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Basics in Budgeting

Updated: 21 hours ago

Disclaimer: For informational purposes only. It is not financial advice, nor is it intended to replace financial advice.


Have you ever found yourself in a situation where the balance in your bank account seemed to shrink faster than you expected? It can leave you feeling anxious and without enough money for your needs. This often results from how we manage our finances. Money management is crucial for living within your means. The first step to doing it properly is to create a budget.


A budget measures income (money coming in), expenditure (money going out), and savings (money you retain). When measuring income and expenditure, it’s important to keep it simple and adaptable to changes. This adaptability is key to a successful budgeting strategy, as both expenditure and income will change over time. In this post, I will lay out three common styles of budgeting and explain why each one is effective. Before diving into these strategies, let’s clarify a few important definitions.


Important Definitions


Understanding key financial terms is essential for effective budgeting. Here are some definitions to get us started:


Income - Money earned during a period. For example, you made $2,400 this month.


Expenditure - Money spent during a period. For instance, you spent $1,920 this month.


Savings - Money retained during a period. In this case, you saved $480 this month.


Financial Investment - Money spent on an asset with the expectation it will yield a return. For example, you bought a stock hoping it will increase in value.


Budget Surplus - This occurs when you spend less money than you budgeted. For instance, you planned to spend $1,920 but only spent $1,500.


Budget Deficit - This happens when you spend more money than you budgeted. For example, you budgeted for $2,400 but spent $2,600.


Sinking Fund - A portion of savings that you don’t intend to use for wants or needs, but are willing to tap into if your budget falls short.


Emergency Fund - A specific type of sinking fund that you only draw from for emergencies, such as rent, food, or medical expenses.


How to Organize a Budget: 3 Common Methods


Now that we have a clear understanding of key terms, let’s explore how to organize a budget using three common methods.


Step One: Calculate Income and Expenditure


First, calculate your income and expenditure. If you receive a paycheck this month for $2,400, then your income is $2,400. If you spent $1,920 on rent, food, gas, and other essentials, then your expenditure is $1,920.


Step Two: Categorize the Expenditure


Next, categorize your expenditure. For simplicity, let’s use two categories: needs and wants. Here are some examples:


  • Needs: Rent, Food, Utilities

  • Wants: Movie Tickets, New Sneakers, Video Games


Step Three: Calculate Your Savings


Now, calculate your savings using the formula: Savings = Income - Expenditure. In this case, $2,400 - $1,920 = $480. Here, we will refer to money retained and invested as savings. Although there is a difference between savings and financial investment, the budgeting model we will discuss lumps them into the same category.


The 50/30/20 Method


The first method we will look at is the 50/30/20 method, also known as the 50/30/20 rule. This budgeting method breaks down your income into needs, wants, and savings/investment.


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  • Needs: 50% of your income.

  • Wants: 30% of your income.

  • Savings/Investments: 20% of your income.


Budgeting this way may not be practical for everyone, but it serves as a good reference point.


The Zero-Based Budget


The next method is the zero-based budget. This budget model allocates every dollar. As the name suggests, there shouldn’t be any money unaccounted for. Giving every dollar a destination is key to managing money efficiently. While it may be tempting to allocate more money towards wants if your needs can be met with 40% of your income, it’s important to consider putting excess money into a sinking fund or an emergency fund.


The Envelope Budget


The last budgeting strategy we will discuss is the envelope budget. This method involves placing your money into envelopes and only withdrawing from the corresponding envelope for purchases. For example, you can only use money in the "wants" envelope for a new TV; you can’t take it from the needs or savings envelopes.


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While the envelope method can be effective, it may feel inconvenient in today’s cashless society. Since debit cards are widely accepted, it might be more practical to keep the money in your bank account rather than holding it as cash. A substitute for this method is to use a spreadsheet where you can input your spending limit and subtract the value of the items you purchase throughout the month.


Combining Budgeting Methods


You may have noticed that all these methods can be used simultaneously. You can use the 50/30/20 method to decide how to divide your income, the zero-based budget method to allocate your income efficiently, and envelopes or a spreadsheet to monitor your spending limits. All three methods are useful and can yield better results when used together.


Real-World Example of Budgeting


To wrap up this post, let’s look at a simplified, real-world example of how to apply these strategies. The first step in budgeting is to make a list of your income and expenses:


Monthly Income: $2,400

  • Money earned from working: $2,400


Monthly Expenses: $1,920

  • Rent: $1,000

  • Food: $160

  • Gas: $40

  • Movie Tickets: $200

  • Sneakers: $240

  • Streaming Services: $160

  • Video Games: $120


Monthly Savings: $480

  • Investments: $120

  • Savings: $240

  • Sinking/Emergency Fund: $120


Now that we’ve made a list of our expenses and savings, let’s categorize them and apply our budgeting strategies. Notice how the money left over from expenses automatically gets divided among the savings groups. This is using the zero-based budgeting strategy. For the 50/30/20 rule, we will need to calculate the percentages of our expenses and savings. You can calculate their percentage by adding them all up, then dividing the individual expense or saving by the sum of everything and multiplying by 100. The percentages below are close estimates:


Needs: 50%

  • Rent: 42%

  • Food: 6%

  • Gas: 2%


Wants: 30%

  • Movie Tickets: 8%

  • Sneakers: 10%

  • Streaming Services: 7%

  • Video Games: 5%


Savings: 20%

  • Investments: 5%

  • Savings: 10%

  • Sinking/Emergency Fund: 5%


In the examples I provided, everything fits neatly into the 50/30/20 model. However, this will most likely not be the case when you set up your budget. The next post will discuss adjusting the proportions of the budget and deciding how much money to allocate to different categories. The 50/30/20 rule is a great target, but everyone’s budget will look slightly different.


The last step is to keep track of your budget using envelopes or a spreadsheet. It’s crucial to keep receipts and monitor your spending. Any budget can (and most likely will) fall apart if accurate bookkeeping is ignored.


Budgeting Tools

Scenario: Managing Grocery Expenses


Scenario: Assume you go to the supermarket and notice you need $180 to cover your monthly grocery bill. How will you pay for groceries if your budget only allows you to spend $160?


Answer: You can take the $20 from your sinking fund. This is the purpose of having a sinking fund, and the less you use it, the more it will grow!


In conclusion, a budget is a tool to help you keep track of your spending habits and manage your money. Three ways of budgeting include, but are not limited to: the 50/30/20 budget, the zero-based budget, and the envelope budget. Each method is useful, and using all three together will yield better results than using them individually.


Bibliography & Source List


1. For General Definitions (Income, Expenditure, Savings vs. Investing)

2. For The 50/30/20 Rule

  • Source: All Your Worth: The Ultimate Lifetime Money Plan

  • Citation: Warren, E., & Tyagi, A. W. (2005). All Your Worth: The Ultimate Lifetime Money Plan. Free Press.

  • Web Alternative: If you prefer a web link over a book citation, you can use a reputable financial review:

- Pant, P. (2023, April 25). The 50/30/20 rule of thumb for budgeting. The Balance. https://www.thebalance.com/the-50-30-20-rule-of-thumb-453922


3. For Zero-Based Budgeting

4. For The Envelope Method

5. For Sinking Funds

 
 
 

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