Budgeting is one of those terms thrown around by millions of people but a few get to master it. I consider budgeting one of the most important habits you need, to properly manage your finances, build wealth, and achieve financial independence.
You can’t invest money you did not save. At the same time, you cannot maximize your savings without a carefully crafted budget. More importantly, reducing your expenses works well only when you have a budget. For these reasons, you need to start budgeting your money as soon as possible.
The question is, do you really know how budgeting works? This article is designed to help you understand how budgeting works with practical examples.
So, what is budgeting?
Budgeting is the process of allocating your funds to services or projects in a budget. In order words, you make sense of your finances by writing down all your incomes, expenses, and savings. This way, you can tell where you are spending more money than you are supposed to or where to cut when necessary.
A budget can be written on a piece of paper or in software such as Excel or a budgeting app. It all depends on your preferences and access to these tools.
This article is designed to show you how budgeting works and how to create a budget step by step. The steps you will find in this article are easy to understand with practical examples. Feel free to use the sample budgets in this article as your reference.
1. Two types of budgets
There are two types of budget from a business standpoint, according to Investopedia.
(1) Static budget: Static budget is a budget that stays the same for the entire duration of the budget. This budget is designed to assess the effectiveness of business budgeting processes. Being static means that it does not change regardless of business operations and sales.
(2)Flexible budget: A flexible budget is a budget that changes over time and its changes follow the company’s sales, production, or external factors. This budget is designed to provide a deep understanding of business operations.
These two budget types help businesses perform effectively and improve their processes.
A flexible budget can also help individuals to manage their finances and adjust their finances on a daily basis. The format of a budget you will create for your finances will be flexible as you will make changes in ways that align with your financial goals.
2. Main parts of the budget and how to create a budget step by step with examples
The purpose of a budget is to help you understand your income(s) and how to effectively spend the money you make. A budget helps you make educated financial decisions.
Many people do not bother creating budgets which make it hard for them to manage their finances. Since you are reading this article, I guess you want to know how to be different from the crowd and I am here to help you with it.
Budgeting is not complicated, but, it can be if you do not approach it the correct way.
The following are the main parts of a budget.
- Income
- Expenses
- Savings
These three parts should be included in each budget. This is because you need to know how much you are making, how it is being spent, and finally, how much you are saving.
For each of these parts, we are going to expand them much further and build a budget from scratch.
a. Income
Your income is the sum of all incomes you have. Many people have one income which comes from their 9-5 jobs. However, there are others who have multiple incomes that come from different sources.
The following are some of the income sources most people have.
- Investments
- Gifts
- Allowances
- Wages
- Salaries
- Commission: Given to you after a successful sale of a product or a service
- Interest: earned from lending money and similar services
- Income from selling products such as clothes, digital products
- Royalties: This is paid to you when people use your inventions
You probably don’t have all these incomes. Not everyone has made inventions or has a ton of free money that they lend to clients and earn interest in return.
Whatever you have is ok. Even if you have just one income from your job, it will still work.
Tips: Never use your gross income when making a budget.
Your gross income includes money that is not yours such as taxes and other deductions. For this reason, using gross income will lead to false assumptions and wrong calculations. In the end, you will end up with an unrealistic budget or an impractical one.
Let’s create a budget using the incomes we listed above.
In order to put our incomes in a budget, we are going to start with two columns where the first column contains the name of incomes and the other contains their values. We are assuming that our client has all incomes described above. At the bottom of the table, we will calculate the total net income which will be the sum of all incomes we listed in the table.
If you have only one income, the same income will become your total income. Make sure to use the money you take home after all deductions.
Here comes the start of our budget.
| Income (monthly) | Dollar value(net value) |
| Wages | $1,000 |
| Salaries | $3,000 |
| Allowances | $500 |
| Investments | $400 |
| Commission | $200 |
| Interest | $100 |
| Royalties | $50 |
| Income from selling products | $200 |
| Gifts | $50 |
| TOTAL NET INCOME | $5,500 |
If you don’t have all these incomes, use what you have. If you only have income from your salary, your total income will become the net income from your salary.
From the table above, you can see that we have listed all incomes our client has and their equivalent values. We also calculated the total net income which is the sum of all these incomes and we ended up with $5,500.
Our next step is to calculate how much this person spends and compare it with the total income. So, let’s move to the next step.
b. Expenses
The next important section in your budget is the expenses section. By expenses, I am referring to anything that costs you money or takes money out of your pocket.
For example, your monthly tv subscription is an expense. Expenses differ from one person to another. However, there are some expenses that are common for almost every person. A good example is food expenses. Everyone eats.
Your budgeting practices should include all expenses no matter how big or small they are. Without including every expense, your budget will be incomplete. There are people who say that they don’t have to budget for the small drinks they get from vending machines. The truth is that those little expenses add to a big sum at the end of the month.
The following list has common expenses that many people have.
