Budgeting: Part 7: Categories

"The small part of ignorance that we arrange
and classify we give the name knowledge."

- Ambrose Bierce

Budgeting articles typically mention that people should not rely on the default list of budget categories that come with their budgeting software. Instead, users are advised to create a list of budget categories that makes sense for them. This is reasonable advice, but how does one determine what works for them? To be sure, you will need some experimentation, but I would offer the following general guidance for creating budget categories.

Use a separate category or subcategory whenever that can help you make better decisions. Here are some typical scenarios where it's worthwhile to have detailed spending information:

• The spending is temporary. If you know that a certain kind of spending is temporary (e.g. tuition, diapers, daycare), then it's quite beneficial to know how much cash flow will be freed up when the spending eventually stops.
  
• You're considering a substitute. In order to make a fair comparison, it's essential to accurately know your current costs. A typical example would be to track automobile repairs to compare with the costs of a newer car. Don't be afraid to temporarily create a subcategory to facilitate a good comparison. You can stop recording the subcategory detail when you've gathered enough information. Examples where we have done this sort of thing in the past include tracking film purchases (to compare with a digital camera), battery purchases (to compare with a recharging system), and even humidifier filters (to compare with a furnace humidifier installation).
  
• You're trying to reduce spending. If a particular category is a large percentage of your budget, then you may need to break it down further if you're trying to reduce your overall spending. For example, suppose you aren't currently saving any money and you want to start saving 10% of your income. If you look at your budget and you see 20% going to "discretionary spending" and 10% to "household expenses", then you'll need to break those categories down further. It's not very realistic to merely say you're cutting discretionary spending to 15% and household expenses to 5% because it won't even be clear what you're supposed to cut. You'll have to break things down a bit further in order to understand where you're currently spending money and how to reduce it.

Don't worry too much about what you name a category or how you group it. Nearly all budgeting software allows you to easily rename categories and move them around. Do you want to rename your "Restaurant" category to be called "Dining"? Fine. You can change that in 30 seconds at any time. Do you want to make auto insurance a subcategory of "Automobile" rather than a subcategory of "Insurance"? It's only another 30 seconds to do that.

If a transaction comes to you already fully categorized, then be sure to preserve those details. For example, you probably receive a monthly electric bill that contains charges for only one thing: electricity. So don't lump that together with all other utility bills in one category. It's no more difficult to preserve the fact that it's an electric bill. If you store the details and you want to aggregate all your utility bills together later on a report, that is very easy to do. But if you lose these details as you enter the transactions, then it's very, very hard to reconstruct them later.

Don't try to use categories to manipulate other members of your household. People try some really stupid shenanigans with regard to budget categories. Resist any urge to track other people's purchases beyond their comfort level or to use categories as a weapon. For example, if your household has decided to track dining as a separate category, then simply enter all applicable dining receipts and stop. Don't secretly create subcategories for each person and each kind of food item and then later attempt to blame high dining expenses on particular items bought by each person. Not only will this sort of manipulation hurt your personal relationships, it's also very likely that it will destroy your budgeting process. In the previous example, isn't it likely that the end result will simply be that others will conveniently lose most dining receipts the next month?

Don't use categories to compare yourself to national averages. First of all, you should strive to efficiently spend your money on the things you value most - not to match or beat the spending of the average person. Secondly, national averages often don't tell you what you might think they do. Usually these averages are calculated by simply adding up the total amount spent by everyone in a given category and then dividing by the total number of people (or households). So for example, if the average household that currently has an infant spends $800/year on diapers, but only 10% of households currently have an infant, then the national average will be reported as $80/year per household spent on diapers. Obviously this is not meaningful information for budget planning.

Categories can sometimes be helpful if they help you to appreciate how little you actually spend on certain things. If you know for certain that the amount spent on a category is small, it can be very liberating because you won't obsess about whether you need to change your spending in that area. In fact, one of the very best things about a good budget is being able to understand that certain expenses are simply way too small to have a material impact on your life. People sometimes have big ideas about how they are going to cut back on expenses and start saving money or paying down debt. Unfortunately, many of these well intentioned ideas fail because people don't have any idea how much they are currently spending on things, and so they target the wrong categories. This is how people arrive at the situation where they are really excited about how they are going to substantially change their spending habits by cutting back on Starbucks coffee, ATM fees, car washes, and sandwich bags. However, in many cases, the amount of money spent on such categories is very small. If you're trying to cut spending by 10% or 20%, you're not going to get anywhere by reducing a few categories where you spend 0.1% of your money. You have to cut the larger expenses, and to do that, you have to know which categories have amounts that are large enough to make a difference.