Budgeting: Part 8: Handling Cash

"Yesterday is a canceled check; tomorrow is a promissory note;
today is the only cash you have - so spend it wisely."

- Kay Lyons

The proper handling of cash in your budget may seem a little confusing as first, but with a few simple rules, cash items can be handled in a straightforward manner and treated like all other items.

Create a cash account with your budgeting software. Unless you pay for almost everything by check or credit, it's generally a mistake not to create a cash account. Even though we prefer to use as little cash as possible, I'm always surprised at how much cash we actually use. It usually totals around $2,000 each year. Some people are uncomfortable creating a cash account because it's not a "real" account with an account number from a financial institution. Keep in mind that an account can be any logical grouping of assets or liabilities that help you organize and track things. An account doesn't have to involve a statement from a financial institution.

Record ATM withdrawals as transfers to your cash account. Your ATM withdrawals are simply entered as transfers from your checking or savings account to your cash account. If you withdraw money by cashing checks from your own checking account made out to "CASH", then that is handled the same way. There is no spending category associated with an ATM withdrawal because you haven't spent the money on anything yet. It's only a transfer at that point.

Save and record your cash receipts in your cash account. Your cash receipts are entered in the register of your cash account, and you categorize each cash spending receipt just like you would any other kind of spending receipt. This makes it very easy to enter the receipts.

Balance your cash account periodically. Another reason some people don't like cash accounts is that there is no monthly statement to balance. Since there is no statement to remind you how you spent your cash, it's often the case that you can't account for quite a bit of it. Sometimes you lose cash receipts, and sometimes you never get them in the first place. I've heard people complain that they really hate to use a cash account because they never have on hand the amount of cash stated in their account. Over time this divergence grows and can be really misleading. This situation is caused by not balancing the account, which is something you should do periodically. I balance our cash account at the end of every month. All I do is add up how much cash we have lying around at the end of the month and update the cash account balance to that amount. The reconciling transaction is categorized as "not categorized" in our budget. There are some people who get squeamish about this sort of approach because it seems like a hack and not the way to properly balance an account. However, when you update a cash account in this way, it does reflect reality. Based on the best information you have, the value of your cash account is now correct, and the amount that was missing should in fact be assigned to some sort of category such as "uncategorized" or "not categorized".

It's possible to track cash expenses without a cash account. In my early years of using Quicken, I actually tracked cash expenses by recording everything inside of ATM withdrawal transactions. This kind of system does work to some extent, but it wastes a lot of your time. Every time you need to enter a cash expense, you have to hunt down an ATM withdrawal that you previously entered as "uncategorized" and then update it to reflect the categorized expense. You often have to split up a single ATM withdrawal into many categories and amounts and you have to keep adjusting the "uncategorized" portion to keep things balanced. You also have to record your spending on the date of the withdrawal, which can be confusing unless the cash was actually spent the same day as the withdrawal. If your cash comes from several checking accounts, you may have to hunt around to find an appropriate withdrawal transaction. All of these steps are horribly inefficient.

It is much easier and faster to use a cash account. If you're not tracking cash expenses at all, a cash account will help you efficiently track those expenses. If you're already tracking your cash expenses, but you're not using a cash account, then creating and using a cash account will probably save you a lot of time and frustration. I would encourage you to start using one soon.

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.

Budgeting: Part 6: Basic Expense Tracking

"There are things known and there are things unknown,
and in between are the doors of perception."

- Aldous Huxley

Here is the very simple approach I take for tracking our household expenses. Your mileage may vary.

1. Record every transaction within reason. For every purchase where I can easily get a receipt, I enter it into Quicken. (You can use whatever software works best for you.) Note that it's irrelevant how the expense is paid. It doesn't matter whether it was paid with cash or credit, and it doesn't matter whether it was deducted automatically or transacted at point of sale.
2. Classify every transaction with a budget category. I use about 80 categories and subcategories. I find subcategories to be particularly helpful. The next article in this series will discuss how to pick meaningful categories.
3. Continue tracking everything forever. A lot of people keep track of all their expenses for one week or one month and then construct their budget based on that information. That doesn't sound like a very good idea to me, as almost all expenses are too irregular to fit into one month cleanly.

---

I've been following these three basic steps for a very long time. Here are the results of a query I ran against the last 11 years of my Quicken data:

Year	Number of Transactions For That Year
1998	1,013
1999	1,815
2000	1,507
2001	1,371
2002	1,120
2003	1,097
2004	1,285
2005	1,279
2006	1,424
2007	1,483
2008	1,666

That's more than 15,000 total transactions in the past 11 years, for an average of about 115 transactions every month. Each of these transactions has a date, payee, amount, and budget category. In many cases, a single transaction is internally "split" so that it has multiple categories and corresponding amounts. And the real shocker to some people is that I entered all these transactions manually!

---

So am I completely obsessed with accounting or something? Should I see a psychiatrist? Actually, this is not nearly as neurotic as it might seem at first glance. Here's why:

• It doesn't take that much time. I've timed myself occasionally, and I can consistently enter transactions at the rate of 2 per minute. (120 transactions/hour) This means I only spend about one hour each month entering these transactions. That's all!
• We don't track everything. About 3% of our expenses is not tracked. There are times when receipts are awkward or I lose them or I simply don't want to bother entering something I bought for 59 cents. I don't sweat any of this. I'm not striving for perfection. The goal is simply to do the best I can.
• It's worth it. It is definitely worth one hour of my time each month to understand where 97% of our money is going at all times. Having that level of information allows our family to make better financial decisions, avoid money arguments, and ensure that we are spending our money on the things we value most.

