While the advice to spend less than you make isn’t new, you will learn how to see your expenses in a new way.
You are going to X-Ray your cash-flow to look for hidden opportunities. What does this mean? It means you are going to take a close look at each expense to determine if it supports your overall vision for your life.
The Expenses X-Ray process is dynamic.
It is not something you do once and forget about it. You should monitor your income, expenses, and progress to ensure you are on track to reach each goal regularly. Once you get the system set up, it will be a snap to review and update.
Okay, let’s get started!
Step 1 – List regularly occurring sources of income.
You first need to get an accurate picture of how much money comes into your budget every month. This will be the foundation of your plans and will help us determine how much you have for expenses and goals. The major categories of income include:
- Earned income. This is the money you earn from your job. List the net amount from your paycheck (the amount listed on your pay stub after taxes are taken out). If you are self-employed and/or do not get a paycheck, determine how much you earn per month after paying income taxes. Include commissions and bonuses if you are sure you will receive them. Make sure you divide the annual bonus by 12 since we’re interested in calculating your income per month.
- Rental income. If you have rental properties, enter the amount of money you make after paying all expenses and taxes. For example, if you rent out a small house, be sure to subtract expenses and taxes that you pay on the property in order to calculate the actual profit per month.
- Interest and dividend income. This income is generated from your savings and investment accounts. While you may earn this income, most of us don’t actually receive a check every month. Normally it stays in the savings or investment account and is reinvested; this is the power of compound interest. If you don’t get a check, don’t list any income here. If you actually receive this income, enter it in this category.
- Other income. Enter any other income you regularly receive.
Step 2 – List all regularly occurring expenses and calculate the average monthly cost.
Now that you have documented your income, it’s time to focus on your normally occurring monthly expenses: rent, groceries, gasoline, car payment, cable TV, and utilities. These expenses are easy to remember because you pay them every month. The major categories of monthly expenses include:
- Household expenses. These expenses are probably one of your largest and include your mortgage or rent, homeowner’s association dues, maintenance and upkeep, utilities, landscaping, pool service, house cleaning, etc. List these expenses individually on the form below.
- Transportation expenses. This includes most of the expenses related to your car: your lease, car payment, gas, toll charges, etc. Don’t include you auto insurance here. We will include it in a separate category for insurance.
- Taxes. This includes various taxes such as property taxes that you are responsible for paying. It doesn’t include income or payroll taxes since we used the “after tax” figure from your paycheck.
- Groceries. Enter your average monthly grocery expenses and toiletries. Do not include the cost of eating out. These expenses will be listed in a separate category.
- Personal care expenses. These are things like haircuts, manicures, facials, massages, therapy, personal trainer, etc.
- Dining out and entertainment expenses. Enter the average monthly amount you spend eating out and on entertainment. This category includes everything from your daily Starbuck’s cappuccino, Friday night date with your spouse, Netflix, TiVo, cable TV, and Internet access.
- Charitable. Include any payments to non-profit organizations.
- Debt payments. If you currently have credit card debt or outstanding loans other than your car or house, list the minimum payment due per month here.
- Childcare. Enter the average monthly figure for daycare and babysitting.
- Miscellaneous. Use this category for all regular expenses that don’t fit within one of the other categories.
Step 3 – List occasional expenses that are paid once a quarter, twice a year, or yearly and calculate their average monthly cost.
These expenses are easy to forget since they don’t occur every month. In fact, some of these may only occur once a year. This is one area where people lose control of their finances. Here’s what can happen. You may be going along smoothly—paying your monthly bills and saving for that vacation you promised your family. A month before the vacation you get six non-monthly bills in the mail that wipes out your vacation savings fund. Hello bills and goodbye vacation. With a little planning, this doesn’t have to happen. The major categories of occasional expenses include:
- Transportation. Tune-ups and oil changes need to be done on a consistent basis. Calculate the projected annual cost for these expenses and determine the average monthly cost. Monthly expenses such as lease payments and gas were already entered above, so don’t duplicate them here.
- Insurance premiums. List all of the premiums you pay including, health, auto, homeowner’s, life, disability, long-term care, etc. For insurance policies that you pay semi-annually or quarterly, just figure out what you pay annually and divide by 12 to get the average monthly expense.
- Taxes. Include real estate taxes if you own a home and estimated tax withholding payments if you don’t have taxes taken out of your paycheck automatically.
- Gifts. These include expenses related to birthdays, anniversaries, and holidays.
- Education. This includes tuition, books, and other education expenses for you and/or your children.
- Clubs/Dues. Include the cost of a health club or country club membership, any personal or professional dues that are not reimbursed by your employer. Again, use an average monthly figure.
- Hobbies. List any costs associated with your hobbies.
- Magazines/Newspapers/Books. Enter subscription expenses for magazines, journals, or newspapers and the average monthly cost for books.
- Medical/Dental. Enter the cost of any medical or dental expenses that are not covered by your insurance policies (e.g., deductibles).
- Clothing. Although you might not buy clothes every month, calculate how much you spend throughout the year and enter the average monthly value.
- Vacations. Figure out how much you spend per year on vacations and getaways and divide by 12 to get the average monthly figure. Don’t forget expenses such as transportation, lodging, dining out, and other expenses such as park admission tickets.
Step 4 – List all goals that cost money and calculate the monthly required savings rate to achieve them.
