How to Create a Budget: Step 1 – Project Your Income

Last week I posted an article explaining why you need to create a budget. Some of the reasons included:

1. To accomplish a financial goal
2. It will help us handle “shocks” to our finances
3. To identify areas of waste
4. To ensure that any surplus is not spent on frivolous items
5. It will help us develop discipline

Today we are going to look at the first step in creating a budget – tracking income.

In order to create a budget, you need to have a rough idea of how much money you will bring in each period. Since many bills are paid monthly, we will use a month as our standard budgeting period in this article.

The first thing that you need to do is to identify all of your sources of income. This will include your full-time job, part-time jobs, any freelance work, alimony/child-support, and any “under the table” income (this is especially important for musicians).

There are a few different ways to come up with a figure for monthly income:

Average Income

Once you have calculated your total income from all sources, you need to figure out an average for each month. If you are able to project your income for the year, just divide that number by 12. Now you have a number that represents your average monthly income. This figure works well if you receive steady and predictable payments throughout the year.

For instance, if you make $35,000 from your regular job, and $2,850 from side job (maybe you sell Mary Kay, or have a blog), you would plan to receive $3,154.17 per month ($37,850 divided by 12). Keep in mind that this is all after-tax income.

Pros and Cons – The great thing about this method is that it is very easy to do. Just divide your annual income by 12 and your done! However, unless your pay schedule is based on a month (either being paid once or twice per month), then you will be overestimating your income in most months and underestimating it during the rest.

If your income fluctuates often, then this next method is for you…

Projected Actual Income

Instead of using an average figure, you can also use the actual numbers for each month. This will call for more work, but is best when you have income that fluctuates or you receive infrequent payments. Suppose you want to be more accurate with your projected income. How can you accomplish this?

Let’s look at the example from above in more detail and see how they are broken out each month:

~ This assumes that you are paid every two weeks beginning on January 8, 2010.

You would take the “monthly totals” above and use them for your income projections for each month. This is a much more accurate way to track your income.

The reason why the “FT Amount” is different in April and October is because there are 3 paychecks received in those months.

Using actual income instead of averages takes a little more effort when initially setting up your budget, but, as you can see above,  it is not difficult to make changes.

Pros and Cons – Initially, this will take more work to set up as compared to using the monthly average. However, this is a lot more accurate if your pay is based on weeks (i.e. paid every week or every two weeks). This will ensure that you are not ending most months realizing that your income estimate was overstated, and thereby falling into a deficit.

Discounted or Adjusted Income:

If any of your projected income is unstable or unpredictable, then you will probably want to “discount” the figures to some degree. That would mean reducing your average or projected actual income by a percentage that you are comfortable with.

So, if you wanted to discount these numbers by 10%, you would just multiply them by 0.9. That would bring your average down from $3,154.17 to $2,838.75 – using the example above. I’ll leave you to figure it out for the projected actuals 😉 .

Doing this will give you a cushion in times when your income is lower than expected. This is great for those who depend on commissions or tips for a part of their income. Of course, if you are expecting a Lebron James-type paycheck, you probably don’t need to worry about this option!

Though this is not necessary for those with steady or predictable income, some people will adjust their projected income in order to force themselves to live below their means! They will go through the month as if they only have $2,838.75, even though they really have $3,154.17. They will then take that extra $315.42 and either save or spend it – or let it build up as a cushion in their checking account.

Pros and Cons – For those who have unpredictable income, this is a great way to create a buffer against those slow months. You can choose whatever percentage you want when choosing to discount – this will depend on your level of  comfort.

However, for those who are just looking for a way to build in discipline into their budgets, I don’t like this approach. Since I believe that every $ that you earn should have a purpose, I feel that you should decide how to spend/save the money before you earn it. We will revisit this topic in detail in a future article.

Determining which method to use depends on your situation. However, there are a few guidelines that you can apply:

• If you are paid once or twice a month (on the 1st and 15th for example), and most of your income comes from your main job, then you can get away with using the monthly average.
• If you are paid every week or every two weeks, then you should use projected actuals instead. This is because you will have several months where you receive an extra payment (as seen in the table above), and that should be budgeted appropriately.
• If a significant portion of your income fluctuates, then you should use probably use a monthly average and discount it.

Ultimately, it pays to be as accurate as possible when creating and managing a budget. A little bit of work in the beginning, can go a long way!

In our next article we will take a look at tracking expenses.