Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.
In this lesson, we'll explain and define the components of a budget: income, expenses, and discretionary income. You'll also learn how to categorize income and expenses as fixed or variable.
What Is a Budget?
Cooper accessed his online bank account and saw his account was negative $125.00. He drove to the bank to speak with a personal banker, who reviewed Cooper's account and told him it had been negative, or overdrawn, every month since it was opened. Overdrawn means Cooper had spent more money than what was in his account.
The banker asked Cooper if he ever made a monthly budget and explained that a budget is a written approximation of how much money you have coming in and how much money you have going out. Cooper told the banker he's never made a budget but would be interested in learning. The banker told Cooper that the bank has a tutorial on personal financial management, which encompasses assessing an individual's budgeting, spending, saving, and investing. The banker took Cooper to the conference room to access the tutorial online and told him to start with the budgeting section first.
There are several types of household income: wages or salary, interest, bonus, tips, and commission.
Wages are income from hourly workers. For example, if you work 40 hours per week at $10 per hour, your weekly wage is $400 (40 * $10). Oppositely, salaried workers are compensated a fixed amount regardless of the number of hours they work. Interest is monies received from investments. A bonus represents income received for a special circumstance or incentive. Tips are income received for services. Lastly, commissions are paid based on how much is sold or a percentage of sales.
The tutorial asks Cooper to enter all of his monthly household income. The system separates the income based on fixed and variable. Fixed income, such as salaries, do not change. However, variable income, such as wages, interest, bonuses, tips, and commission, changes. It's imperative to understand your fixed and variable income. Fixed income you can rely on, but variable income must be carefully estimated to ensure you can meet your monthly obligations.
Expenses are defined as the cost of running a household. Expenses are also separated by fixed and variable. Examples of fixed expenses are rent, car payment, credit card payments, insurance, and student loan payments. Variable expenses can include gas for your car, utilities, food, and cell phone service.
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The system calculates Cooper's discretionary income by subtracting expenses from income. He has $950 left over after his expenses are paid. Now, there are still some important decisions to be made with this discretionary income: save, invest, and spend. Most research shows, 10% to 20% of your monthly income should go toward savings. After you've accumulated four to six months' income in savings, you can invest the remaining amount. There are also some monthly expenses not included, since the amount you spend is dependent on your discretionary income. These items are called non-essential because they are not necessary to live; for example, entertainment and shopping.
The banker reviews Cooper's budget and tells him he has plenty of money remaining every month and should never go negative in his account. Cooper responds by saying that he was making several mistakes, such as not making a budget and spending too much money on entertainment and shopping first before paying his bills. He says the tutorial helped him understand budgeting and the importance of paying his expenses first then saving, investing, and spending on non-essential items.
Budgeting is a process whereby you total your income, subtract your expenses, and determine your discretionary income. It's important to understand if your income is fixed or variable. Variable income should be estimated accurately each month. If there is a low probability that you may not receive the variable income, it should not be included in your monthly budget. Expenses should be analyzed based on fixed or variable status also. After subtracting expenses from income, we get our discretionary income. From our discretionary income, we should account for savings, investing, and non-essential expenses.
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