5.3: Creating the Comprehensive Budget
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\(\newcommand{\avec}{\mathbf a}\) \(\newcommand{\bvec}{\mathbf b}\) \(\newcommand{\cvec}{\mathbf c}\) \(\newcommand{\dvec}{\mathbf d}\) \(\newcommand{\dtil}{\widetilde{\mathbf d}}\) \(\newcommand{\evec}{\mathbf e}\) \(\newcommand{\fvec}{\mathbf f}\) \(\newcommand{\nvec}{\mathbf n}\) \(\newcommand{\pvec}{\mathbf p}\) \(\newcommand{\qvec}{\mathbf q}\) \(\newcommand{\svec}{\mathbf s}\) \(\newcommand{\tvec}{\mathbf t}\) \(\newcommand{\uvec}{\mathbf u}\) \(\newcommand{\vvec}{\mathbf v}\) \(\newcommand{\wvec}{\mathbf w}\) \(\newcommand{\xvec}{\mathbf x}\) \(\newcommand{\yvec}{\mathbf y}\) \(\newcommand{\zvec}{\mathbf z}\) \(\newcommand{\rvec}{\mathbf r}\) \(\newcommand{\mvec}{\mathbf m}\) \(\newcommand{\zerovec}{\mathbf 0}\) \(\newcommand{\onevec}{\mathbf 1}\) \(\newcommand{\real}{\mathbb R}\) \(\newcommand{\twovec}[2]{\left[\begin{array}{r}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\ctwovec}[2]{\left[\begin{array}{c}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\threevec}[3]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\cthreevec}[3]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\fourvec}[4]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\cfourvec}[4]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\fivevec}[5]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\cfivevec}[5]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\mattwo}[4]{\left[\begin{array}{rr}#1 \amp #2 \\ #3 \amp #4 \\ \end{array}\right]}\) \(\newcommand{\laspan}[1]{\text{Span}\{#1\}}\) \(\newcommand{\bcal}{\cal B}\) \(\newcommand{\ccal}{\cal C}\) \(\newcommand{\scal}{\cal S}\) \(\newcommand{\wcal}{\cal W}\) \(\newcommand{\ecal}{\cal E}\) \(\newcommand{\coords}[2]{\left\{#1\right\}_{#2}}\) \(\newcommand{\gray}[1]{\color{gray}{#1}}\) \(\newcommand{\lgray}[1]{\color{lightgray}{#1}}\) \(\newcommand{\rank}{\operatorname{rank}}\) \(\newcommand{\row}{\text{Row}}\) \(\newcommand{\col}{\text{Col}}\) \(\renewcommand{\row}{\text{Row}}\) \(\newcommand{\nul}{\text{Nul}}\) \(\newcommand{\var}{\text{Var}}\) \(\newcommand{\corr}{\text{corr}}\) \(\newcommand{\len}[1]{\left|#1\right|}\) \(\newcommand{\bbar}{\overline{\bvec}}\) \(\newcommand{\bhat}{\widehat{\bvec}}\) \(\newcommand{\bperp}{\bvec^\perp}\) \(\newcommand{\xhat}{\widehat{\xvec}}\) \(\newcommand{\vhat}{\widehat{\vvec}}\) \(\newcommand{\uhat}{\widehat{\uvec}}\) \(\newcommand{\what}{\widehat{\wvec}}\) \(\newcommand{\Sighat}{\widehat{\Sigma}}\) \(\newcommand{\lt}{<}\) \(\newcommand{\gt}{>}\) \(\newcommand{\amp}{&}\) \(\definecolor{fillinmathshade}{gray}{0.9}\)- Describe the components of the comprehensive budget and their purposes.
- Describe the components of an operating budget.
- Discuss the sources of recurring income and expenses.
- Identify the factors in the operating budgeting process.
- Identify the factors in the capital budgeting process.