---

Notice that there are three dimensions to this process: how many expenses you record, how many expenses you classify, and how long you continue doing it. You may be wondering if it's really necessary to try to continually maximize all of these dimensions. I happen to think it is. Let's take the three dimensions one at a time:

• Isn't recording 70% or 80% of transactions good enough? Probably not. Most household finance decisions are made at the margin, which is to say that people wonder what are the costs and benefits of certain small changes to their present behavior. People ask questions such as:
• Can we afford a two week vacation instead of one week?
• Will I have enough money for a new couch if I stop eating out?
• How much debt can I pay down this year?

It's hard to answer these kinds of questions with any degree of accuracy when the whereabouts of one quarter of your spending is completely unknown.

• Why categorize everything? Why not just record the amount of money spent? The problem is that if things are not categorized, you just end up learning to whom the money was paid. While it might make for interesting trivia, it's not really helpful to know that last year you spent $3,400 at Wal-Mart, $4,750 at Costco, and $975 at CVS. This is basically meaningless information for budgeting purposes.
• What's wrong with recording expenses for one month and then multiplying by 12 for a yearly budget? Irregular expenses are problematic for planning, but unfortunately the reality for most people is that almost all expenses are irregular! I just looked through all my budgeting categories and the only ones in the whole list that were regular on a monthly basis were taxes, mortgage, and telephone (we have a flat rate bill for phone service). While a lot of expenses are recurring, most do not have a monthly schedule of identical payments. Instead, there are several different variations of recurring expenses:
  
  
  • Yearly expenses. (e.g. automobile registration; membership dues; subscriptions)
  • Quarterly expenses. (e.g. water; trash)
  • Monthly expenses with highly seasonal amounts. (e.g. electric; school expenses)
  • Monthly expenses that usually vary within a band. (e.g. gasoline; groceries)
  • Highly irregular expenses, both in timing and amount. (e.g. major maintenance expenses for cars and homes; medical expenses; spending binges)
  
  One of the tools for dealing with irregular expenses is to track everything long enough for a lot of the uncommon expenses to show up and the uneven expenses to average out. This will probably take a minimum of one year, and sometimes a lot longer.

Budgeting: Part 5: Budgeting Software

"If time be of all things the most precious, wasting time must be the greatest prodigality."

- Benjamin Franklin

I suppose this post might disappoint those who are looking for a budgeting software review or a flame war about which product is best, but I need to state what I really believe: your choice of budgeting software won't significantly affect the quality of your household budget, and it's probably better not to spend a lot of time selecting the perfect budgeting software for you.

I'm not dismissing the fact that everyone has particular likes and dislikes about budgeting systems, and I'm well acquainted with how annoying budgeting software can often be. I have used Quicken for 15 years! While it has proved adequate, I am the first to admit it is full of odd quirks, annoying constraints, and baffling limitations. But from time to time I've tried other products, and from my perspective, they just contain a different list of quirks, constraints, and limitations. I'm also quite certain that if I hired some company to create a budgeting software package that did everything exactly the way I wanted, then it would not work the way anyone else would like it to work. Such is the nature of personal preferences.

For each person, there probably is one software package that will be less frustrating to use than all the others. If you are the kind of person who gets easily frustrated by technology, then it's definitely worth some of your time to choose the right one for you. But I wouldn't agonize over the decision. Even the "best" software for budgeting won't make your budget succeed, and even the "worst" product won't make your budget fail. So pick something that works for you and start using it. Don't let an automation tool become your focus.

On two occasions, I searched the web for a couple of hours looking for budgeting software reviews to use as background material for this article. What I found was very interesting and only reinforced my view that many people waste too much time on this decision and are easily manipulated by product vendors. A large number of "reviews" looked like blatant advertisements for particular budgeting software packages, complete with loads of affiliate links on the pages. Even among the less dubious reviews, most of them seemed to focus on extolling one or two particular features with which the author was personally enamored or blasting one or two things that were a pet peeve of the author. If you simply need an overview of what budgeting tools are available, I would start with this post from the Get Rich Slowly blog.

This article is a turning point in this budgeting series. The first four posts attempted to show that the budgeting process is not just about trying to make sure you don't run out of money by the end of the month. It should be an opportunity to take control of your finances and align them with your goals in life. In that respect, the first four posts could be considered motivational, in that I attempted to show that the budgeting process holds deep personal value to enrich your life. I realize that a fairly large percentage of the population has no personal budget and considers budget construction on par with going to the dentist. While I'm not saying it can be made easy and fun, I am saying that the effort will be well worth your time. The rewards are very significant.

Now we need to turn to the "nuts and bolts" of household budgeting. The next few posts will describe how I handle typical budgeting details such as tracking, categorization, overruns, and irregularities. I'm also going to discuss at length the most common mistake that people seem to make with their personal budgeting. I see this same mistake over and over again both on the blogosphere and when I discuss money with my friends. It's easy to correct if you are willing to think in a way that most people are not willing to do. I don't believe there are any silver bullet solutions to most complex problems, but this budgeting tip is about as close as you will find. From what I observe, a sizable percentage of people would benefit tremendously from correcting just this one subtle problem with their budget plan.

Lastly, don't lose sight of the big picture. Remember that people don't create incorrect or irrelevant budgets because they use the wrong software. People create bad budgets because they use bad assumptions and bad numbers. In other words, budgeting goes awry due to factors far outside the realm of technology. I would suggest de-emphasizing the software and spending your time making sure you are using the right assumptions and the right numbers.