Budgeting Pitfalls and Remedies
This is an edited guest post from Bruce, a professional tax preparer and adviser, who writes the Tax Guy blog. He has some great personal finance & tax related articles at his site and given he is qualified to talk taxes, it is worth heeding some of his tips and advice.
Budgeting provides a way for people to track their income and expenses. However the hard part, once people are aware of their expenses, is to actually cut back on discretionary items. Budgeting fails for many people because they fail to address this key shortcoming. Budgeting will not reduce your expenses; it is how you react to the income/expenses information that allows you to reap the benefits from budgeting. It is important that you sit down and evaluate your budget. Then come up with a plan on how to best deal with cutting back on various expenses in line with your income, so that eventually you are spending less than you earn.
When you are trying to find areas where you overspend, look at the small things. It is always amazing to me how quickly small things add up. My wife likes to buy soda and treats. She assumes she is staying within budget because the purchase price is so small. Yet at the end of the month, she is always surprised to see how much she has actually spent on these small purchases. The top budget busters are food, clothing and the miscellaneous category, and here’s how to deal with them:
~ Many families eat out at least once a week. This adds up quickly and can easily push you over your budget. Plan your meals at least a week in advance, use crock-pots and purchase convenient meals to make at home to help cut down on eating out costs.Try switching to cash only for purchases that you go over budget on. I was always going over my personal spending money by going out to lunch and buying soda. So a few months ago, I switched to a cash only policy. Every two weeks I get a certain amount of cash. Then if I want to go out to lunch or purchase soda I have to use my cash. Once my cash is gone then my lunches out end as well.
~ Clothing is another category in which it is easy to go over budget. Set yourself a monthly limit and then don’t go over it. Try shopping sales or consignment shops to get your money to stretch further.
~ The last category that people often spend too much on is the miscellaneous category. Earlier in our marriage, we had only four budget categories: groceries, entertainment, gas and other. Because the other category was so broad, we often went over budget. So we broke it down into specifics like household expenses, medical, gifts, automotive expenses, school lunch, diapers and miscellaneous. Then we figured out how much we needed in each of these areas. Now we are much less likely to go over in the miscellaneous category because there are fewer things that qualify. We also have a better idea of exactly where we are spending our money.
Making the necessary changes will not happen overnight. If you are spending a lot on clothing every month, it is not practical to say that you will just quit shopping. It will have to be a gradual weaning process. Evaluate how much you are spending or how many shopping trips you take each month and then cut it down. The next month, cut it down even more until you are where you should be. Obviously, you can’t completely eliminate shopping, so enjoy the money that you can spend. You might try shopping at less expensive stores so you can get more for your money.
Be accountable to someone for your spending. My wife and I sit down every week and evaluate our budget. Download free software to track your budget. Each week we also discuss how much money we will probably spend. This process makes us accountable to each other for the money that we spend.
Other budgeting pitfalls:
~ Not putting money aside for emergencies. Part of living debt free is having a small cushion saved in the bank for unexpected expenses that come up in everyday living. What if your car breaks down? Or your child needs a root canal? Prepare for the unexpected.
~ Calculating your expenses based on two incomes. You may plan for both you and your spouse to work, but what if there is an unexpected illness or pregnancy? I recommend budgeting based on one income.
~ Spending money as soon as you get it. For example, you get your tax return and go out and buy a Plasma television right away. Or you get a bonus at work and go out and buy that hot tub you’ve been thinking about. A much better idea is to put any extra small or large amounts of money into savings.
~ Buying items on impulse. This includes buying anything that is not budgeted for. It could be a coffee every morning before work. Or perhaps you have a bad day and decide to spend an afternoon at the mall shopping. Remember, if you don’t have money set aside for it, don’t spend it.
These are just a few of the common budget mistakes people make. The main thing is to have a financial plan (adjusted over time) and stick to it. Once you start active budgeting, you will get such a good handle on your finances that you will regret all the years spent living in the financial wilderness.