Gathering data and creating a budget, with some goals already in mind, are the initial steps in the process. Understanding the format or shape of the budget will help guide you to the kind of information you need. A comprehensive budget, that is, a budget covering all aspects of financial life, will include projections of recurring incomes and expenses, as well as nonrecurring expenditures. (Nonrecurring income or "windfalls" should not be counted on or "budgeted for," conservatively.) Recurring incomes would be earnings from wages, interest, or dividends. Recurring expenditures may include living expenses, loan repayments, and regular savings or investment deposits. Nonrecurring expenditures may include capital improvements, such as a new roof for your house, or the purchase of durable items, like a refrigerator or a car. These are purchases that would not be made on a regular basis. A comprehensive budget diagram is shown in Figure 5.3.1 .
Another distinction in recognizing recurring and nonrecurring items is the time frame for each. Recurring items require repeated attention and are therefore considered in the short term, whereas items on the capital budget may allow for long-term planning because they occur less frequently. The different time horizons for planning recurring and nonrecurring items may allow for various strategies to achieve those distinct goals.
A comprehensive budget is a combination of an operating budget, which focuses on short-term goals involving recurring items, and a capital budget, which addresses long-term goals involving nonrecurring items.
Operating Budget: Recurring Incomes and Expenditures
Recurring incomes and expenditures are usually the easiest to determine and project, as they occur consistently and have an immediate impact on your everyday life. An income statement shows income and expenses; a cash flow statement shows actual cash inflows and outflows. Recurring incomes and expenditures are planned in the context of short-term lifestyle goals or preferences.
Consider a time period that is large enough to capture relevant data. Some incomes and expenditures recur reliably but only periodically or seasonally. For example, you may pay the premium on your auto insurance policy twice per year. It is a recurring expense, but it only occurs in two months of the year, so you would need to examine expenditures over a sufficient number of months to notice it. Additionally, your heating or cooling expenses may fluctuate seasonally, resulting in higher utility expenses in some months than in others.
The time period you choose for a budget should be long enough to categorize intermittent items as recurring and nonrecurring items as unusual, yet short enough to follow and manage choices within the period. For personal budgets, a month is the most common budget period to use, since most living expenses are paid at least monthly. However, it is best to use at least one full year's worth of data to obtain a reasonable monthly average and to identify seasonal and periodic trends as they occur.
Some items may recur, but not reliably. The frequency, amount, or both may be uncertain. Taking a conservative approach, you should include the maximum possible amount of uncertain expenses in your budget. If income occurs regularly but the amount is uncertain, conservatively include the minimum amount that is expected. If income happens irregularly, it may be better to leave it out of your budget - and your plans - since you can't "count" on it.
Consider the following example: Mark works as a school counselor, tutors on the side, does house painting in the summer, and buys and sells sports memorabilia online. In 2016, he bought an older house with a $200,000 fixed-rate mortgage at 5.75 percent. Each year, he deposits $1,000 into his retirement account and makes home improvements. He used a car loan to buy his car. Whatever cash is left after he has paid his bills is saved in a money market account that earns 3 percent interest. At the end of 2023, Mark is attempting to draft a budget for 2024. Since he bought the house, he has been keeping pretty good financial records, as shown in Table 5.3.2 .
Mark has five sources of income - some more constant, some more reliable, and some more seasonal. His counseling job provides a steady, year-round paycheck. House painting is a seasonal, although fairly reliable, source of income; however, in 2022, Mark fell from a ladder and was unable to paint for two months. Tutoring is a seasonal source of income, and since the school hired an additional counselor in 2021, his income has decreased. Memorabilia trading is a year-round but unpredictable source of income. In 2023, he made some very lucrative trades, but almost none in 2021. Interest income depends on the balance in the money market account. He would include his counseling, painting, and interest incomes in his budget, but should be conservative about including his tutoring or trading incomes.
