When it comes to the topic of managing your money, are you taking the best approach? While many people may believe they have a sound budgeting system and process, only a few manage to set aside money for their future.
And from those few, even fewer make substantial progress toward their financial goals. A common issue is that many people use a traditional budgeting method or tool but don't stick with it or fail to account for every expenditure. These breakdowns in their budgeting systems eventually lead to confusion and frustration.
If this sounds familiar zero-based budgeting (ZBB) can improve your budgeting process.
What is Zero-Based Budgeting?
The basis of zero-based budgeting, also referred to as zero-sum budgeting, is a simple elementary school math equation. Your budget is considered “zero-based” or “zero-sum” when your total income minus total expenses equals zero.
The “zero” in zero-based budgeting tends to worry people. However, it does not mean that your bank account balance equals zero. Instead, it simply means you must consider the money you save and invest as “expenses” and subtract them from your income.
For example, if your net income is $3,000 a month and you use a zero-based budget, your expenses would need to equal exactly $3,000 a month. However, when totaling your expenses, you need also to include any money you save and invest, as that money will still be leaving your bank account.
What Is the Benefit?
The beauty of zero-based budgeting is that you account for every dollar you receive. Using traditional budgeting methods, you typically list all necessary expenses, such as rent or mortgage, car, and debt payments.
However, in many cases, you may neglect to consider miscellaneous spending or expense categories that don't occur regularly, such as quarterly bills. Frequently irregular income, unexpected expenses, or even misunderstanding the basic steps of balancing your budget can easily throw your budget off track.
With zero-based budgeting, every cent has a specific purpose. This structured approach allows you to be more intentional with your spending and, in turn, makes you more likely to stick to your budget.
How to Create a Zero-Based Budget
If this is your first introduction to budgeting, it will be helpful to grab your bank statements for the past 3-6 months. Combing through them is the best way to determine the amount of money you've spent monthly in each expense category.
Gather Your Income
Begin by listing all money that flows into your bank account throughout the month. This income will fund your entire budget and should include the money you earn and any money you deposit into your account throughout the month.
Income sources include (but are not limited to):
You can choose to do your budget work on whichever medium you prefer, whether it be paper and pencil, a digital spreadsheet, or even an online budgeting app.
The key is to ensure your income is as accurate as possible. While predicting sources like dividend income can be challenging, it's good to include your best estimate.
Gather Your Expenses
The next step is to list all of your mandatory expenses. These are payments that you need to make every month and usually include costs such as:
- Interest payments on debt (credit cards)
- Food / Groceries
- Transportation expenses
- Phone bill
Similar to the income section, you'll want to ensure each of these expenses is as accurate as possible. Use your bank statements to determine the average amount you've spent on each expense in recent months.
Many of your recurring expenses will be “fixed expenses,” meaning the amounts will not change monthly. “Variable expenses,” however, such as food, clothing, gasoline, and the like, tend to vary or fluctuate each month. Therefore, using your average spending for those categories is a great way to estimate your monthly spending.
Analyze Your Financial Data
Once you've gathered your income and expense information, it's time to analyze your financial data. Sticking with our equation from above, total up your estimated expenses and subtract them from your total estimated income.
The remaining number will indicate your current financial position. If the difference is negative, that means more cash flows out of your bank than into your account every month; in essence, you have a negative cash flow in your budget.
While a negative cash flow may sometimes stem from a simple budgeting mistake, more often than not, it results from overspending. When you spend more money than you earn, you essentially operate your household finances in a deficit.
Zero-based budgeting means your total income minus your total expenses must equal zero. Therefore if your budget equals a negative number, you must increase the money coming in, decrease the money going out, or preferably, some combination of the two.
Conversely, suppose the difference between your income and your expenses is a positive number. In that case, it indicates a surplus in your budget – likely the result of proper money management.
While a surplus is an excellent position, your goal is to get your budget balanced to “0”. Assigning a “job” to the rest of your dollars by allocating them to another category such as savings, retirement investing, or sinking funds will reduce the leftover to zero.
Why Your Dollars Need a Job
When done correctly, zero-based budgeting is a practical approach that will help you regain control of your finances. However, for beginning budgeters, the concept of “giving your dollars a job” can be confusing.
Often, we think our money's job is simply to pay bills or make purchases. The phrase “assigning a job” can feel misleading.
If you cover all of your expenses and struggle to find a job for the remaining dollars, these options may be helpful:
- Miscellaneous expenses – There is no “perfect budget,” so you'll want to account for the times you make unplanned purchases. These expenses could include a spontaneous night out, Starbucks runs, or small impulse items you toss in your cart while waiting in line to checkout. Unplanned purchases will happen, so contributing extra money to a miscellaneous budget category will ensure you don't feel guilty when they do.
- Savings – It's imperative to plan for your future; opt to allocate leftover money to a savings or investment account. Planning for future expenses such as car maintenance or Christmas gifts by saving smaller amounts throughout the year in a sinking fund is also a good option. Lastly, if you don't currently have an emergency fund, consider moving it to the top of your financial priority list.
- Giving – If charitable, you'll want to include all your offering expenses as a line item in your budget.
- Periodic expenses – Some expenses don't fit into a monthly box, such as your bi-yearly auto insurance or quarterly trash bill. Give your extra dollars the job of covering your periodic expenses when they come due.
- Personal money – Budgeting can be tricky, especially when starting. Building in some personal cash for yourself and your spouse to spend at your discretion goes a long way in keeping you from feeling burnt-out or deprived.
- Debt payoff – If you have debt, such as credit cards or student loans, your surplus would be suitable for your debt repayment. Putting less money toward monthly debt payments will increase your budget margin.
Once you've determined your budget categories, assign dollars to each category based on your calculated estimates. Be sure to clarify your financial goals and values, as your budget and spending should support your goals and reflect your priorities.
Lastly, review the budget you've created and make any necessary adjustments until your income – expenses = 0.
Rinse and Repeat
Before starting each new budget period, you'll need to repeat the process. It's good practice to incorporate some review process at the end of your budget period. Review your budget for accuracy, determine where you need to make changes, and revise accordingly. It's normal to make mistakes such as forgetting to include new expenses, underestimating a budget category, and overspending.
Prepare your new budget by following the same steps outlined above. As with any new habit, consistency is crucial, so continuing to budget each month is the secret to mastering your budget.
Big companies use the zero-based budgeting method for their annual budgeting process to reduce costs, boost revenue, and forecast sales. These companies will identify specific areas of the organization and tie the budget and each line item to compare whether they have improved from one year to another.
Applying these same principles to your budget annually will significantly impact your finances. An annual budget will allow you to create a spending plan for the entire year and more accurate timelines for when you'll hit specific financial milestones.
Don't Be Discouraged
Creating a budget doesn't need to be complicated.
Zero-based budgeting requires you to approach your finances with a new perspective and embrace alternative ways of managing your money. Accounting for every dollar forces you to pay attention to your finances and encourages you to make intentional choices on how you spend your hard-earned money.
Don't be discouraged if this new way of budgeting doesn't feel natural. Zero-based budgeting is incremental, meaning your budgeting skills will improve monthly. As a result, you'll find yourself more motivated to stick to your plan, and your confidence will grow over time.
This article originally appeared on Wealth of Geeks.