Step 1: Tracking Every Penny

In order to start making a budget, you need to get a handle on what your current financial picture is. There are two overarching categories that shape your financial picture: cash flow and net worth. The whole idea of making a budget is to use positive cash flow to increase net worth (ideally anyway, the other situation is minimizing a negative cash flow to maintain net worth). Before going further, let’s define these terms.

Net worth is assets — stuff you could theoretically sell for a quick buck — minus liabilities — the technical term for debt (not necessarily true for businesses, but that’s another topic). Cash flow also has two components, which is what a budget is all about. The first is income, which for most people means their wages/salaries. The other component is expenses — everything people spend money on that aren’t investments. With the categories defined, we get a functional definition for budgeting:

A budget is a plan for maximizing income while minimizing expenses in order to increase assets while decreasing liabilities.

With all of definitions out of the way, we can actually begin. The first step to making a budget is tracking where every penny goes. Know your income and record every expense. Do this for 1 to 3 months to determine an average; and while you’re at it figure out your assets and your liabilities. Beyond pen and paper, there’s a plethora of apps and Excel templates to help you track everything.

Step 2: Categorize

Once you’ve determined your net worth and calculated your cash flow, the next step is categorizing your expenses. I’m leaving a more detailed look at net worth for later (in posts on Savings, Investing, and Loans). Income has few categories, since for most people the only major income is wages/salaries. Besides, interest, dividends, and capital gains, etc. — which are the other categories, but only major if your a) rich or b) retired — will be discussed in later posts.

There are several categories of expenses — housing, food, clothing, hygeine transportation, utilities, entertainment, and insurance. The first part of categorization is dividing your expenses into these categories. The second is identify which of the three types of spending each expense within a category falls under. You’ve probably heard of two of these types before, but I’ll go with 20SomethingFinance’s analysis here and throw in the third. They are Wants, Needs, and what I’ll call Pseudo-Needs.

The definitions of the three types are mostly self-explanatory. Needs represent the minimal spending that keeps you safe and alive. Pseudo-Needs are the quality-of-life spending that you don’t absolutely need but that you psychologically think you do. Wants are exactly that, everything you don’t need and you know you don’t need.