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Budgeting
What is budgeting?
Budgeting is a process for tracking, planning, and controlling the inflow and outflow of income. How does the budgeting process work? The budgeting process begins with gathering the data that makes up your financial history. Next, you use this information to do a cash flow analysis. You will calculate your net cash flow, which tells you whether cash is coming in faster than its going out, or vice versa. Then you will determine your net worth. Having a snapshot of your present financial situation, youll then define your financial objectives and create a spending plan to achieve them. Finally, you will periodically check your progress against the plan and make adjustments as needed. How to Formulate a Budget? A budget is a plan for how you intend to spend your money during the coming month or year. It is an integrated statement based on details of your income statement and balance sheet for the past month or year. The budget expresses what you would like to achieve in terms of spending and savings in the future.

A budget can assist you in determining whether: You are living within your income limits Your current spending patterns are satisfactory You are saving and investing sufficient amounts to satisfy your financial goals You need to make changes in order to satisfy your financial goals A suggested budget format is shown in Worksheet 4.1. You can also make budgets using personal finance software programs. More specifically, a budget can be drawn up in six steps: Estimate your future net income for the period of the budget. Determine your expected expenditures during the period of the budget.

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Determine what you expect to spend to fund your personal goals. Determine whether there is a surplus or a deficit. Record your actual income and expenditures. Evaluate whether changes in spending and saving are necessary. Step 1: Estimate Your Future Income Estimating income is self-explanatory but seldom easy to implement. It is the process of combining everything you know or sense what is likely to affect your income for a specific future period, then using it to forecast income. Some sources of income are naturally much more difficult to forecast than others. One way to arive at an estimate is to combine prior period income with anticipated changes to estimate your future income. When there are multiple income sources, it is necessary to first estimate each one, and then add the individual estimates to derive total estimated income for the period being considered. Common income sources include all anticipated receipts of money, such as future salary, estimated profits (or losses, which are deductions from income) from a business, bonuses, commissions, interest, dividends, rent, gains, tax refunds, loans, and other sources of income. Some of the factors that can increase (or decrease) future levels of income are: Bonuses Business upturn/downturn Commissions and royalties Cost-of-living adjustments Disability Dividends Gifts Health condition Inheritance Interest rate changes Investment gains/losses Job promotion Personal property sale Salary increase/decrease Change in tax bracket Tax refunds Remember When estimating income that is highly variable, the estimate should be conservative. Being surprised by an income surplus is far more pleasant than having an unexpected income shortfall. In fact, the latter can cost even more if you need to rely on credit to cover the shortage. Being conservative by underestimating budgeted income is prudent so as to avoid overspending.Use the reasonableness test to avoid unrealistic estimates.

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Step 2: Determine Your Expected Expenditures The second step is to estimate all expenditures during the period of the budget. Estimating expenses is similar to estimating income. Both are equally important and use a prior periods information as their starting point. Naturally, some expenses are more difficult than others to predict and therefore require estimation. Unlike income, expenses can arise from tremendously diverse sources, estimating expenses is more complex and requires greater effort to do well. Estimating expenses is central to the budgeting process, because it is the first step in controlling the outflow of household income. Forecasting expenses is also directly related to achieving financial goals. Only by knowing what your expenses are likely to be, can you plan for meeting financial goals. The following steps are involved in estimating expenses for a future period: Review prior period expenses and determine which will recur in the forthcoming period Determine what new expense items are anticipated Estimate the amount of each expense for the period Add individual estimated expenses to obtain total estimated expenses Whether estimating expenses or income, you should always estimate conservatively. Being surprised by lower than expected expenses is far more pleasant than experiencing a spending deficit. If you need to borrow funds to cover a spending deficit, youll be spending even more. Use the reasonableness test to avoid unrealistic estimates. Expenses can come from many directions, so be careful not to overlook any that could be significant. Expenses that are uncommon and nonrecurring are the most difficult to predict, yet are frequently the cause of budget chaos. Certain expenditures such as rent, mortgage, and car loan payments are fixed in amount and do not vary from month to month, whereas other expenditures such as food, clothing, and utilities vary in amount from month to month. Anticipating these variable expenditures with accuracy may be difficult. The purpose of budgeting is not to bind you so much that you cannot maneuver. On the contrary, its purpose is to provide you with flexibility in your financial planning so you can achieve your financial goals. Step 3: Determine Your Financial Goals In order to set aside money for your financial future, you need to estimate the expenditures that go toward your savings and investments. Financial goals vary from person to person over time. Some sample financial goals maybe: Saving for an emergency fund Increasing savings and investments Buying a new car Paying off a loan Buying a house Saving to fund childrens education Providing retirement income Some of these are short-term goals while others are longer term. It is often easier to concentrate on the short-term goals and neglect longer-term goals. By assigning priorities to each of the goals and quantifying their cost, you can determine the amount of savings needed to fund them.

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The table below shows an example of prioritizing of goals:

1. 2. 3.

Column 2 shows the estimated amount of money needed to fund each goal. Column 3 lists each goals priority. For example, buying new furniture is the lowest of the familys priorities. Column 4 shows when the expenditures will be needed. For example, a new car to be purchased in 12 months; fund childrens education in 15 years (180 months); retirement in 24 years (288 months); and new furniture to be bought in six months. Column 5 shows the amount that will be needed every month to finance each goal. It is calculated as follows: Monthly Amount = Estimated Cost Time Needed

4.