- Mortgage
- Rent
- Health insurance
- Food expenses (groceries shopping, dining out, food giveaways, etc)
- Car expenses (gas, insurance, maintenance, loan payments, interest, etc)
- Cell phone expenses (data, minutes, movies, and app subscriptions)
- Shoppings-related costs (clothes, shoes, and related items)
- Entertainment (movie subscriptions, streaming services, apps, newspaper subscriptions, video games, etc.)
- Internet/TV
- Student loans
- Miscellaneous
It is possible that you don’t have all these expenses or have more. For example, there are people who will not have student loans but have college-related expenses such as tuition, books, etc.
In addition, It is not possible to have rent and a mortgage at the same time unless you are an investor. Again these expenses will differ from one person to another. So, go ahead and list the expenses you have in the following budget.
Tip: List every expense you have no matter how small they are
Our client has different expenses. Yours (your expenses) might be different depending on your lifestyle. After listing our client’s expenses, we will calculate the total monthly expense and the difference between total income and total expense.
| Income/mo | Dollar value | Expenses/mo | Dollar value |
| Wages | $1,000 | Mortgage | $0 |
| Salaries | $3,000 | Rent | $2,500 |
| Allowances | $500 | Food | $500 |
| Investments | $400 | Car | $600 |
| Commission | $200 | Cellphone | $100 |
| Interest | $100 | Shopping | $500 |
| Royalties | $50 | Entertainment | $200 |
| Sales | $200 | Internet/tv | $150 |
| Gifts | $50 | Student loans | $150 |
| TOTAL INCOME | $5,500 | Medical | $300 |
| TOTAL EXPENSES | $5,000 | ||
| INCOME – EXPENSES = $500 |
At this point, we have listed all of the client’s incomes and expenses in a budget. From these calculations, we are able to make a decision about where our client stands financially. That is our client is saving money every month which is a good thing.
There are some expenses we did not include in our budget. For example, there are a lot of people who have child support expenses whereas others don’t. So, make sure you include every expense on your budget.
What we have done so far is not a complete budget. We only illustrated how much our client makes, where he spends his money, and how much he is saving or losing. The good news is that he is saving $500 every single month which translates to $6,000 ($500/mo x12 mo) every year assuming that his expenses stay the same all year round.
C. Increasing your savings through budgeting
Even if our client is saving money, the main purpose of this budget is not to illustrate how much he makes and where it is spent. Instead, we want to use a budget to help him cut down on expenses and increase his savings. Basically, we know where he stands. It is now our job to look into his expenses column and reduce some of those expenses.
The best way to reduce expenses is to eliminate your wants and figure out a way you can minimize how much you spend on needs.
If you look at the table depicted above, entertainment, shopping, and tv can be classified as wants. You can either choose to eliminate all of them or minimize how much you spend on them. For example, we can choose to get rid of TV services and keep the internet. In this case, the TV portion will go to his savings.
For our client’s needs, we can reduce how much he spends on wants. For example, instead of spending $2,500 on rent, he can move in a $1,500 monthly rent. He can achieve this by having a roommate and staying in the same house or by moving to chea[er house.
How to save money through budgeting?
A complete budget should have saving strategies that are designed to help you make decisions that align with your financial needs. The following are sections we need to add to our budget to help our client save more money.
- Target expense: The highest amount our client should spend on each expense in his budget
- Actual expense: What he actually spent at the end of the month
- Difference: Difference between the target expense and actual expense for each item. This will show us whether we are going over budget or meeting our budget requirements.
So, let us continue to develop our budget and see how we can cut down on expenses.
| Income | Value | Expenses | value | Target expenses | Actual expenses | Difference | Savings |
| Wages | $1,000 | Mortgage | $0 | $0 | $0 | 0 | $0 |
| Salaries | $3,000 | Rent | $2,500 | $1,500 | $1,600 | $100 | $900 |
| Allowances | $500 | Food | $500 | $300 | $300 | $0 | $200 |
| Investing | $400 | Car | $600 | $400 | $450 | $50 | $150 |
| Commission | $200 | Cellphone | $100 | $70 | $70 | $0 | $30 |
| Interest | $100 | Shopping | $500 | $200 | $250 | $50 | $250 |
| Royalties | $50 | Entertain | $200 | $100 | $100 | $0 | $100 |
| sales | $200 | Internet | $150 | $50 | $50 | $0 | $100 |
| Gifts | $50 | loans | $150 | $300 | $300 | $0 | -$150 |
| TOTAL INCOME | $5,500 | Medical | $300 | $300 | $300 | $0 | $0 |
| TOTAL | $5,000 | Total savings= $1,580 | |||||
| INCOME – EXPENSES | $500 | Target-Actual=> | $200 |
What can we learn from the completed budget above?
Let’s dive deeper into our budget. by now, the budget has gotten a little complicated for an untrained eye. The funny thing is that we did not add complicated numbers or hard calculations.
We decided to increase our savings by reducing expenses. To do so, we needed to have target expenses and evaluate how much our client spent at the end of the month.
Unless our client increased his income, the only way to boost his savings was to reduce his expenses.
