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Thank you to Philip Adler from Knapsac for this guest post. This is the second post in our budgeting series, aimed at helping you budget personally and in business.
Budgeting when you’re self employed or have a variable income can be tricky. Philip helps to build a budget and manage it for you so we thought he’d be the perfect guest to ask, ‘How do you budget when you have variable income?’
Budgeting – When You Have Variable Income
Freelancers, the self-employed and salespeople have one thing in common, fluctuating and unpredictable incomes.
For those of you with variable income it’s common to plan your monthly spending without knowing how much you’ll earn, when you’ll get paid or what the following month will look like.
Let’s also consider the less obvious income dependencies not felt as punishingly by your fixed income brothers and sisters.
Managing/scheduling your workload. If you’re on a fixed income and you miss occasional deadlines, you may face the wrath of your reasonable or unreasonable boss. If you’re in the variable income world you don’t get paid.
Uncertainty until the month end. In the fixed income world if you miss customer service or sales targets, again you may have some answering to do but in the variable income world you don’t get paid.
Sickness or leave. If you’re sick or need to take time off, in the fixed income world you’re likely to be sent wishes for a speedy recovery or waved farewell if off on your travels. In the variable income world you don’t get paid.
Wholly or Partly Variable
Your income may be wholly or slightly variable. In other words, perhaps you have a base salary and rely on some form of overtime, revenue sharing or other bonus arrangements to make up the balance. Perhaps you have 2 or more jobs with one providing a fixed income and others providing variable income. Perhaps you are a freelancer with wholly variable income.
Either way, it’s more difficult to budget for someone with variable income than it is for someone with fixed income. But of course, you can do it. Here are some tips to help you on your way.
Income Estimate
In the budgeting world estimating gets a bad rep. But we love an estimate as it sets you on your way. If you stick with your budget each month your estimate will sharpen.
Your starting point is trying to estimate your monthly income. If you are self-employed one option is to look at your tax returns for the last couple of years. Work out your net yearly income and monthly income. Then estimate whether you are currently ahead or behind these previous numbers and pick a monthly income number to get your budget started.
If your income is partly variable, tease out the fixed component and try to estimate what your average variable monthly income has been over recent months. Use a cautious average monthly estimate of the variable component to add to your fixed monthly income to get your budget started. If your variable income is paid less than monthly, look at the variable income that you have earned over a longer period, perhaps a year or eighteen months, and then average those earnings into monthly numbers. Again, add a cautious version of this monthly variable average to any fixed monthly income to get your budget started.
Expenses
It’s really important to know your baseline i.e. the minimum non-discretionary expenses you need to cover on a monthly basis. For most people this includes, housing (rent or mortgage), utilities, transportation, groceries, childcare, interest on any debt and the item that many people forget to include, taxes (unless you’re taxed at source).
At this point let’s consider your budget format. It does not matter whether you use a notepad and pen, spreadsheet or app. What matters is your intention to build a plan and your commitment to stick with it. Also remember that whatever format you choose your plan will adapt and change shape if you’re regularly attending to it. My budget started with a few scribbles in my notepad with the intention of knowing whether I was likely to make it through to my next pay-check. After a while I was developing spreadsheets to satisfy my curiosity but my advice now would be to keep your intentions simple and get the job done.
Once you have noted your monthly baseline expenses, sum and compare to your monthly income estimate. Hopefully your income will be greater than your baseline expenses and you can move onto noting your discretionary expenses. You can have any number of discretionary expense categories providing your overall aggregate monthly spending is not greater than your monthly income estimate.
Discretionary expenses
Some of these discretionary categories will be a fixed amount payable monthly such as your Netflix or Spotify subscription. Categories such as dining out can also be considered as monthly expenses but you choose the amount. Some categories such as gifts will be occasional but can still be expensed monthly. Ultimately however the regularity of the expense falls, you should start by expensing each one monthly. This will even out your spending profile and lead to less unwelcome surprises and cash flow pinches.
One discretionary expense category that is less well considered but very important for those with variable income is an emergency fund. If you enjoy a fixed income and you have no emergency fund and you suffer unexpected expenses, you can probably get a short-term loan or use any available credit to smooth things over. You can access this debt within the security blanket of next month’s salary. However, for our variable income brothers and sisters there is no such security blanket so the emergency fund is more important.
Make It Real
Once you have estimated your monthly income, noted your monthly baseline expenses and noted your discretionary expenses you need to check that you are living within your current means. If not, you need to revise your discretionary spending and this is likely to take a few attempts. If you are in the enviable position of having monthly income left over, really consider what you would like to save for. Maybe you have particularly adventurous or very simple savings goals. Unless you create specific savings priorities and categories, the excess monthly income is likely to be frittered away.
Now we have the basis of your plan but what’s the best way to transfer the plan from your notepad or your spreadsheet or your app to actionable behaviours? i.e. how are we going to make it real.
