When it comes to finances, it’s easy to feel lost. We all know we need some kind of budget, but we aren’t always sure where to begin.
Many people start by categorizing their expenses in a spreadsheet or computer program (like Mint.com or Quicken), hoping to figure out where they’re going wrong. The problem is, simply organizing/plugging in numbers won’t solve your financial problems. Let me explain.
Going over past expenses is a great way to know where you stand. It gives you a solid foundation to create a cash-flow forecast for the next year. However, what is the next step once your forecast is completed? In other words, how do you stick to the forecast?
The truth is that you need both a forecast AND a budgeting system to keep your spending in line. Because while forecasting helps predict what we want to happen with our finances, budgeting provides the means to make sure it WILL happen.
A Road-Worthy Analogy
Imagine you want to take a road trip to the Grand Canyon. The first thing you do is map out how you’re going to get there (think pre-GPS, please). You calculate the most efficient route and pencil it in. You factor in rest times, plan your accommodations, and voila! – you’re all set to go.
The trouble is, when the time comes to hit the road, your car sputters to a halt, and you barely made it out of your driveway. You’re puzzled for a while, wondering what’s gone wrong. And then it hits you: You forgot to tank up!
On a road trip, a map won’t get you anywhere without enough gas. Similarly, when you’re heading toward a financial destination, a forecast won’t get you where you want to go if you don’t have a good budget to fuel your journey. Forecasting gives a general idea of what should happen with your finances, but without a budget, you won’t get off to a good start. Instead, you’ll find yourself stuck just outside the driveway, asking “What do I do now?”
On the flip side, you won’t get very far if you’re trying to reach your financial destination with only a budget and no forecast. Let’s return to the road trip analogy. There you are, headed to the Grand Canyon, all set to go with a full tank of gas – not to mention some tasty munchies. You hop in the car and get on your way. The skies are clear and all signs point toward a smooth trip.
After several hours of travel, you pull into a gas station and ask the attendant how far you are from your destination. The answer? “Another 15 hours or so.” You’re shocked. The Grand Canyon should only have been 12 hours away. That’s when you realize you were headed in the wrong direction. You took a bad turn because you didn’t map out your trip.
It works the same way when planning a financial journey. Without a clear idea of where you’re going and what you can expect along the way, a budgeting system can only take you so far – and it may well be in the opposite direction you intended to go.
I admit that the road trip analogy might be an oversimplification. But I want to drive home the point that you need both a road map (your forecast) and fuel (your budgeting system) to reach your financial destination. One without the other will either get you nowhere or get you completely lost.
Let’s take a closer look at these key components for a successful financial journey.
Forecasting: Mapping Out a Solid Spending Plan
Forecasting is the attempt to accurately predict your expenses for the coming year. It’s your financial road map, and it should be the first thing you do to get your spending under control.
Here’s how it works: Categorize all your expenses from the previous year (you might save time by doing this with a program like Quicken or iBank.) Be sure to remove any categories that won’t apply in the coming year; for example, physiotherapy bills for an injury you’ve recovered from.
When that’s done, you need to brainstorm any new expenses for the upcoming year. It’s important to anticipate financial roadblocks, such as that leaky roof that really should be fixed. You can use a simple Excel spreadsheet to input your anticipated expenses.
Once you’ve charted out your relevant previous expenses and anticipated expenses, you’ll have a workable forecast for the coming year.
Budgeting: Fueling Financial Success
I often say that budgeting starts where the spreadsheet stops. With a brand new financial forecast in your hands, the next step is to find a budgeting system that will enable you to stick to your forecast.
There are lots of different types of budgets out there. Some involve dropping cash in jars, others involve stuffing dollar bills into envelopes. But I prefer the Daily Discretionary Income (DDI) system. I find it the simplest and least time-consuming budgeting system out there.
Your DDI is what you have left over to spend each day at your discretion, for items like groceries, gas, clothes and entertainment. In a nutshell, here’s how it works:
Step 1: Calculate your Annual Discretionary Income (ADI)
ADI = Annual Net Income – Annual Fixed Expenses
Step 2: Calculate your Daily Discretionary Income (DDI)
DDI = Your ADI ÷ 365
Once you know your DDI, you should track it daily. If you have any extra at the end of a given day, carry it forward to the next day and watch it build up. You might be surprised at how fun it is to watch the numbers in your DDI column grow.
The DDI budgeting system is just one of many that might help you reach your financial destination. If you want to explore other options, Google “household budgeting systems” and find one that fits best for your needs, goals and temperament.
On the Road to Success
The road to good spending may be paved with good intentions, but those won’t do you much good without a plan and a means of getting where you want to go. To gain control of your finances, you need an accurate forecast and have a reliable budgeting system. Once those key components are in place, you’ll be well on your way to reaching your desired financial destination.