Remember back on Day #1 when you determined what you want to own, what you want to accomplish, and who you want to be? Many of your goals require money or can be achieved more easily with money. You’ve already calculated the total cost to achieve your goals. Now it’s time to calculate how much you need to save per month to accomplish each of your goals.
Calculate how much you need to save per month to reach your goal. For example, if you want to buy a house in three years (36 months) and you know that you will need a $30,000 down payment, you will need to save approximately $884 a month ($30,000 ÷ 36 months). Do this calculation for each of your goals.
You’ve only completed four steps, but you’ve already discovered how much money comes in each month, how much your monthly expenses total, how much your non-monthly expenses total, and how much it would cost per month to fund all of your goals. Keep up the good work, only a few more steps to go!
Step 5 – Subtract income from your expenses and goals.
The moment of truth . . . subtract your income from your total expenses and from the cost of funding your goals. If you have money left over each month, congratulations! You can take that money and add it to your retirement goal. Most likely though, you will find that your total expenses and goals exceed your monthly income. Don’t panic! That’s normal. Proceed to Step 6 to solve the problem.
Step 6 – Go back over your expenses and goals and mark each one as a goal, need, or want.
As you discovered in the Cash-Flow Quiz, you are swimming, treading water, or sinking. When it comes to cash outflows (i.e., money leaving your pocket), they help you get you closer to your goals, help you survive, or move you away from your goals.
For each of your expenses, mark it as one of the following:
- Goal. This is an expense that gets you closer to a goal. Contributing money to a savings account is a goal just as is investing for retirement or financial independence. Mark any cash outflow as a goal if you are saving money for a specific purpose.
- Need. A need is a cash outflow that is necessary to live and survive. Groceries, rent, and insurance are all needs. Dining out, although it is food, is not a need. You could survive by eating at home. Likewise, clothing is a need, but only up to a point. That tenth pair of shoes or the Prada bag is not a need.
- Want. If money is leaving your hands and it is not getting you closer to a goal or is not helping you survive, it is a want. Dining out, entertainment, TiVo, CDs, and just about everything else you can think of is a want. Yes, many of these things are important. I’m not suggesting you sell everything and become a Buddhist Monk. You just need to take a realistic look at each of your expenses.
Step 7 – Determine which of your expenses and goals are negotiable.
What does it mean for an expense to be negotiable? It means you are open to the possibility of eliminating, reducing, or postponing the expense. For example, maybe one of your short-term goals is to buy a used motorcycle. If you decide that this goal is not immediately necessary, mark it as negotiable. Likewise, if you come to a “DVD of the Month” expense, you might also mark this as negotiable if you absolutely, positively do not have to have it. On the other hand, most of the expenses you marked as a need are probably not negotiable—but they could be. For example, if you rent a two-bedroom apartment for $1,400 a month and you could get by with a one bedroom, this expense could be negotiable. You may have listed an expense as a want, but found it to be a non-negotiable want. For me, my monthly TiVo expense is definitely a want (although it would be hard to imagine, I could theoretically survive without TiVo), but it is a non-negotiable want. No matter what, I intend to keep my TiVo account.
Step 8 – Evaluate your list of negotiable wants and mark the ones you would consider eliminating, reducing, or postponing, or keeping.
Once you mark an expense or goal negotiable, you have four choices:
- Eliminate – If you determine that an expense/goal is no longer needed, you can remove it from your cash-flow form. For example, if you have season tickets to the opera but never go, you could eliminate the expense. The more expenses or goals you eliminate, the better your cash-flow situation.
- Reduce – If you are open to decreasing the cost or frequency of an expense/goal, mark the expense reduced. For example, if you go out to lunch every day at work but are open to bringing a lunch twice a week, mark the expense reduced. In this case, you are reducing the frequency of the expense. Likewise, you could continue to go out to lunch every day, but go to less expensive restaurants. Both situations reduce your expense.
- Postpone – If you have an expense or goal that is important to you and you don’t want to eliminate or reduce it, consider postponing it. This will free up the cash now that can be used for more pressing expenses or goals. For example, if one of your goals is to learn how to play the piano and you have piano lessons as a near-term expense, you could consider postponing the lessons for another six months or year. Warning: some goals such as saving for retirement should never be postponed. Since these goals often occur in the future, it is easy to put them on the backburner and concentrate all of your resources on more immediate but less important expenses or goals.
- Keep – Although you initially thought this expense/goal was negotiable, you can always change your mind. If you decide you don’t want to eliminate, reduce, or postpone the expense or goal, keep it.
Step 9 – For each negotiable expense or goal, re-calculate the new cost depending on which action you marked.
Recalculate your new expenses. The more items you marked as eliminate, reduce, and postpone, the better your cash-flow situation.
Step 10 – Re-total the new cost of your expenses and goals and go back to Step 5 to see if your income now supports all of your expenses and goals.
If you eliminated, reduced, or postponed enough, your income may now cover all of your expenses/goals. If so, congratulations!
If your income still doesn’t support your expenses/goals, you need to go back over your list of negotiable items and eliminate, reduce, or postpone more of them. In a perfect world, you would have plenty of income to support all of your expenses and goals, but for most of us this isn’t the case. The process of eliminating, reducing, or postponing your goals is certainly painful, but if you want to reach your most important goals, it is necessary. Continue to work with the negotiable expenses and goals until your income supports your expenses goals.
The proceeding blog post is an excerpt from The Six-Day Financial Makeover: Transform Your Financial Life in Less Than a Week!, available now on Amazon.
About the Independent Financial Advisor
Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.