If there is one thing I have come to learn about personal finance, it is that budgets are among the worst tools for people to use when trying to manage their daily cash flow. I am not saying that budgets are not important or useful; however, they are not designed to manage day-to-day cash flow.
Budgets Are Good for Some Things
Imagine you wanted to separate a piece of wood into two pieces and you had two options for tools: a drill bit or a saw. You could use a drill bit and drill a bunch of holes, in a line, until you eventually cut through the piece of wood or you could use a saw. Budgets are like the drill bit for daily finance; they will do the job, but it requires a lot of work. Budgets are generally more suited for projecting cash flow, now or a moment in the future. So, what makes budgets so ineffective?
Budgets Conflict with Wealth Creation
We have seen hundreds of budget templates and calculators and they all inherently conflict with creating wealth. If you think of a budget template, what is the first expense that is typically listed? Without fail, it is almost always a mortgage or rent. However, if you consider any book, blog, podcast, or lesson about the principles of creating wealth, the number one principle is to pay yourself first. So why is it that every budget template insists on paying someone else (rent or mortgage) and puts the pay yourself first (savings) part at the bottom?
Budgets Are Complicated and Time-Consuming
In society today, our most precious commodity is our time. Budgets tend to be extremely time-consuming with the amount of data that needs to be entered in order to ensure they are up-to-date and accurate. Budgets also tend to consume a lot of our attention, tracking things that do not need to be tracked every month. For example, while you should account for your house or content insurance when analyzing your cash flow, the cost of this remains static and consistent. Once you have taken a fixed cost into account, it does not need to be reviewed until it comes up for renewal. Then there are those variable categories that get used almost weekly, like groceries, or less frequently, such as clothing or gifts. It seems that these categories inevitably end up over or under budget each month, which then requires greater analysis to reconcile your numbers and make sure you are on track. As if that was not enough, what happens if you shop at Costco or Walmart?
The Costco Conundrum
It is commonly accepted that you cannot just go to Costco for “one thing”. Costco carries a variety of items including groceries, clothing, gardening supplies, automotive parts & electronics. Let us assume you purchase groceries, a t-shirt, and a $50 gift certificate for your friend’s birthday. When you get home and sit down to enter your spending into your budget will you take the time to separate all your purchases, including taxes, into your various categories? Most people I know would probably just throw this shopping under the groceries column and call it a day. If this was just occasionally, it probably wouldn’t be a problem; however, if you’re like my family, we shop at Costco or Walmart on a weekly basis (I have 4 kids so that may explain our weekly trips!). After a month or two of shopping at Costco or Walmart, our budget would be completely inaccurate. From a psychological perspective, this would be quite demoralizing and likely cause someone to give up on using their budget at all!
Budgets are not a true reflection of how cash flows in and out of our lives. For example, we might determine we spend $600 on clothing annually and therefore budget $50 per month. However, we do not really spend $50 each month but rather we might spend $125 on a pair of running shoes at some point. There is a much better method.
A cash flow worksheet, unlike a budget, requires much less time to maintain and can give you just one number to focus on per week. You begin with accounting for all recurring income that hits your bank account each month. The next step is pay yourself first! We typically advise around 12% of total net income. Once you have deducted the 12%, you are left with your Gross Monthly Spend. Now deduct all your fixed, non-negotiable, recurring expenses in the following three categories: Home (Rent/Mortgage, Utilities, Cable/Internet), Auto (Car payment/Insurance), Personal (Cell phone/Gym/Daycare). Congratulations, you have now arrived at your Variable Monthly Spend (VMS). To make your life much easier, take your (VMS x 12 (months)) / 52 (weeks) to arrive at your Weekly Variable Spend.
Weekly Variable Spend
This final number is all you really must concern yourself with when faced with everyday spending. Whatever your number may be, if you keep at or below that amount each week, everything else will be covered. Now the important thing to note is that your variable monthly spend covers everything from groceries and clothing, to dining out, gifts and travel. Basically, if your weekly amount is $500, so long as you stay within this amount for the week, it does not matter what you spend it on!
The simplicity of this method is what makes it so powerful but do not be deceived by this simplicity. It will likely require some changes in your habits to adhere to your weekly amount; however, it has been our experience that your chance of success is greatly increased when you implement a cash flow approach over a budget.