Budgeting for the Blips

I am a personal finance junkie, but I have always left it to others to blog about. Today I thought I’d share my method of “cash flow budgeting” and see if I can compare techniques with you!

Balancing the ins and outs

Cash flow budgeting comes from the business world. Companies are always concerned about whether their inflows and outflows are timed right. Maybe they take out a start-up loan to manufacture a product, and need to recoup their costs through sales, but their loan is due before their clients pay up! The business could go belly up because of cash flow problems.

I can relate! My household hasn’t “crashed”, but there have been some tight times. Usually it’s when I tried to pay a large or annual expense “up front” to avoid finance charges. I then had a long dry spell before I could spend a cent outside of essentials. Worse yet, I might have to put a regular expense on credit! Then I beat myself up because I should have anticipated and planned for the bill.

The most common way to budget is to list your normal expenses for a month, and subtract the total from your monthly income. I’ll just call that the Standard Monthly Budget. Whatever is left over, you can save or spend. If you come up short, you cut back on a variable category like groceries. With this kind of budget, I found it was easy to spend the surplus and forget that the following month had a big one-time expense I should have saved for.

Most people think the ideal budget is one in which you save an equal amount every month to pay off major bills, so your costs are the same every month. I will call that the Equalization Budget.

About 3 years ago I started doing cash flow projections a year at a time, and aiming to break even monthly. It has solved most of my budgeting problems. I call this one the Neutral Cash Flow Budget.

For either Equalization or Neutral Cash Flow, there are 3 basic steps:

• Set goals for the year, such as “pay car insurance in full when due” or “save $700 for canoe” or “don’t get into debt to buy holiday gifts”
• Do a cash projection for the entire year, month by month or pay cheque by pay cheque, to see if your goals are possible within your income
• If not, adjust goals – or adjust income!

There are lots of advantages to either one:

• It takes into account one-time, irregular and annual expenses; and savings goals
• You can start saving for them as early as possible
• You always know how much is left for discretionary spending
• You can choose to set aside equal monthly amounts for annual/irregular/one-time expenses, or you can schedule them for times when you receive lump sum payments (like when you get paid biweekly and have a 3 pay cheque month)
• It takes into account the timing of pay cheques and other income
• You always know what the rest of the year will look like and what new expenses you can take on

And only a couple of disadvantages:

• It takes a few hours to set up
• You need to do a new projection for the rest of the year every time your financial situation changes
• It is difficult to make it through the first year of an equalization budget without a lump sum “float” from savings or from a windfall!

I think the last “disadvantage” is why I put off equalization budgeting for so long. My car insurance is due annually in November. Ideally, I would save monthly from December of one year to November of the next, and pay it in full. But then maybe I’d  tell myself, “I’ll start saving in February after the holiday bills are paid off,” so I would only have 10 months to save. It seems like there is never a good time to start saving for all those irregular expenses.

Forecasting eliminates this mentality by showing me what the rest of the year will look like, based on the choices I make today.

Here is an example for a whole year based on an annual take-home pay of $40,000 for a household of two adults, no kids. I put in expenses that a typical couple would have, with realistic costs for the area where I live. (I am not saying that Rom and I are a typical couple – our actual income and expenses are not identical to this.)

Regular monthly fixed expenses:

• Mortgage and property tax 1500
• Internet/Landline/Cable (introductory rate) 115 for 6 months, increasing to 155
• Cheap cell phone 45 x 2 = 90

Variable monthly expenses (some discretionary):

• Groceries, personal care & cleaning supplies 400
• Gas for 1 small car 240
• Misc house/yard maintenance 100
• Meals out 43
• Entertainment 43
• Haircuts 43
• Gifts and work expenses 43

Utilities:

• Heat 275 x 9 times/year
• Electricity 160 x 6 times/year
• Water 150 x 4 times/year

Annual Expenses:

• Home insurance 600
• Car insurance 700
• Holiday (gifts, decor, special meals) 500
• Vacation travel 2000

This budget does not allow for clothes, gym memberships, dentist visits or eye glasses, furniture, car repairs…or children…or pets! The expenses add up to $39,999, so this couple theoretically could squeak through the year if they had no emergencies.

The following tables are available as a pdf: Budgeting for the Blips Tables

Here is what the year would look like if they used a Standard Monthly Budget:

• Expenses vary each month, so does income = cash flow problems
• Need “float” of $500 to cover shortfall Jan-Apr, and $125 extra in July
• Break even by year end ($173 surplus)

And here’s what it would look like using Equalization Budgeting (Year 1 – “Transition Year”):

• Allows all annual/irregular bills to be paid in full when due this year and start saving for next year’s annual/irregular bills
• Requires additional up front cash of $ 1891 to pay this year’s bills and start saving for next year’s bills at the same time
• Payments will be completely equalized starting Jan 1 of Year 2 (need to decrease spending by $7/month next year to break even)
• No more fluctuations!

And finally, here is the one I use, Neutral Cash Flow Budgeting:

• Rearrange monthly expenses to fit monthly pay
• Pay all fixed costs/essentials and juggle all discretionary spending as needed to break even every month, no up-front cash needed for “smoothing”
• Results in deprivation some months (e.g., entertainment) but satisfaction of bills paid on time and in full
• Adds up to savings by year end that can be allocated to new expenses/increases, saved, or spent

What works for you? Have you ever tried to switch budgets completely?