Budget Using Fixed vs Variable

In order to budget effectively we need to understand the way we spend our money and how the budget categories behave each month. A common method that finance planners use to do this is to identify each expense as either fixed or variable. 

Fixed expenses are those with amounts that change very little from month to month. Your largest expenses each month are likely fixed. Examples of fixed expenses are tithing, mortgages, car payments and car insurance. These expenses are often part of long-term agreements (debt). Even small fixed expenses can add up to significant annual expenses (a small $25 monthly payment adds up to a $300 annual payment). The key to managing these types of expenses is to enter into few long-term agreements.

Variable expenses are those that can change from month to month or are unexpected. Examples of these include food, clothing, utilities, car repair, home maintenance and medical. These expenses vary due to individual impulses, changes in market prices and often involve short-term agreements. The key to managing variable expenses is to treat them like fixed expenses. I’ll talk about this more in a bit.

Each expense should be classified in one of these categories, however, there are some expenses that may exhibit both fixed and variable traits. Take a cell phone bill as an example. Many cell phone plans have a fixed portion (monthly rate) and a variable portion (extra cost for additional minutes or data). If this is the case, and for simplicity sake, you can treat the whole expense as variable.

How do I use the fixed variable method to manage my budget?

A healthy budget has a controllable amount of fixed cost. That way if income drops there is enough cash flow available to meet all other obligations--low fixed costs are sustainable. Many people suffer from fixed costs that are too high due to consumer, vehicle, student and mortgage debt. Assuming the fixed cost is related to an asset with sufficient market value, the remedy for these people is to trade down the asset thereby trading down the corresponding liability. This is why it is so important that before we enter into any long-term financial arrangement it’s critical that we don’t let our wants speak louder than our needs. Unless you have extenuating circumstances, non-secured debt such as most consumer debt can only be lowered by paying it off.

Another trait of a healthy budget is one that treats variable expenses like fixed expenses. For variable expenses that can’t be predicted you can make monthly advance payments to a savings account. This is called a sinking fund. Although these expenses may be unknown at the time they still can be planned for well in advance. For recurring expenses like groceries we can treat them as variable by not overspending the budget. Techniques such as envelopes and spending freezes are excellent ways to keep these recurring items within a fixed budget.

This concept of fixing our variable expenses is also a critical component of the debt snowball technique for long term financial planning. It is also the best way to keep debt from coming back.

What is a Personal Financial Statement?

Let’s start by reviewing a few fundamental accounting documents. There are two accounting statements that you should become very familiar with. The first accounting statement you should know is the Income Statement and the second is the Balance Sheet.

The Income Statement is where we keep track of our monthly income and expenses. Among other things this document helps us understand how well we are “living within our means.” Our monthly Income is usually the easiest item for us to keep track of because receiving money is not painful and there are only a few of these transactions to deal with each month. It feels good when others value our efforts enough to fairly compensate us.

Depending on our personal financial position our monthly expenses may look very different when compared our neighbors. Monthly expenses are usually more difficult to keep track of than incomes. For instance, my family may have 200 expenses per month but only 2 income transactions. The amount of money remaining at the end of the month after all expenses are accounted for is Net Income or Cash Flow. Income, expenses and cash flow are managed together using a budget.

A budget is nothing more than a target for our monthly income and expenses and is usually broken into categories. A target amount is allocated to each category. These targets should be flexible and adjust as your needs change, preferably before the month begins. Budgets are a vehicle to help us reach our long term goals. The majority of people I speak with have a budget. However, many of these folks miss the point when they try to execute it. Ultimately they should be using their budget to reach their long term financial goals. This brings us to our second financial statement.

The Balance Sheet contains the cumulative effect of our financial decisions. All financial decisions that we have made throughout the course of our lives are funneled into this record. The balance sheet is broken into two categories Assets and Liabilities. Assets are items we own that are of worth to others. My home, cars, furniture and other possessions fall into this category. Some of these items such as furniture I have purchased with available net income. Other items such as my home and cars I’ve borrowed from a bank in order to obtain them.

Our long-term financial obligations are Liabilities. Everyone dollar that we’ve borrowed that we have not paid back yet, debt, is a Liability. A mortgage, car loans, student loans, credit card balances, overdraft balances all fall into this category.

The difference between the value of our Assets and Liabilities is Equity or Net Wealth. Our goal should be to avoid, minimize and eliminate Liabilities and increase our Assets in order to maximize Equity or Net Wealth.

Now, the Balance Sheet and Income Statement are inseparably connected.

Income Statement drives the Balance Sheet

Our monthly Income Statement shows us the change in our Balance Sheet. For example if my monthly income is $1,000 and expense is $800 I have $200 in Cash Flow. Unless I blow the $200 on a party for my son’s football team, this Cash Flow is the change to my Balance Sheet for the month. My assets go up by $200 which increases my Net Wealth by $200. My Liabilities are unaffected unless I choose to take the cash and pay off some debt. In this case my Liabilities go down by $200 which also increases my Net Wealth by $200.

Balance Sheet drives Income Statement

Liabilities or Debt usually come with strings attached. I might take a mortgage out for $100,000 with an interest rate of 5%. Each month I will pay a portion of the annual $5,000 interest expense. This interest expense will be recorded as an expense on my Income Statement. Also, I may have a rental property as an Asset on my Balance Sheet. If I’ve played my cards right this rental will provide a monthly income. The conclusion that can be drawn here is that Liabilities -> Expenses and Assets -> Income

My Personal Financial Statement

As a finance professional I am often regarded by others as someone that knows money. I’ve spent the last decade learning principles of accounting, investing, budgeting, cash flow management and other financial planning techniques. I spend most waking moments analyzing financial statements looking for opportunities to improve the financial position of my organization. I also spend a number of hours each month reviewing my personal financial statements.

It is funny how different my attitude is toward my personal financial decisions during the day compared to what I do at work. When I’m at a cash register for lunch or at the grocery store I often pay little attention to the amounts that I am spending. I consider myself a frugal person but I know that these are where my weak spots are—food. It is very easy to deviate from the monthly budgeted amounts, and most of the time I feel little remorse until I come back and review my personal financial statements. Reviewing my Personal Financial Statements each month allows me to know how close I am to reaching my goal of financial prosperity.

The Goal

It is impossible to reach goals that are never set. My life goals tie closely to my priorities which are, in order of importance, my family, my religion and my employment. As I observe those around me I am impressed that those whose priorities are similar to mine seem to be a little happier and go through their day-to-day activities with purpose. Taking a deeper look at these priorities you would see that the first two are full of "expenses" and the last is there out of necessity in order to fund the first two. Another item of note is that I spend a very large portion of my time at work and this takes me away from my home. Don't get me wrong, I really enjoy work and appreciate all of the benefits and comfort that come from putting in a full days effort. I would prefer to put these efforts toward something more valuable and that has a longer reaching effect.
In order to make more room in my life for my first two priorities, one of my top goals is to achieve financial prosperity. I define financial prosperity as being completely free from all debt and having enough in reserve to comfortably support my family into perpetuity. As with any goal, in order to achieve it I've got to have a plan. In this blog I'd like to share with you my plan to achieve this goal.

Inaugural Post

Welcome to the Finance Fitness blog. I hope that you find these ideas fresh, meaningful and useful.