate Necessary and Optional?

Dividing your expenses between Necessary and Optional will help you decide how large your Emergency Savings fund should be. If your family has a financial crisis—say one wage earner is laid off—think of the Necessary expenses as those you must continue paying to keep a roof over your head, the utilities turned on, and your family clothed and fed. Optional expenses are those that could be scaled back or “turned off,” if you absolutely had to, in a crisis.

Finished Product

In the end you’ll have a worksheet with each of your expense categories down the left side—divided into Necessary and Optional groups—and a column for each of the 12 months across the top. You’ll want to total both ways: At the right side you’ll have a total for the year for each expense item, and across the bottom you’ll have a total of all expenses for each month. Also, subtotal all the expenses in each of the two groups—Necessary and Optional—for each month and for the year.

How to Estimate Your Expenses

If you’ve never tracked your spending, you may have no idea how much you spend in some areas. Start with the easy ones that you can just look up in your checkbook: mortgage payment, car insurance, telecom bill, and so on. For others that may be trickier—like dining out or alcohol or entertainment—just spend a couple of minutes thinking through the past month or two, then guess high. Like most people, you’re probably spending more than you realize!

Say to the best of your recollection you ate out 8 times last month and spent about $200.

That’s an average of $200 ÷  8 times out = $25 each time you ate out.

Does last month seem like a typical month? If not, do the exercise above for the prior month too. Then settle on a guess for the number of times you will eat out each month, and the average cost of each experience. Let’s say you decide on 10 times out each month at an average cost of $30 per dining out experience.

Your dining out budget = $30 per time out x 10 times out = $300 per month

As will be discussed more below (Document, Document!), it’s important to break down each of your budgeted expenses into pieces—in this case, times eating out per month, and the average cost each time you eat out. The better job you can do breaking down each expense category into smaller pieces, the more valuable your budget will be to you, as we’ll see. Also, you’ll find it a lot easier to think about and make estimates for these smaller pieces than for the big expense category of which the pieces are components.

Periodic Expenses

A future post will make clear why I suggest the following, but for now, trust me please.

For expenses you don’t pay every month—I call these “periodic expenses”—divide the estimated annual expense by 12 to get a monthly average. For example, your water bill, car insurance, or school tuition might be paid four times a year or twice a year or once a year. Instead of putting these expenses in your budget in the month you actually pay them, estimate the total amount you spend for a year, divide by 12, and put the result in each month. Trust me on this for now; doing it this way is going to help you stay out of debt!

Say you pay your car insurance four times per year and each time it’s $250:

Total annual car insurance cost = $250 x 4 payments = $1,000 per year

Monthly budget amount = $1,000 per year ÷ 12 months = $83 per month

On the car insurance line in your budget, you enter $83 in each of the 12 months.

Document, Document!

And now, the most important part of your budget: Documenting how you came up with each estimate. You may have noticed that I’m not hung up on getting “accurate” estimates for your budgeted monthly expenses. Again, a budget is not about seeing how well you can predict the future; you can’t, and neither can I. It’s value is in understanding, over the course of the year, why your actual expenses differed from what you budgeted. Unless you document how you made your budget estimates, you won’t be able to reach conclusions like:

“Oh—gasoline has jumped to $4.50 per gallon and we guessed $3.75 per gallon in our budget.”

“Our home insurer raised our premium 30%!!”

“We didn’t count on that roof leak, so our home repair budget was a bit low.”

These are examples of the sort of insights that are going to improve your money choices over time. Maybe the bus makes sense? Time to shop around for a new home insurer? Expect the unexpected and build a cushion into your home repair budget?

So spend a little time on each estimate, and write down how you made it.

Nice job, really! Don’t you feel better about your money already! And the hardest part of the 6 Steps are done! Have an adult beverage, if you partake.

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