One of the first financial coaches I listened to when I started my debt repayment journey was Dave Ramsey. His book, the Total Money Makeover, played a big part in my decision to become debt free. In one of his podcasts he says (I am paraphrasing), ‘….if a company had you to manage their money like you manage your own, you would be out of a job’. Although harsh, this may be true. Take a look:
- Canadians have a debt to income ratio of 163.3%. They hold $1.63 in debt for every $1.00 they earn. (Financial Post) The average household family income in Canada is $76,000.
- 45% of Canadians have no emergency fund (CBC News), and 66 million Americans also have no savings. (Forbes).
- Americans have $15,310 in credit card debt, $171,775 in mortgages, $27,188 in auto loans and $48,986 in student loans (Nerd Wallet). The average household income in America is approximately $52,000.
If you were required to run your finances at home like you do at a corporation, what strategies would you need to implement to be successful?
I hope to answer this question by looking at 3 ways successful corporations implement their budget to make a profit and how these strategies can be translated in a personal budget.
(1) Zero based budgeting
Zero-based budgeting tries to achieve optimal allocation of resources to the parts of the business where they are needed most. It forces the managers to justify activities in their department. In this way, unjustifiable expenses are not included. Because expenses must be justified, managers are required to ask themselves questions like:
- Is the activity really necessary?
- Is the current budget amount adequate?
- What other ways can I carry out this activity?
In personal finance, we can take a similar approach with our money and budget. In zero-based budget, every dollar is assigned a purpose and the objective is to allocate our resources to get the most out of our money and meet our financial goals (a corporations main financial goal is to increase profits). If your goals is to pay off debt or save for retirement as an example, you can find ways to carry out activities in order to reach your goal. Some examples include:
- Cancel cable service and switch to streaming services
- Go from eating out every day of the week to eating out twice a week, if need be, and packing a lunch most days.
- Go from buying 2 cups of coffee a day to making one at home, and resist buying one while on break.
It is a simple but not easy process. For every expense in your budget, go through the following steps:
- Analyze the cost of the activity
- State its purpose
- Identify alternative methods to achieving the same purpose
- Look at the consequences of not performing the activity at all or performing it at different levels
(2) Incremental budgeting
Incremental budgeting is when companies take the current year’s spending and add or subtract to the amount based on information they have about each expense. The amount to increase or decrease may be based on a percentage or fixed amount. For example, corporations may assign a 2% increase on all expenses to account for inflation. Alternatively, if the exact amount is known like insurance premium rates, a fixed amount can be used. The original amount plus or minus the amount become the budgeted expense for the next year.
Incremental budgeting can be applied in personal budgets and tweaked on a monthly, quarterly or yearly basis. Here is an approach:
- Retrieve your current budget. On your current year budget spreadsheet create two columns next to each expense, one titled ‘fixed amount’ and the other ‘percentage change’.
- Determine the change in amount for each expense. Go through all expenses and determine whether each will fall under fixed amount or percentage change. Some things to remember:
- Even for expenses that you can control i.e. groceries, you should account for uncontrollable expenses like inflation (~2%)
- If a cost fluctuates depending on usage, this is probably a percentage increase. For example, cost of utilities may be higher in the winter than summer, or because of an additional member in the home.
- Expenses that state the amount of change ahead of time are a fixed amounts. Examples include: rent, auto or home insurance premiums, internet services etc.
- Determine the new amount for each expense: Your current year’s expense plus or minus the change in amount for each expense will give you the new budgeted amount for next year. Other ways to determine how much the change should be include:
- Reviewing old bills and statements and determine trends in purchases
- Watch for a notice by provider for increase or decrease in cost of services.
- When in doubt, estimate for cost of inflation.
Here is an example of our 2015 budgeted expenses and our 2016 projected amounts when developing our budget for 2016. Yours may be different.
|Renters insurance||$43||+$2.52||$45.52||*based on insurance notice|
|Auto insurance||$85.50||-$3.20||$82.30||*based on insurance notice|
|Internet||$0||+$60||$60||*we moved. New place does not include internet|
|Cell phone (2 plans)||$129||$0||$129|
(for 2 people)
|$400||+$120||$520||*we paid off debts in 2015 & relaxed our grocery bill a bit|
|Percentage change (monthly)
|Change||(New amount) 2016||Comments|
|Medical expenses||$30||+ 20%||$36||*Estimate to account for non-deductible portion & adding Mr. MMC onto my plan|
|Charitable giving||$582||indeterminate||$582 or higher||*can fluctuate based on income including bonus & side hustle income.|
|Fuel||$120||+10%||$132||*Estimate to account for increase in gas prices, although this has not been the case|
|Transit pass||$99||+5%||$104||*Estimate to account for the city of Calgary increasing cost of transit passes each year. Although this was not the case this year.|
(3) Establish a cash reserve
Most corporations keep a cash reserve for various reasons, including:
- To deal with unexpected expenses such as, the loss of a major contract or weak economy.
- To meet lending requirements. Depending on the size of the corporation and the amount of the loan, some lenders may require the corporation to keep a fixed amount in cash reserves as a condition to extending the loan. Failure to do this may result in the lender requesting full payment of loan.
Our personal finances should be no different. An emergency fund acts as our cash reserve in the event of an unexpected event and ensures lenders like banks that we are financially able to keep the loan in good standing. Corporations are not the only ones susceptible to financial loss, individuals are as well, so we should prepare ourselves accordingly.
By looking at how corporations prepare their budgets, we can gain a better understanding and appreciation of how to budget and manage our money.