Personal Finances

Step 3: Develop a Budget and Use It to Evaluate Financial Performance

Once he has reviewed his cash-flow statement, Joe has a much better idea of what cash flowed in for the year that ended August 31, 2012, and a much better idea of where it went when it flowed out. Now he can ask himself whether he's satisfied with his annual inflow (income) and outflow (expenditures). If he's anything like most people, he'll want to make some changes - perhaps to increase his income, to cut back on his expenditures, or, if possible, both. The first step in making these changes is drawing up a personal budget - a document that itemizes the sources of his income and expenditures for the coming year, along with the relevant money amounts for each.

Having reviewed the figures on his cash-flow statement, Joe did in fact make a few decisions:

• Because he doesn't want to jeopardize his grades by increasing his work hours, he'll have to reconcile himself to just about the same wages for another year.
• He'll need to apply for another $7,000 student loan.
• If he's willing to cut his spending by $1,200, he can pay off his credit cards. Toward this end, he's targeted the following expenditures for reduction: rent (get a cheaper apartment), phone costs (switch plans), auto insurance (take advantage of a "good-student" discount), and gasoline (pool rides or do a little more walking). Fortunately, his car loan will be paid off by midyear.

Revising his figures accordingly, Joe developed the budget in Figure 14.9 "Joe's Budget" for the year ending August 31, 2013. Look first at the column headed "Budget". If things go as planned, Joe expects a cash surplus of $1,600 by the end of the year - enough to pay off his credit card debt and leave him with an extra $400.

Figure 14.9 Joe's Budget

Figuring the Variance

Now we can examine the two remaining columns in Joe's budget. Throughout the year, Joe will keep track of his actual income and actual expenditures and will enter the totals in the column labeled "Actual". Like most reasonable people, however, Joe doesn't really expect his actual figures to match with his budgeted figures. So whenever there's a difference between an amount in his "Budget" column and the corresponding amount in his "Actual" column, Joe records the difference, whether plus or minus, as a variance. Two types of variances appear in Joe's budget:

• Income variance. When actual income turns out to be higher than expected or budgeted income, Joe records the variance as "favorable". (This makes sense, as you'd find it favorable if you earned more income than expected.) When it's just the opposite, he records the variance as "unfavorable".
• Expense variance. When the actual amount of an expenditure is more than he had budgeted for, he records it as an "unfavorable" variance. (This also makes sense, as you'd find it unfavorable if you spent more than the budgeted amount.) When the actual amount is less than budgeted, he records it as a "favorable" variance.

Setting Mature Goals

Before we leave the subject of the financial-planning process, let's revisit the topic of Joe's goals. Another look at Figure 14.8 "Joe's Goals" reminds us that, at the current stage of his financial life cycle, Joe has set fairly simple goals. We know, for example, that Joe wants to buy a home, but when does he want to take this major financial step? And of course, Joe wants to retire, but what kind of lifestyle does he want in retirement? Does he expect, like most people, a retirement lifestyle that's more or less comparable to that of his peak earning years? Will he be able to afford both the cost of a comfortable retirement and, say, the cost of sending his children to college? As Joe and his financial circumstances mature, he'll have to express these goals (and a few others) in more specific terms.

Levels of Mature Goals

Let's fast-forward a decade or so, when Joe's picture of stages 2 and 3 of his financial life cycle have come into clearer focus. If he hasn't done so already, Joe is now ready to identify a primary goal to guide him in identifying and meeting all his other goals. Suppose that because Joe's investment in a college education has paid off the way he'd planned ten years ago, he's in a position to target a primary goal of financial independence - by which he means a certain financially secure life not only for himself but for his children, as well. Now that he's set this primary goal, he can identify a more specific set of goals - say, the following:

• A standard of living that reflects a certain level of comfort - a level associated with the possession of certain assets, both tangible and intangible.
• The ability to provide his children with college educations.
• A retirement lifestyle comparable to that of his peak earning years.
  

Having set this secondary level of goals, Joe's now ready to make specific plans for reaching them. As we've already seen, Joe understands that plans are far more likely to work out when they're focused on specific goals. His next step, therefore, is to determine the goals on which he should focus this next level of plans.

As it turns out, Joe already knows what these goals are, because he's been setting the appropriate goals every year since he drew up the cash-flow statement in Figure 14.7 "Cash-Flow Statement". In drawing up that statement, Joe was careful to create several line items to identify his various expenditures: housing, food, transportation, personal and health care, recreation/entertainment, education, insurance, savings, and other expenses. When we introduced these items, we pointed out that each one represents a cash outflow - something for which Joe expected to pay. They are, in other words, things that Joe intends to buy or, in the language of economics, consume. As such, we can characterize them as consumption goals. These "purchases" - what Joe wants in such areas as housing, insurance coverage, recreation/entertainment, and so forth - make specific his secondary goals and are therefore his third-level goals.

Figure 14.10 "Three-Level Goals/Plans" gives us a full picture of Joe's three-level hierarchy of goals.

Figure 14.10 Three-Level Goals/Plans

Present and Future Consumption Goals

A closer look at the list of Joe's consumption goals reveals that they fall into two categories:

1. We can call the first category present goals because each item is intended to meet Joe's present needs and those (we'll now assume) of his family - housing, health care coverage, and so forth. They must be paid for as Joe and his family take possession of them - that is, when they use or consume them. All these things are also necessary to meet the first of Joe's secondary goals - a certain standard of living.
2. The items in the second category of Joe's consumption goals are aimed at meeting his other two secondary goals: sending his children to college and retiring with a comfortable lifestyle. He won't take possession of these purchases until sometime in the future, but (as is so often the case) there's a catch: they must be paid for out of current income.

A Few Words about Saving

Joe's desire to meet this second category of consumption goals - future goals such as education for his kids and a comfortable retirement for himself and his wife - accounts for the appearance on his list of the one item that, at first glance, may seem misclassified among all the others: namely, savings.

Paying Yourself First

It's tempting to glance at Joe's budget and cash-flow statement and assume that he shares with most of us a common attitude toward saving money: when you're done allotting money for various spending needs, you can decide what to do with what's left over - save it or spend it. In reality, however, Joe's budgeting reflects an entirely different approach. When he made up the budget in Figure 14.9 "Joe's Budget", Joe started out with the decision to save $1,600 - or at least to avoid spending it. Why? Because he had a goal: to be free of credit card debt. To meet this goal, he planned to use $1,200 of his current income to pay off what would continue to hang over his head as a future expense (his credit card debt). In addition, he planned to have $400 left over after he'd paid his credit card balance. Why? Because he had still longer-term goals, and he intended to get started on them early - as soon as he finished college. Thus his intention from the outset was to put $400 into savings.

In other words, here's how Joe went about budgeting his money for the year ending August 31, 2013 (as shown in Figure 14.9 "Joe's Budget"):

1. He calculated his income - total cash inflows from his student loan and his part-time job ($25,700).
2. He subtracted from his total income two targeted consumption goals - credit card payments ($1,200) and savings ($400).
3. He allocated what was left ($24,100) to his remaining consumption goals: housing ($6,600), food ($3,500), education ($6,500), and so forth.

If you're concerned that Joe's sense of delayed gratification is considerably more mature than your own, think of it this way: Joe has chosen to pay himself first. It's one of the key principles of personal-finances planning and an important strategy in doing something that we recommended earlier in this chapter - starting early.