One way is to add up your baseline and discretionary expenses and on the first of the month make sure that this is the amount of money in your current account. If you have more than is necessary in your current account, move the excess into your savings account. Don’t have enough in your current account? Move the necessary shortfall from your savings account. If you’re short of money in your savings account to cover the shortfall go back and revise your discretionary spending until you do.
Emergency Fund
Another word at this point about your emergency fund. Ideally you should consider your emergency fund separately from any savings that you may have. As mentioned above, set aside a monthly amount for your emergency fund and assuming that there are no genuine (!!) emergencies during the month, at month end transfer the budgeted amount to a second savings account and this becomes the start of your ring-fenced emergency fund. You can then decide if you want to have a cap on your emergency fund whereby when the fund reaches your cap you can stop budgeting for an emergency. You can then redirect this expense to one of your other savings goals.
Once the end of the month comes around, there should still be money in your current account as you will have budgeted for some discretionary expenses such as yearly insurance premiums which accrue monthly but where the bills come in less frequently. Also, budget for some items such as holidays or gifts which are better described as savings goals which again do not expense monthly. Let’s say you have £200 left over in your current account at the month end, and in your monthly budget you originally allocated £25 to gifts, £100 to holiday, £20 to Christmas, £30 to your emergency fund and £25 to a cookery course. As you tip that £200 excess from your current account into your savings make sure your savings allocations are noted.
Gifts £25
Holiday £100
Christmas £20
Cookery Course £25
Total £170
As stated earlier I suggest that the £30 that is left at the month end for your emergency fund is set aside in a different savings account, safely ring-fenced.
But let’s say that at the beginning of the month you already had £500 savings that you did not need to move to your current account. Then your savings allocation would look more like –
Gifts £25
Holiday £100
Christmas £20
Cookery Course £25
Unallocated £500
Total £670
Goals
I mentioned earlier how important it is to have savings priorities and goals so we need to find a savings goal for your unallocated £500. I wrote about goal setting in one of my previous blog posts about switching banks. Once done, your savings allocations may look something like this –
Gifts £25
Holiday £150
Christmas £20
Cookery Course £25
New Laptop £100
Flat Deposit £300
Summer Festivals £50
Total £670
Tracking Spending
Each month you’ll want and need to know how accurate your expense and income estimates were. Assuming you don’t pay for lots of things with cash, your bank and your credit card can offer you some rudimentary tools for tracking and categorising your spending. There are also aggregation services available such as Moneydashboard.com. This enables you to see all your categorised expenses in one place. But these services are in their infancy and nothing will beat keeping your own records. However, if you choose to use your bank or a third-party aggregation service to categorise your transactions and you use this as the basis for tracking your spending, I thoroughly recommend putting some time aside every week to check the on-line categorisation and to make changes where necessary. Banks or providers may enable any changes you make to transaction categories to be saved as rules to better categorise future transactions.
If you choose not to use one of these categorisation tools, I guess you’ll be paying the bills, buying the groceries, taking occasional taxis, dining out etc. throughout the month and ticking off these items from your budget as they occur or during a weekly catch up. If you’re self-employed this is an excellent opportunity to pull out any business expenses for offset purposes.
Spontaneity
A note on spontaneity. It may seem that budgeting in such a prescribed way sucks all the fun out of living. However, if you decide on the spur of the moment (or in a few more considered moments) to buy something that you had not budgeted for, this is not financially reckless. This is re-aligning your priorities in the moment. We all do it. But you will need to decide which discretionary spend category or savings goal is going to take the hit.
Summary
So, you have estimated your income, estimated your baseline and discretionary spending categories including your emergency fund, moved sufficient money to your current account to cover all budgeted monthly expenses and started tracking your income and expenses in order to sharpen your estimates.
Very probably your expense estimates will be accurate in some categories but not in others. As the bills come in or you track spending in a particular category through the month, you should always be noting the differences. Alternatively make micro changes to the following month’s budget. As each month passes your estimates will become more trustworthy.
Some people call this zero-sum budgeting. As you allocate jobs to all your income and to all your savings leaving you zero to fritter. Personally, I like the method as I’m pushed to look at my spending critically, to look at my savings goals as if they were ordinary bills and crucially to regularly review my savings priorities and adjust my spending accordingly.
Have Faith
Perhaps variable income was a lifestyle choice that you made. Or perhaps a variable income job was the only one that you could find. Either way remember that all budgets start with something of a leap of faith. For those of us who rely on variable income that leap of faith is even more pronounced. In order to stick with your budget and for that leap of faith to be justified you need to see results. But results come in phases. In phase one you will see that your savings are growing and that you are saving for things that are really important to you. In phase 2 you may actually be enjoying the cookery course, the festival or the holiday that you made happen with your budget.
Philip Adler is a co-founder of Knapsac. Knapsac are a new business that wholly believes in personal budgeting while recognising its many difficulties. Knapsac’s solution is to do it for you all. They sit and chat with you, build your budget and manage it for you.
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