Mark's expenses are reliable and easily predictable, with a few exceptions. His 2022 accident increased his medical expenses for that year. Both gas costs for the car and heating expenses vary with the weather and the highly volatile price of oil; in 2021, those expenses were unusually high. Property tax increased in 2023, but is unlikely to do so again for several years.
| 2019 | 2020 Actual | 2021 Actual | 2022 Actual | 2023 Actual | |
|---|---|---|---|---|---|
| Incomes | |||||
| Wages | $ 32,000 | $ 33,500 | $ 35,000 | $ 36,500 | |
| Tutoring | $ 3,000 | $ 400 | $ 5,000 | $ 500 | |
| Memorabilia Sales | $ 2,500 | $ 950 | $ 2,650 | $ 5,300 | |
| House Painting | $ 10,000 | $ 11,000 | $ 4,500 | $ 10,250 | |
| Interest Income | $ 180 | $ 192 | $ 173 | $ 146 | |
| Total Income | $ 47,680 | $ 49,642 | $ 47,323 | $ 52,696 | |
| Payroll/Income Taxes | $ 8,000 | $ 8,375 | $ 8,750 | $ 9,125 | |
| Disposable Income | $ 39,680 | $ 41,267 | $ 38,573 | $ 43,571 | |
| Living Expenses | |||||
| Groceries | $ 3,120 | $ 3,120 | $ 3,120 | $ 3,120 | |
| Car-Fuel | $ 1,688 | $ 1,875 | $ 2,813 | $ 1,500 | |
| Car-Services, etc. | $ 350 | $ 350 | $ 320 | $ 350 | |
| Car-Insurance | $ 800 | $ 800 | $ 800 | $ 800 | |
| Electricity | $ 780 | $ 780 | $ 780 | $ 780 | |
| Phone/Internet | $ 1,500 | $ 1,188 | $ 1,188 | $ 1,068 | |
| Heat | $ 1,240 | $ 1,200 | $ 1,990 | $ 1,125 | |
| Health Insurance | $ 320 | $ 335 | $ 350 | $ 365 | |
| Medical | $ 50 | $ 50 | $ 1,200 | $ 50 | |
| Dental | $ 200 | $ 200 | $ 200 | $ 200 | |
|
Travel/Entertainment |
$ 3,000 | $ 3,000 | $ 3,000 | $ 3,000 | |
| Car Loan Payment | $ 3,600 | $ 5,400 | $ 5,400 | $ 5,400 | |
| Mortgage Interest | $ 11,433 | $ 11,281 | $ 11,120 | $ 10,950 | |
| Property Tax | $ 3,450 | $ 3,450 | $ 3,450 | $ 4,350 | |
| Total Living Expenses | $ 31,530 | $ 33,029 | $ 35,761 | $ 33,058 | |
| Income after Living Expenses | $ 8,150 | $ 8,238 | $ 2,813 | $ 10,514 | |
| Interest Expense | |||||
|
Capital Expenditures/ Investment |
|||||
| Mortgage Principal | $ 2,573 | $ 2,725 | $ 2,886 | $ 3,056 | |
| Free Cash Flow | $ 5,577 | $ 5,513 | -$ 73 | $ 7,458 | |
| Retirement Account Deposit | $ 1,000 | $ 1,000 | $ 1,000 | $ 1,000 | |
| Home Improvement | $ 4,357 | $ 5,327 | $ 0 | $ 4,146 | |
| Savings Deposit (withdrawal) | $ 220 | -$ 814 | -$ 1,073 | $ 2,312 | |
| Draw on (pay off) Line of Credit | |||||
| Net Cash Flow | $ 0 | $ 0 | $ 0 | $ 0 | |
| Line of Credit | |||||
| Money Market Account Balance | $ 6,000 | $ 6,400 | $ 5,778 | $ 4,878 | $ 7,336 |
Using New Information and "Micro" Factors
Along with your known financial history, you should also include any new information that may change your expectations. As with any forecast, the more information you can include in your projections, the more accurate the forecast will be.
Mark knows that the hiring of a new counselor has significantly cut into his tutoring income and will likely continue to do so. He will get a modest raise in his wages, but has been notified that the co-pays and deductibles on his medical and dental insurance will increase in 2024. He has just traded in his car and gotten a new loan for a used car.
The personal or micro characteristics of your situation influence your expectations, especially if they are expected to change. Personal factors such as family structure, health, career choice, and age significantly influence financial choices and goals. If any of those factors is expected to change, your financial situation will probably change as well, and that expectation should be included in your budget projections.
