How to Make a Budget in Just a Few Easy Steps

One of the common mistakes people make is thinking that economics is the same thing as finance. Many economics professors will attest that this leads to us getting several questions about financial planning.

The key difference is that while economics studies exchange and the institutions under which exchange takes place, finance deals more with the practical study of managing money and other assets.

So, as an economist, I won’t be planning your retirement anytime soon. But, in my time in business school and my own life, I have picked up a trick or two relating to money management.

So with that I present a simple guide for making a budget. Please note, none of this is financial advice. I’m just describing a method you can use to make a budget, and some ways of thinking someone may find helpful.

Step 1) Know Your Income

Your budget requires you to compare your income to your expenses. That means you’re going to have to know your income. But just knowing the number associated with your yearly salary or wages is not enough. Why? Two reasons.

First, unless your boss is really cool, you don’t get your entire salary paid to you on January 1st. You can’t just assume you have access to your whole salary when you plan your expenses for the month.

Second, your yearly salary number is likely not adjusted for taxes. So if your salary is $100,000 a year, you’re not going to get all that money. Some of it is going to Uncle Sam rather than your budget, and likely to state and local government as well.

So can this be fixed? Well, for me, keeping track of my income on a monthly basis is best. The issue is, I get paid every other week rather than monthly, so I have to do some math.

Since there are 52 weeks in the year, getting paid every other week means I get 26 paychecks. So I take the dollar amount I get on my paycheck after taxes, multiply it by 26 to get my annual income after taxes and other deductions are removed, then I divide that number by 12 to get my average monthly income.

Situations and preferences vary, of course. You might want to keep track of your budget on a biweekly basis. In that case, you can just use the amount on your bi-weekly paycheck.

If you work for a wage at a job with irregular hours, things are tougher. You’re going to have to make a guess on the number of hours you’re going to work. I recommend trying to take an average of your last few paychecks so long as one of them isn’t extremely abnormal. Ultimately, if you have irregular pay, it will be important to make sure you have some savings on hand to cover you when you have a smaller pay period.

So we have a number now. I use my monthly average income. Others might use bi-weekly income. But what do we do when we get that number?

Step 2) Categorize Your Expenses

For a good budget, the next thing you’re going to have to do is make categories that describe everything you spend money on. That’s right, all your spending is going to fit in some category. The number of categories you need depends on a lot of factors. My wife and I have around 27. Here are some examples:

• Mortgage
• Gas
• Utilities
• Water
• Cell Phone
• Savings
• Medical
• Toiletries
• Date (what can I say? I’m a romantic.)
• Fun budget
• Groceries
• Other (Do not use this too much!)
• Holidays
• Vacation
• Auto Insurance

Again, these are not all of my categories. These are just a sample. But there’s a few lessons in this list. First, you may wonder why I separate out water and utilities. This separation illustrates a general rule that I think works well for budget categories. If you’re nearly certain of how much something will cost you, give it its own category.

Water almost always costs me the same amount every month. Our usage doesn’t fluctuate much, so I have that as its own category. This same rule applies to phone and auto insurance expenses. I know how much I need each month to cover them, so I just give them their own categories.

On the other hand, my electricity cost increases tremendously over the summer with AC, and my propane (heating) cost increases massively in the winter. These two utilities do not cost me the same every month, so I lump them together in one category and make sure I give enough to that category to cover both.

You may also notice the date and “fun budget.” Date is exactly what it sounds like, and fun is whenever I spend money just on myself. This might seem like a bit of a drag to predetermine how much you spend on these sorts of things, but it’s important to set some limits. First, it will help you to tell if you can afford the sorts of fun things you’re doing. Second, it’s a good discipline tool.

I won’t promise you’ll become a millionaire by cutting out daily coffee, but I will say you’ll have a lot less money in the future if you let yourself use it in a totally unlimited manner. This doesn’t mean there are no exceptions, but I’ll return to that later.

You might also notice an “other” budget. It’s easy to let this get out of hand. Any large expense that recurs frequently enough should not be here. The perfect item for an “other” budget is batteries. I barely ever buy them, and they’re cheap. They don’t fit in any category and don’t merit their own. To be explicit, I’ll share that I currently only put away $23 a month on “other” expenses.

Step 3) Decide How Much Income Goes Toward Each Category

So, you have an income number. Let’s say you make $50,400 a year after taxes or $4,200 average monthly. You need to allocate that $4,200 among your monthly expenses.

Of your categories you likely have:

1. Things that are necessary (think groceries)
2. Things that are superfluous (think vacation)

You also have:

1. Things that cost the same every month (think mortgage)
2. Things that fluctuate month-to-month (think gas or groceries)

The easiest way to start is to begin with categories that are necessary and cost the same every month. Say your mortgage is $1,100 (note: I live in rural Kansas where this number is not unrealistic at all). So of your $4,200, you now have $3,100 remaining.

Once you’ve done all your necessary expenses that cost the same each month, move on to your necessary expenses that cost different amounts each month. You’re going to have to give your best guess on these. For example, what did you spend on groceries last month? Try that number. For things like utilities, often companies will offer average price information for a year on their website.

Before moving on to superfluous things like vacations, you should have some amount of money go to savings each month. In theory, you want to build up an emergency savings fund on hand. Many in finance recommend having 3-6 months of living expenses in an emergency fund. So, you should put money in that category to start building it.

At this point, check how much your monthly expenses come to, and compare it to your monthly income. If monthly expenses are greater than monthly income at this point in the process, you have an issue. This means you cannot sustainably afford to pay for monthly necessities. Something has to change.

If this is the case, I can’t give too much advice. Situations vary wildly enough that there’s not a one-size fits all for this case. Obviously, lowering expenses for necessities or raising income is a fix in one sense, but this is easier said than done. Technically, you could take on debt to cover the gap, but this is not a sustainable long-term strategy and would be very costly because of compound interest.

If your income is greater than your expenses at this point, you can distribute the rest to your various superfluous budgets. Even small amounts are better than nothing. I looked at the history of our budget, and, at one point early in our marriage, my wife and I put away $20 per month for our date budget. It wasn’t much, but setting aside money for fun things is important if you can afford it.

If, after you fill all your superfluous categories, you still have extra, I recommend throwing it back into savings to build that emergency fund.

Step 4) Doing the Budget

So we have our categories, and we have how much income is going toward each category each month (or every two weeks if you did it that way). Now what?

Well, budgeting is a process. It’s no good if you just write it down. You have to stick to it. There are lots of ways to keep track of your income and expenses. You could use pen and paper or fancy software. I use an Excel spreadsheet. I have a column for each budget category. It looks something like this:

Again, I have a lot more columns because we use 27 categories, but it’s the same idea. Under the column headings I add income and deduct expenses. So, at the end of the month, I add my average monthly income broken up by categories. So let’s say for mortgage we have $1,100, Gas we’ll have $100, and everything else we’ll just say is X dollars for simplicity. So when…