The standard lecture on budgeting advises you to make a list of all your expenses and then see what you can either reduce, eliminate or defer.
Sounds simple enough, in theory. But really hard in practice. To see why consider the following post by an Internet user asking for advice on how they could reduce their cell phone bill.
Here the user wants to pay for their own cell phone plan (an admirable sentiment), wants something “good but cheap” (also admirable), and then immediately asserts that “unlimited text/data is must.”
The obvious question — an outsider would ask if they were helping this user — would be “Why is unlimited text/data a must?”. There may well be good reasons but those reasons need to be carefully articulated in order to convince oneself that a “must” is a really a must.
This distinction between “needs” and “wants” is a crucial precursor to any budgeting exercise. Done poorly, any budgeting activities that follow are doomed to failure. After all if all your current expenses are labeled as “needs” then there will be nothing to cut, right?
In our experience, this is the central reason why people are often unable to budget effectively — they don’t know how to distinguish between needs and wants.
This is a super difficult problem — as we just illustrated with the user and their cell phone plan. It normally takes an outsider to ask probing questions to make one realize whether something is truly a need or a want. (In fact, parents play this role when deciding whether to buy something their children want. Bosses at work play this role as well when expenses are proposed by their employees.)
The good news is that most of us, as adults, live free of bosses at home. The bad news is that there is no one to push us when we need it. And, because money tends to be a very private matter, we have no one to consult with to help us in this task.
To distinguish between needs and wants pretend to drop your income by 25% to 50%. This gives you the needed jolt to dramatically re-think your expenses. Think about it this way: If you lost your job, or you were forced to take a pay-cut in a new position, what would you do? You would not continue to spend as before, would you? You would tighten your belt to fit the new income reality. Suddenly that “must have unlimited plan for data/text” does not look like a “must” any more.
Now that we have a concrete guideline for how to distinguish between needs and wants, we will lay out the rules for zero baseline budgeting.
Before you get started collect data on your expenses for the last year (or, more). If you are already using a budgeting tool, this should be easy. If not, go through your checkbook, credit/debit card statements to collect this data.
Step 1: Pretend that your income has dropped by 25% or more.
Step 2: Adhere to a budgeting rule that you will not take any action to jeopardize your health, income, credit-worthiness, legal standing, and those you are responsible for (children, parents, etc.).
Not jeopardizing your (& family) health means that medicines, insurance payments are now “needs.” Not jeopardizing your income means you cannot do anything to hurt your ability to work which means that expenses related to getting to/from work (like car, auto insurance, etc.) are deemed essential. Ditto for loan payments — which are essential to preserve your credit score. Etc.
Step 3: Zero out all your expenses.
Yes, you read that right. Start by zeroing out every last expense — food, shelter, medicines, and, yes, our favorite in this post, any “unlimited data/text expenses.” This is why this process is called “zero baseline” — we start from zero.
Step 4: Pay yourself first. Save 10% or more of your paycheck.
Set aside 10% or more of your paycheck towards savings. Don’t do this at the end when all the money may have been spent. Do this first.
Step 5: Examine each and every expenditure to determine whether to reduce, eliminate or defer.
This step is familiar — normal budgeting techniques do this. But they don’t provide the underlying foundation to help you decide how to proceed with this step. But now we are well-equipped to do proceed methodically.
When all your expenses have been examined and all “needs” been processed, go on to step 6 for “wants.” If there are still needs that have not been processed, and money has run out, repeat this step again (and, again) until you can make it fit.
In some cases (as when your debt load is too high) it may be impossible to make ends meet. In this case, talk to financial counselor in your area to see if they may be able to look at your loans, your financial situation and offer advice on how best you can move forward.
Step 6: Now slowly add back “wants” — these are things you’d like to spend on (like hobbies, setting aside money for holiday gifts, etc.).
Step 7: Write down your targets for needs and wants in a simple spreadsheet (or, budgeting tool). Then track your expenses each month to see how you’re doing.
It is super important that in the first few months you strictly adhere to the budgets you set. The longer your “streak” of meeting/exceeding the budgets you set, the more motivated you will be to continue to meet/exceed your budget targets. (At Arnexa, we focus on the savings habit through our tools. You may wish to try our free iPhone app where we focus on small goals to help you adhere to the budgets you set.)
Every couple of years or so, you can repeat the entire 6 step process to make sure that you are accommodating any changes in your financial situation.
Simply saying that one needs to set a budget, tighten one’s belt is not enough. It is important to provide a methodical framework for someone to be able to distinguish needs and wants. We propose you do that through a “pretend income jolt” where you drop your income dramatically to force you to consider choices you would otherwise not. Then, starting with a zero-baseline add back needed expenditures first according to the previous steps laid out.
Our zero-baseline approach is not new. Stephen Covey first proposed this idea for time management in his classic “First Things First.” There Covey proposed that we should organize our time by focusing on the important tasks first (“rocks”) and only then allot time for lesser important tasks (“pebbles and sand”).
In our case “rocks” are “needs” and “pebbles” are “wants.”
Originally published at medium.com