Budgeting and Cash Flow
Fixed Expenses
Fixed expenses are those costs in your life that are occurring today and are designed to pay for something that is needed today, but will be fixed over a longer time period and can be hard or impossible to cancel in the event of a financial shock. The amount of the payment tends not to be affected by seasonality or the time of the year. These expenses tend to persist in their current form for at least several years, and even though everything can be changed eventually, these expenses tend to take longer to modify due to commitments being made to them. A mortgage is a good example of this: The terms will be renewed every few years and payments may change slightly, but it will be done over time. It is difficult to make radical changes to your mortgage within hours. Other examples are car leases, utility contracts like Bell or Rogers, or payment plans for renovations.
When you zoom in on the details of the budget or zoom out to make decisions on the big picture cash flow, what you have control over and what decisions you have made will allow you to ask different questions about what can be changed in your budget. Fixed expenses get the most attention because of the lack of control over short time periods. So carefully consider your mortgage, rent, lease payments for your car, utilities, property taxes, voluntary insurance payments for a house or car, interest payments on other forms of debt that are long term like lines of credit or student loans, instalment payments for big ticket items and sometimes daycare if it is relatively fixed in cost.
Discretionary Expenses
The last category of expenses is the discretionary expenses. These are expenses for everything else including food, entertainment, clothing, gifts, travel, household goods, electronics, hobbies, small repairs, furniture, children’s needs and any other items where money is spent. You have the most control over these types of expenses, and they get a lot of attention when it comes to budgeting for this reason.
Budget Framework
Generally speaking, the budget should be created over a 1-year period. Why? There are seasonal spending patterns that affect what you spend. What you purchase in the winter in terms of food, entertainment, travel, gifts will be different than in the summer. What you do with your children during summer break or camps will be different than when they are in school. Shopping for gifts tends to be highest at Christmas time and lowest in the summer time versus other points in the year. To capture these seasonal differences, a budget should be done over a calendar year. There can be a breakdown by month or quarter if this is helpful to manage day to day bills.
Balancing your budget, emergency funds and other reserves
A budget that is balanced is one where there is enough income coming in to pay for all of the expenses. Ideally, you want to have a budget surplus, where you have more money coming in, unless building your savings is already an item in your budget. This is because unexpected expenses can crop up from time to time – emergencies and other surprises. Building an emergency fund or buffer can help your multi-year budget deal with the year-to-year differences that will appear. The reserve fund adds a greater margin of error in balancing your budget. Some expenses will also only appear in certain periods. Taxes, for example, may only be due once a year (every three months for some), so you may need to plan ahead and save for them each month. Major home repairs can be even less frequent, requiring that homeowners plan to save over multiple years for some expenses.
A budget shortfall, where expenses are greater than income, can lead to drawing down your savings, or going into debt. Achieving a balanced budget can relieve a lot of stress in a person’s life, even if it means sacrificing some discretionary spending. This psychological trick has been known for centuries, as Charles Dickens put it:
“Annual income twenty pounds, annual expenditure nineteen pounds, nineteen shillings and six pence, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery”
Framing budget decisions in different ways can also help make the decisions easier to make. For example, increasing your budget surplus (your savings rate) from 5% to 10% may sound daunting – a doubling of your savings rate! However, it only requires that you cut your spending from 95% to 90% of your disposable income, a much more achievable-sounding reduction in your spending.