Related Posts:
~ Personal Budget Spreadsheet - how to make it work for you
~ Am I a Cheapskate or Just Frugal?
~ Slamming the brakes on spending via effective budgeting
~ The A to Z of good personal finance (Part 2: L to Z)
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December 27, 2008 12:14 PM
I agree that budgetting is crucial but until you have a basic hold on your situation - your assets, liabilities and the changes over some period,you will never be in a position to properly work out a budget and know what difference it has made - assuming you keep to it!
My response has to be ...
Have you thought about Personal Accounting?
There are so many articles and blogs today addressing the problems of personal finances, budgeting, debt and provision for retirement, particularly for those living in difficult circumstances such as on a single income, through loss of job, health problems etc.
More important perhaps, is the need for basic personal financial management to determine as time goes on, how much is being spent and on what, and therefore if there is any surplus available for investment; and the lifestyle changes that might be appropriate if these amounts are deemed insufficient.
Most financial management articles concentrate on purchases - loans, insurance, investment, credit cards, etc. Some address potential changes to expenditure via budgets, with a view to achieving a better overall balance between the increases and decreases. The only problem with this approach so far as it goes, is that it is always difficult to keep track of the effects of each change and to be aware of how much of a difference each change makes in the bigger picture. The other thing is what is the best balance? How do you know if all the different aspects of financial responsibility are receiving the proper attention they deserve, not only now, but on a continuing, lifetime basis?
The answer surely is a more systematic approach that addresses the fundamentals. What we actually talking about is formally managing and controlling financial activity – of a particular type – our domestic or personal activity.
We all probably know that in business, the only way, indeed the legally required way, to manage finances is by the use of accounting. Accounting has evolved over hundreds of years with national and international supervisory authorities ensuring that it best meets the needs of the many different forms of business in place throughout the world.
Surely I am not suggesting that we should all start using accounting for managing home finances? Isn’t it much too difficult and time consuming; and help - I do not understand all the terms and techniques!
Well, yes, why not use accounting? I am going to suggest that we do all start to use accounting for controlling our personal finances, but not quite the sort of accounting that businesses use. The reason is that with appropriate modifications, accounting can be made easy to understand and implement for home use. Most important, it can be made to actually produce the real information we need to manage and control our personal finances, on a continuing basis.
Now well retired, I decided to start using accounting a long time ago to manage my own finances. I had learnt a little about accounting through a business correspondence course and much later, decided to try using it for my personal finances. I bought an off-the-shelf accounting package and set to work. I soon realised that it was all very difficult to do and that it didn’t actually help very much once I got it set-up. The problem was that the focus was all wrong and the reports didn’t relate to day-to-day personal financial transactions.
The business accounting focus, understandably, is all about profits and owner’s or shareholder’s value. The reports such as the Trading account and Profit & Loss account are designed to track and help maximise these values. Most personal accounting packages are based on business accounting with the problems I encountered, or only address simple features (all very useful as far as they go) such as bank statement reconciliation or budget lists.
Over many years, I evolved a new domestic accounting model. By this, I mean the set of reports and individual accounts needed to implement a new form of accounting, with a new focus on what I called, Domestic Well-Being (DWB).
As a model, the method is capable of being implemented on some off-the shelf personal accounting software packages on a home PC. I initially used the well known Microsoft Money© software package but now prefer a package called Personal Accountz©. The differences relate to alternative accounting architectures embodied in these two products – categorisation of transactions versus ‘nominal’ accounts – one account for each increase and decrease category.
DWB Accounting is all about maximising the effect or balance of the decreases compared to the increases, in a way that ensures that appropriate emphasis is given to all of the different categories of each, corresponding to the nature of the financial transactions that characterize domestic life.
