As we ring in the New Year and resolutions are made, let’s resolve to make this the year we budget properly and stick to it.
Budgeting focuses us to live within our means, which is the cornerstone to financial independence and the first step on the path to wealth accumulation.
Budgeting is the process of projecting out income and expenses. It can be done on an annual basis however it is more effective to break the year out by month as your income and especially expenses likely fluctuate depending on the time of year. Past results are helpful when starting the budgeting process, but are not necessarily indicative of the income and expenses that will be incurred in the future. Therefore, analyze past results and make adjustments where necessary in order to determine projected figures for the coming year.
Start with income. If you have a salary this is fairly easy and predictable to project for the coming year. If you are self-employed or have a secondary income source, project out the income you expect to make and when you will receive the cash. Remember to be conservative. Being overly optimistic may feel good when you budget, but it leads to a rude awakening when reality hits just a few months into the year.
Next review expenses. Start with fixed costs (i.e. mortgage payments, rent, insurance, property taxes, car payments, etc). These typically represent the majority of cash outflows and can be easily predicted for the year ahead. Remember to include rate increases announced by municipalities.
Include savings as a fixed cost. Whether it is contributions to your RRSP or TFSA, or money you are allocating to a savings account (emergency fund), make sure an amount is set for Savings. Do not define your savings as “whatever is left”. It is recommended that 10% of income be allocated to savings. If you have the means go higher. If you are at a point in your life where 10% is not feasible, go lower and set a specific percentage, and stick to it. This is an important fixed cost that should not be overlooked or ignored.
Now, let’s move on to variable costs. These will vary widely and are much harder to predict. Whether it’s gas, car maintenance, groceries, clothing and grooming, restaurants and entertainment or travel, make sure all categories you spend money on are accounted for. Review your expenses for the past two years to make sure no category is skipped. Predict as accurately as possible the costs in each category and the fluctuations by month. Try to find areas to make cuts and find savings. Be conservative. Some costs (i.e. gas) may fluctuate more than you think. Don’t forget about taxes.
Leave room for spontaneity. Being spontaneous and impulsive brings pleasure to our lives and is something that should not be left out. Sometimes it is important to go out for dinner, catch a new movie or get away for a weekend. It doesn’t have to be categorized but leave room for it in your budget. You are not “blowing up the budget” on a weekend away if the cost of such an expense was already budgeted for! Some months it will be a fact that your financial situation is so tight spontaneity will be a challenge. Budget so that you are not always living too close to the wire such that you can’t afford to be spontaneous every now and then. Keep some fun in your life and the new year won’t be such a tough year to get through.
After all is said and done, what is the net amount? Are you planning to live within your means? Ideally you should have something left over at the end of every month. If you are negative more often than not this is an indication that a major change is needed. A second job, getting rid of a car, postponing a vacation may be necessary this year. Take these steps now before you are forced to take on debt or reduce savings to cover the shortfall.
Review your budget frequently. Don’t go through all the work preparing it and then stick it in a drawer. Review it monthly and compare actual results to the budget. Are you sticking to your goals? If categories need to be adjusted to more accurately reflect expected costs for the rest of the year, make the changes and recalculate to ensure you are still living within your means.
Remember, budgeting is a tool to help you achieve financial independence and wealth accumulation!
Peter Berry, CPA, CA