That is where target expenses and actual expenses come into play. The idea is that some of his expenses could be trimmed down and that is what we did. The target expenses represent the maximum amount we want to spend on each item. The actual expense represents what was actually spent on each item at the end of the month.
The difference between these two numbers shows us whether we met our goal or if we missed it.
The savings column compiles the difference between what he used to spend and actual expenses. For example, his previous rent was $2,500 but he decided to move into a new house and ended up paying $1,600. This turned into a $900 savings on rent alone.
In addition, he decided to increase his student loan payments from $150 to $300. That is how we ended up with $150 over his usual payment.
Every budget you create should follow this blueprint. If you don’t like the above budgeting format, use the budget depicted in the following table.
Another useful budgeting format
If you find the above format not practical, consider using the following one. They all display the same information in a different style.
| Income (monthly) | Dollar value(net value) | ||||
| Wages | $1,000 | ||||
| Salaries | $3,000 | ||||
| Allowances | $500 | ||||
| Investments | $400 | ||||
| Commission | $200 | ||||
| Interest | $100 | ||||
| Royalties | $50 | ||||
| Income from selling products | $200 | ||||
| Gifts | $50 | ||||
| TOTAL INCOME | $5,500 | ||||
| Expenses | Dollar value | Target Expenses | Actual Expenses | Difference | Savings |
| Mortgage | $0 | $0 | $0 | $0 | $0 |
| Rent | $2,500 | $1,500 | $1,600 | -$100(over) | $900 |
| Food | $500 | $300 | $300 | $0 | $200 |
| Car | $600 | $400 | $450 | -$50(over) | $150 |
| Cellphone | $100 | $70 | $70 | $0 | $30 |
| Shopping | $500 | $200 | $250 | -$50(over) | $250 |
| Entertainment | $200 | $100 | $100 | $0 | $100 |
| Internet/tv | $150 | $50 | $50 | $0 | $100 |
| Student loans | $150 | $300 | $300 | $0 | -$150 |
| Medical | $300 | $300 | $300 | $0 | $0 |
| TOTAL EXPENSES | $5,000 | TOTAL: $3,220 | TOTAL: $3,420 | $200 (over) | Total savings = $1,580 |
3. Creating micro budgets
There are times when you will need to create small budgets within a budget. I call these small budgets micro budgets. For example, if you are a frequent traveler, you can create a travel budget. In this budget, you will not need to worry about listing all your income.
Instead, you will need to deal with the specific amount designed for traveling and divide it into all expenses you will encounter during the duration of your travel.
Your travel budget could be as simple as the following example. We are assuming that you have $5,000 to spend and your travel will last 10 days.
| Items | Dollar value |
| Lodging | $100/night = $1,000 |
| Flight ticket | $1,500 (round ticket) |
| Entertainment | $500 |
| Food | $500 |
| Transportation | $500 |
| Others (Souvenirs, other expenses, or savings) | $1,000 |
Your goal, in this case, is to make sure that you do not spend more than you have listed in this travel budget. Keep in mind that the money you are spending in this micro-budget must be listed in the expenses section of the main budget.
To make it easy for you and avoid messing up your budget, start saving for major expenses like this travel ahead of time.
4. Budgeting mistakes you should always avoid
Many people underestimate budgeting and assume that it is not that important. On the other hand, other people overcomplicate their budgeting styles which makes it difficult to follow the numbers they wrote in their budgets.
Budgeting goes beyond writing numbers on a piece of paper or in budgeting software. Without proper budgeting methods, you will find yourself among millions of people who create budgets and fail to follow them. According to PRNewswire, 33% of people are unable to maintain their budgets. This is a huge percentage given the importance of budgeting.
Why do many people fail when budgeting?
There are many reasons many people fail to sustain their budgets. The following are some of the budgeting mistakes you must avoid in order to create a practical budget and increase the odds of succeeding.
- Creating a very strict budget: The purpose of your budget is not to deprive you of things you love or need. Instead, it is there to help you manage and spend your money wisely. A strict budget could be difficult to follow and increase your chance of failing.
- Creating a budget using a gross income: A gross income contains tax and other deductibles. Because of this reason, a budget you create with gross income will not meet the reality. Always, use your net income.
- Not being serious about your budget: There are two important steps when it comes to budgeting. The first step is to make a budget and the second step is to follow your budget. It is always easy to create a budget. However, it is hard to follow it and respect it. This is why you must be serious about your budgeting practices and never leave anything to chance.
- Creating an unrealistic budget: Your budget should be meaningful and realistic. You can’t just say that you will cut down your expenses by 70% without numbers that support this goal.
- Not budgeting every expense: A big budgeting mistake many people make is to ignore some expenses. No expense is too small and small expenses add to big numbers once repeated many times.
- Not budgeting at all: Not budgeting at all is a budgeting mistake. If your life involves money, you should always have a budget to help you manage it.
- Forgetting to update your budget: You must update your budget from time to time.