For example, if you expect to increase or decrease the size of your family or household, that will affect your consumption of goods and services. If you anticipate a change in job or career, it will likely affect your income from wages. A change in health may result in working more or less and thus changing income from wages. There are many ways that personal circumstances can change, and these changes can alter your financial expectations, choices, and goals. All these projected changes need to be included in the budget process.
Using Economics and "Macro" Factors
Macro factors affecting your budget stem from the broader economic context, so understanding how incomes and expenses are generated is useful in forming accurate estimates. Incomes are created when labor or capital (liquidity or assets) is sold. The amount of income created depends on the quantity sold and the price.
The price of labor depends on the relative balance of supply and demand for labor, as reflected in unemployment rates. The price of liquidity depends on the relative supply and demand for capital reflected in interest rates. In turn, unemployment rates and interest rates are influenced by the complex and dynamic economy.
The economy tends to behave cyclically. If the economy is in a period of contraction or recession, demand for labor is lower, competition among workers is higher, and wages are unlikely to rise. As unemployment rises, especially if you are working in an industry that is cyclically contracting with the economy, wages may become unreliable or increasingly risky if there is a risk of losing your job. Interest rates are generally more volatile and difficult to predict, but they tend to fall during periods of contraction and rise during periods of expansion. A budget period is usually short, so economic factors will not vary widely enough to affect projections over that brief period. Still, those economic factors should inform your estimates of potential income.
Expenses are incurred when a quantity of goods or services is consumed at a specific price. That price depends on the relative supply and demand for those goods and services, as well as the broader context of price levels in the economy. Inflation decreases the value of our currency, thereby reducing the purchasing power of goods and services. Again, as a rule, the budget period should be short enough so that changes in purchasing power do not significantly affect the budget; still, these changes should not be ignored. Price levels are much quicker to change than wage levels, so it is quite possible to have a rise in prices before an increase in wages, which decreases the real purchasing power of your paycheck.
If you have a variable rate loan - that is, a loan for which the interest rate may be adjusted periodically - you are susceptible to interest rate volatility. You should be aware of that particular macro factor when creating your budget.
Macroeconomic factors are challenging to predict, as they reflect complex scenarios; however, news about current and expected economic conditions is readily available in the media every day. A good financial planner will also track the economic indicators and forecasts. You will have a fairly concrete idea of where the economy is in its cycle and how that affects you simply by seeing how your paycheck covers your living expenses (e.g., filling up your car with gas or shopping for groceries). Figure 5.3.3 shows the relationship between personal history, microeconomic factors, and macroeconomic factors.
Using his history, current information, and understanding of current and expected macroeconomic factors, Mark has compiled the budget shown in Table 5.3.4 .
To project his income, Mark relied on his most recent information to estimate his wages and tutoring income. He used the minimum income from the past four years for memorabilia sales, which is conservative and reasonable given its volatility. His painting income is less volatile, so his estimate is an average, excluding the unusual year of his accident. Interest income is based on his current money market account balance, which is adjusted for an expected drop in interest rates.
Mark expects his expenses to remain the same as they were in 2019, since his costs and consumption are not expected to change. However, he has adjusted his medical and dental insurance and his car loan payments based on his new knowledge (Table 5.3.4 ).
The price of gas and heating oil has been extraordinarily volatile during this period (2019-2023), affecting Mark's gas and heating expenses. Therefore, he bases his estimates on his expected consumption and the current price. He knows he drives an average of about 15,000 miles per year and that his car gets about 20 miles per gallon. He estimates his gas expense for 2024 by guessing that since oil price levels are about where they were in 2021, gas will cost, on average, what it did then, which was $2.50 per gallon. He will buy, on average, 750 gallons per year (15,000 miles ÷ 20 mpg), so his total expense will be $1,875. Mark also knows that he uses 500 gallons of heating oil each year. Estimating heating oil prices at 2021 levels, his cost will be about the same as it was then, or $1,200.