For example: Monthly amount required for a new car = 600000 !12 = 50000 Since setting appropriate financial goals forms the foundation of any budget, we will look at the process of setting budget goals in detail in the next chapter. Step 4: Determine whether there is a Surplus or a Deficit If budgeted amounts for income exceed expenditures, there is a surplus. Expenditures and the amounts needed to fund personal goals added together equal the total expected expenditures. It is a good idea to incorporate goals into a budget so that monthly or periodic income is set aside to address them. When projected income exceeds projected expenditures, there will be additional amounts of cash, which can then be added to savings/investment plans or used to pay down liabilities. When projected expenditures exceed projected income, there is a deficit. This means additional amounts will have to be withdrawn from savings/investment plans to pay for these additional expenditures. In such a case, it may be necessary to review projected expenditures and reduce some of them, or look for ways to increase projected income. Step 5: Record Actual Income and Expenditures for the Period Budgeted Actual amounts earned and spent are not always the same as those projected. By recording the actual amounts and comparing them with the budgeted amounts, you can immediately see the differences, called variances. Spending more than a budgeted amount for one item can be offset by spending less than the budgeted amount for another item. Similarly, if actual income exceeds actual expenditures, there is a surplus, which means additional cash. The opposite is a deficit, which means that cash will have to be withdrawn from cash savings or other assets in order to pay for the deficit spending. Step 6: Evaluate Whether Changes in the Budget Are Necessary If there are large variances, or your surplus/deficit is not what you would like, you need to analyze your budget. Examine the variances and study where the amounts spent are greater than the budgeted amounts.

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For example, if your actual phone bills are consistently greater than the amounts budgeted, then you need to either reduce your phone usage, if possible, or increase the amount budgeted for this item. When you increase planned spending, you will need to find items where you can make corresponding cuts to compensate for the increases. If you dont, the amounts set aside for personal goals or savings will be reduced. There are certain expenditures over which you have some degree of control. These are your discretionary or variable expenditures, such as entertainment and miscellaneous expenses. Entertainment and food are the most common areas of overspending, particularly when they involve eating out at restaurants. By contrast, non-discretionary fixed expenditures such as rent, loan payments, taxes, and insurance premiums cannot be easily trimmed without consequences. You may need to prioritize your expenditures to see which are necessary and which can wait. The purpose of a budget is to help you plan the use of your resources so that you can fund your goals and set aside more of your money to savings. Following your budget will help you achieve what you want most from your resources. Establishing appropriate financial goals is the foundation on which a budget is built. We will look at the process of setting goals in more detail in the next chapter.

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Exercise
1. Priti is a 30-year-old young professional. Her net salary is Rs. 50,000 pm. She is expecting a bonus of Rs. 30,000 in the next 6 months. Her car loan outflow is Rs. 6,000 pm. The rent is Rs.15,000 pm. She spends on food and clothing Rs. 9,000 pm.She invests all her surplus funds in retirement schemes, so far. She invests Rs.10,000 pm on pension annuity fund. She wants to save money to enjoy a holiday with her parents and take them on a world tour. She will have to have Rs. 6 Lakhs for this trip. She has monthly medical and miscellaneous expenses for her parents to the tune of Rs. 5,000 pm. Her salary is expected to go up by Rs. 5,000 net of tax, in 2 months time. Prepare a budget for Priti. Should she invest in any other instruments as well? What could they be? Discuss. 2. Nitish is a 40year old, working with Elder Pharma Ltd. He lives with his wife, child and elderly parent. In the year 2007-2008, he expects interest from his Fixed Deposits to amount to Rs. 20,000. He has invested in mutual funds to the tune of Rs. 2 Lakhs, the value of which all together is Rs. 2.5 Lakhs. He has received tax-free dividends of Rs. 10,000, in the year. His agricultural income comes from the land in his village. He received Rs. 1 Lakh this year as agricultural income. He is quite generous with the people who look after his farm, and they are faithful farmers who have been associated with his family for more than 40 years, now. He lives in a self-occupied house, where the EMIs are Rs. 15,000 pm. His salary is Rs. 8 Lakh pa. His monthly expenses to look after the house inclusive of groceries, utility bills, car maintenance, and childrens education comes to Rs. 30,000 pm. Medicines and miscellaneous purchases come to approximately Rs. 10,000 pm. His insurance payment is Rs. 5,000 pm. He wants to set up an emergency corpus of Rs. 2 Lakhs and set aside Rs. 10,000 pm as retirement funds. There is an anticipated expense to cover the leakage in the house to the tune of Rs. 50,000. This leak has to be fixed before the monsoon begins, which is in another 2 months time. Prepare a worksheet and analyze his expenditure pattern to determine if his future goals can be achieved. 3. Naik, who is living in Mumbai decided to look into his finances one saturday afternoon. He had not had a look at them in a long time for now. It was decided that it was high time that he took out some time for stocktaking regularly. He and his wife Renu, sat down to discuss and enumerate all their respective responsibilities and priorities. Renu said that she had a family wedding coming up and there were some gifts to be purchased on an immediate basis. Her brothers wedding was fixed up and she wanted to buy a gift worth Rs. 8,000 for him. Their son would require tuition fees to be paid to Aggrawal classes. Aggrawal Classes charged Rs. 20,000, a year which was due to be paid in 2 months time. Mr. Naik had a commitment to pay EMIs for his home loan for which the monthly outflow was to the tune of Rs. 12,000 pm. Looking at their long-term plan, they wanted to save Rs. 5 Lakhs for their childs education, Rs.8 Lakhs for his wedding and Rs. 50 Lakhs as a corpus for their retirement. Mr. Naik is due to retire in 5 years time. He earns Rs. 60,000 pm, after taxes. Identify the short term and the long-term goals, their priority and the time needed to fulfill the goals and their monthly cost. Determine if there is a surplus or a deficit to fulfill these goals.

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Chapter Review

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