5.2: The Budget Process

Learning Objectives

1. Trace the budget process.
2. Discuss the relationships between goals and behaviors.
3. Demonstrate the importance of conservatism in the budget process.
4. Show the importance of timing in the budget process.

The budget process is an infinite loop similar to the larger financial planning process. It involves

• defining goals and gathering data
• forming expectations and reconciling goals and data
• creating the budget
• monitoring actual outcomes and analyzing variances
• adjusting budget, expectations, or goals
• redefining goals

A review of your financial statements or your current financial condition (as well as your own ideas about how you are and could be living) should indicate immediate and longer-term goals. It may also highlight new options. For example, an immediate goal may be to lower housing expenses. In the short term, you could look for an apartment with lower rent; however, in the long run, purchasing a home may be more advantageous. This long-term goal may suggest the need to establish a savings plan for a down payment.

Figure 5.2.1 : The Budget Process

The process of creating a budget can be instructive. Creating a budget involves projecting realistic behavior. Your assumptions may come from your actual past behavior based on accurate records that you have gathered. If you have been using personal finance software, it has been keeping those records for you; if not, a thorough review of your bank account and investment statements will reveal that information. Financial statements are useful summaries of the information you need to create a budget.

After formulating realistic expectations based on past behavior and current circumstances, you still must reconcile your future behavior with your original expectations. For example, you may recognize that greater sacrifices need to be made, that you must change your behavior, or even that your goals are unattainable and should be more realistic, perhaps based on less desirable choices. On the other hand, this can be a process of happy discovery: Goals may be closer or require less sacrifice than you may have thought.

Whether it results in sobering dismay or ambitious joy, the budget process is one of reconciling your financial realities to your financial dreams. How you finance your life determines how you can live your life. Budgeting is a process of mapping out a life strategy. You may find it difficult to separate the emotional and financial aspects of your goals, but the more successfully you can do so, the more likely you will reach your goals.

A budget is a projection of how things should work out, but there is always some uncertainty. If the actual results are better than expected, and incomes are higher or expenses lower, expectations can be adjusted upward as a welcome accommodation to good fortune. On the other hand, if actual results are worse than expected, if incomes are lower or expenses are higher, future budgets—and current living choices—may need to be adjusted to accommodate that situation. Those new choices are less than preferred, or you would have chosen them in your original plan.

To avoid unwelcome surprises, it is advisable to be conservative in your expectations, thereby maximizing the likelihood that your actual results will exceed expectations. Thus, when estimating, you should always underestimate the income items and potential gains, and overestimate the expense items and potential losses.

You will also need to determine a time period and frequency for your budget process, such as annually, monthly, or weekly. The timing will depend on the level of financial activity you have and the degree of discipline or guidance you want your budget to provide. You should assess your progress at least once a year. In general, you want to keep a manageable amount of data for any one period, so the more financial activity you have, the shorter your budget period should be.

Summary

• A budget is a process that mirrors the financial planning process.
• The process of creating a budget can suggest goals, behaviors, and limitations.
• For the budget to succeed, goals and behaviors must be reconciled.
• Budgets should be prepared conservatively, so
  • Overestimate costs.
  • Underestimate earnings.
• The appropriate time period is
  • Short enough to limit the amount of information.
  • Long enough to capture meaningful information.

Exercises

1. In your financial planning journal, begin your budgeting process by reviewing your short-term and long-term goals. What will it take to achieve those goals? What limitations and opportunities do you have for meeting them? Then gather your financial data and choose a time period and frequency for checking your progress.
2. Watch Building a Better Financial Future: Developing A Realistic Budget (www.youtube.com/watch?v=voNDemdJTi4) (2:04 minutes). Why is a budget so important in personal financial planning? What kinds of problems can you resolve by manipulating your personal budget? What types of goals can you attain through changes to your personal budget?
3. Watch and reflect on Why we make bad financial choices -- even when we know better (www.youtube.com/watch?v=caGlzR9F2zI) (3:36 minutes). Add notes in your personal finance journal reflecting on what you heard and learned.