Mark knows that the more knowledge and information he can bring to bear, the more accurate and useful his estimates are likely to be.
| 2019 | 2020 Actual | 2021 Actual | 2022 Actual | 2023 Actual | 2024 Budget | |
|---|---|---|---|---|---|---|
| Incomes | ||||||
| Wages | $ 32,000 | $ 33,500 | $ 35,000 | $ 36,500 | $ 38,000 | |
| Tutoring | $ 3,000 | $ 400 | $ 5,000 | $ 500 | $ 0 | |
| Memorabilia Sales | $ 2,500 | $ 950 | $ 2,650 | $ 5,300 | $ 950 | |
| House Painting | $ 10,000 | $ 11,000 | $ 4,500 | $ 10,250 | $ 10,417 | |
| Interest Income | $ 180 | $ 192 | $ 173 | $ 146 | $ 49 | |
| Total Income | $ 47,680 | $ 49,642 | $ 47,323 | $ 52,696 | $ 49,416 | |
| Payroll/Income Taxes | $ 8,000 | $ 8,375 | $ 8,750 | $ 9,125 | $ 9,500 | |
| Disposable Income | $ 39,680 | $ 41,267 | $ 38,573 | $ 43,571 | $ 39,916 | |
| Living Expenses | ||||||
| Groceries | $ 3,120 | $ 3,120 | $ 3,120 | $ 3,120 | $ 3,120 | |
| Car-Fuel | $ 1,688 | $ 1,875 | $ 2,813 | $ 1,500 | $ 1,875 | |
| Car-Services, etc. | $ 350 | $ 350 | $ 320 | $ 350 | $ 350 | |
| Car-Insurance | $ 800 | $ 800 | $ 800 | $ 800 | $ 800 | |
| Electricity | $ 780 | $ 780 | $ 780 | $ 780 | $ 780 | |
| Phone/Internet | $ 1,500 | $ 1,188 | $ 1,188 | $ 1,068 | $ 1,068 | |
| Heat | $ 1,240 | $ 1,200 | $ 1,990 | $ 1,125 | $ 1,200 | |
| Health Insurance | $ 320 | $ 335 | $ 350 | $ 365 | $ 760 | |
| Medical | $ 50 | $ 50 | $ 1,200 | $ 50 | $ 50 | |
| Dental | $ 200 | $ 200 | $ 200 | $ 200 | $ 500 | |
| Travel/Entertain ment | $ 3,000 | $ 3,000 | $ 3,000 | $ 3,000 | $ 3,000 | |
| Car Loan Payment | $ 3,600 | $ 5,400 | $ 5,400 | $ 5,400 | $ 5,988 | |
| Mortgage Interest | $ 11,433 | $ 11,281 | $ 11,120 | $ 10,950 | $ 10,769 | |
| Property Tax | $ 3,450 | $ 3,450 | $ 3,450 | $ 4,350 | $ 4,350 | |
| Total Living Expenses | $ 31,530 | $ 33,029 | $ 35,761 | $ 33,058 | $ 34,610 | |
| Income after Living Expenses | $ 8,150 | $ 8,238 | $ 2,813 | $ 10,514 | $ 5,305 | |
| Interest Expense | $ 321 | |||||
| Capital Expenditures/Investment | ||||||
| Mortgage Principal | $ 2,573 | $ 2,725 | $ 2,886 | $ 3,056 | $ 3,226 | |
| Free Cash Flow | $ 5,577 | $ 5,513 | -$ 73 | $ 7,458 | $ 1,748 | |
| Retirement Account Deposit | $ 1,000 | $ 1,000 | $ 1,000 | $ 1,000 | $ 1,000 | |
| Home Improvement | $ 4,357 | $ 5,327 | $ 0 | $ 4,146 | $ 15,000 | |
| Savings Deposit (withdrawal) | $ 220 | -$ 814 | -$ 1,073 | $ 2,312 | -$ 7,385 | |
| Draw on (pay off) Line of Credit | $ 6,870 | |||||
| Net Cash Flow | $ 0 | $ 0 | $ 0 | $ 0 | $ 3 | |
| Line of Credit | $ 6,870 | |||||
| Money Market Account Balance | $ 6,000 | $ 6,400 | $ 5,778 | $ 4,878 | $ 7,336 | $ 0 |
Capital Budget: Capital Expenditures and Investments
The income, or free cash flow, that remains after paying living expenses and debt obligations is cash available for capital expenditures or investment. Capital expenditures are usually part of a long-term plan for building an asset base. Investment may also be part of a longer-term plan to build an asset base or to achieve a specific goal, such as financing education or retirement.