What this means is that we have a pre-defined DWB structure for domestic change (the increases and decreases) that goes into successively more detail down this hierarchical structure. From the top level of Basics, Discretionary and Others, the Basics are categorised at the next level in terms of Essentials, Responsibilities and Family Circumstances. Discretionary is sub-categorised as Nice-to-Have, Investment for the Future and Luxuries. At a lower level, Essentials include Utilities, Food and Drink, Clothing, Health and Transport, whilst Nice-to-Have includes Vacation, Leisure and Entertainment, Hobbies, Charities and Timeshare, Mobile home and Caravan, with more and more detail as needed, at successive lower levels.
The model facilitates the bookkeeping which is the means (using individual accounts and/or categories) to enter transactions from bank statements and credit card statements to match the DWB structure; often semi-automated, this typically takes only a couple of hours a month which is trivial compared to the benefits available. Other techniques include naming conventions for the accounts and transactions, to make it all easy to understand what is going on, in terms of what I call, the Domestic Accounting Equation.
The main tool or benefit of the model is the Domestic Well-Being Statement (DWBS) which is a structured report showing from high, medium to low sub-category levels, the amounts of increases and decreases over any period – a week, month, quarter, year or whatever. From a management and control perspective, at the top level, you can see the proportions of total expenditure between the Basics, Nice-to-Have and Others. A first question is ‘are these proportions about right’? At a more detailed level, if the Basics are considered too high, you can then see at progressively lower levels in any of the areas, where there might be scope for planned reductions or increases in certain sub-categories, over future periods. It is all about searching for and achieving the best balance across the out-goings to make sure that the decreases are affordable and that all the highest priority categories and sub-categories are getting a fair share of what is available from the increases!
Of particular interest in this context is Investment for the Future (IFF); are the amounts sufficient and more important if they are not, where is the scope for increasing this amount? Where are the imbalances and which other subcategory amounts are potentially ripe for change – either by increases or decreases?
The key is visibility. Suddenly, everything is exposed. You can see whether appropriate amounts are being put aside for the future; you can see where dangers might be lurking with potential debt problems; and for those with some existing debt, the management of its reduction is much easier to plan and execute.
Budgeting can be set up to plan future expenditure with warnings triggered if spending over the next period approaches pre-set levels in whatever categories or sub-categories are set to be watched.
For the more adventurous, the model includes new domestic financial ratios for additional control capabilities, as well as numerous graphical displays (a picture speaks a thousand words!).
With a best possible financial balance achieved through maximizing Domestic Well-Being, provision for retirement will be at the fore. Decisions can be made on how best to provide the appropriate amounts for retirement investments and if necessary, change other lifestyle priorities to ensure that the required amounts are made available. Advice will still be needed on the choices and tailoring of investment plans but that is specialised and different from the basic personal financial management required to provide a rock-steady platform for all other financial decisions throughout life.
In the global financial turmoil today, everyone ought to consider how to take advantage of new ideas as a basis for starting to better manage and control their personal finances. DWB Accounting offers the potential for lifestyle improvements and goal achievement since good financial management can also point to the need for many other initiatives such as job change, better qualifications, re-location and so on.
In summary, by using accounting for managing and controlling home and personal finances, based on the new Domestic Well-Being accounting model, you will always know in detail, the past and present state of your finances as a proper basis for comparison and control. You will be able to ensure that all aspects of your financial responsibilities are being met through achieving the best possible balance across all of your categories of increases and decreases, based on your own priorities and approach to indebtedness.
All that is demanded is an appropriate sense of responsibility from those in some form of family situation, be it a marriage or partnership, with or without children, or even just a single person. The sooner domestic accounting is underway, the greater the potential for lifetime and continuing benefit. It will take a few months to get things going and to accumulate sufficient figures to start seeing a meaningful basis for gaining and exercising control. Remember that accounting on its own will not get you out of debt or make you rich. It will however enable you to take financial control and to decide what to do but you must exercise the discipline to put your decisions into effect. Now is the time surely, to find out more about DWB Accounting!
John M Passmore Christchurch, Dorset UK dwba.co.uk