Long-term strategies are based on expected changes to the micro factors that shape goals. For example, you want to save for retirement because you anticipate aging and not being as willing or able to sell labor. Expanding or shrinking the family structure may create new savings goals or a change in housing needs, indicating a shift in the asset base (e.g., buying or selling a house).
Some changes will eliminate a specific goal. A child finishing college, for example, ends the need for education savings. Some changes will emphasize the necessity of a goal, such as a decline in health that underscores the need to save for retirement. As personal factors change, you should reassess your longer-term goals and the capital expenditures associated with those goals, because long-term goals and thus capital expenditures may also change in response.
While many personal factors are relatively predictable over the long term (e.g., you will get older, not younger), the macroeconomic factors that will occur simultaneously are much harder to predict. Will the economy be expanding or contracting when you retire? Will there be inflation or deflation? The further (in time) you are from your goals, the harder it is to predict those factors and the less relevant they are to your budgeting concerns. As you approach your goals, macro factors become increasingly influential in assessing your progress toward them. This was discussed in detail in Chapter 4.
Since long-term strategies unfold over time, you should utilize the relationship between time and value to calculate capital expenditures and track progress toward long-term goals. Long-term goals are often best achieved through a progression of steady and even steps; for example, a savings goal is typically reached by a series of regular and consistent deposits. You can also determine if your goal is too modest or too ambitious and should be adjusted in terms of the time required to reach it or the rate at which you achieve it.
Capital expenditures may be a one-time investment, like a new roof. A capital expenditure may also be a step toward a long-term goal, like an annual savings deposit. That goal should be assessed with each budget, and that "step" or capital expenditure should be reviewed. Figure 5.3.5 shows the relationship of factors used to determine the capital budget.
Mark's 2024 budget (shown in Table 5.3.4 ) projects a decline in income and disposable income, along with an increase in living expenses, resulting in less free cash flow for capital expenditures or investments. He knows that his house needs a new roof (estimated cost: $15,000) and was hoping to have it done in 2024. However, that capital expenditure would create a negative net cash flow, even if he also uses the savings from his money market account. Mark's budget shows that both his short-term lifestyle preferences (projected income and expenses) and progress toward his longer-term goals (property improvement and savings) cannot be achieved without some changes and choices. What should those changes and choices be?
- A comprehensive budget consists of an operating budget and a capital budget
- The operating budget accounts for recurring incomes and expenses
- Recurring incomes result from selling labor and/or liquidity
- Recurring expenses result from the consumption of goods and/or services
- Recurring incomes and expenses
- satisfy short-term, lifestyle goals
- create free cash flow for capital expenditures
- The capital budget accounts for capital expenditures or nonrecurring items
- Capital expenditures are usually part of a longer-term plan or goal
- Projecting recurring incomes and expenses involves using
- financial history
- new information and microeconomic factors
- macroeconomic factors
- Different methods may be used to project different incomes and expenses depending on the probability, volatility, and predictability of quantity and price
- Projecting capital expenditures involves using the following:
- New information and microeconomic factors
- Macroeconomic factors are harder to predict for a longer period, and are therefore less relevant
- The relationships described by the time value of money
- Using Mark's budget sheet as a guide, adapt the budget categories and amounts to reflect your personal financial realities and projections. Develop an operating budget and a capital budget, distinguishing recurring incomes and expenses from nonrecurring capital expenditures. On what basis will you make projections about your future income and expenses?
- How does your budget sheet relate to your income statement, your cash flow statement, and your balance sheet? How will you use this history to develop a budget to reach your short-term and long-term goals?