When I was a kid before even high school years, I loved saving money. If I got $10 for my birthday from my grandparents, that’s $10 that went straight to my piggy bank that I would never spend. I didn’t have a lot of electronic toys such as an X-Box or a PlayStation in middle school, high school, or in college years (except the gameboy SP that had Pokemon ruby, sapphire, and emerald in it, hey who doesn’t have one of these things?).
Saving was all I focused on when it came to money, even when I was younger, and it was in college that I began to quickly realize that I can’t budget well to save money until I understand the nuances of expenses.
In every budget, there are two categories of costs. Fixed costs and variable costs. Fixed costs are costs that are fixed and doesn’t change significantly month to month. For example, rent cost is a fixed cost and car insurance is a fixed cost (assuming no accidents happen that change your monthly premium). Variable costs are costs that aren’t fixed and can change daily.
For example, food costs are variable unless someone measures and weighs their food for every meal and sticks strictly to that diet. Fixed costs are easier to forecast and variable costs are harder to forecast.
Solving the Problem of Forecasting
I will focus on variable costs first. Things like fuel cost, groceries, vacations, and the like should be forecasted with a Margin of Safety. Margin of Safety is what gets you to achieve your forecasted budget without fail and if you add in a significant Margin of Safety, you should have money left over to save even more and achieve financial independence even earlier than forecasted!
It is better to under-promise your ability to save then over-deliver actual results than the other way around. When it comes time for the check-in for the results of your hard work, you will be happy. The over-deliverance of results can add up quickly and can shave off weeks, months, or years of your forecasted retirement age. Who doesn’t like to have extra time?
What is Margin of Safety?
If you see that in a given week, you’ve spent $30 on groceries and another week, you spent $50 on groceries, $40 will be the average. However, in order to be safe, you could budget $50 PLUS an additional 10% increase for a total of $55 to budget in for your grocery bill this week. If in fact, you spend the average of $40, then BAM!
That’s an additional $15 in your 401k or savings account. If done consistently over a year, that’s an extra $780 funded towards retirement! Keep in mind that this is only one line item of your budget and as you over-deliver on other expense items, that’s even more savings you can have. Add in compounding interest and you’ve got yourself a nice recipe for financial independence.
Taking Care of the Fixed Costs
Now that we’ve looked at analyzing variable costs, let’s take a look at fixed costs. Adding in a margin of safety for fixed costs isn’t too necessary, unless you know the probability of getting in a car accident and know how much the accident might increase your car insurance premium, then forecasting necessary Margin of Safety possible, but for right now, let’s assuming fixed costs are fixed for the remainder of your forecasted budget (most likely 1 year).
For Fixed Costs, there is a marvelous and fantastic finance concept called Operating Leverage. Operating Leverage is leveraging your fixed costs to achieve awesomeness (profitability for the technical minded).
Let’s call this person, John Doe. John Doe has been working hard for 2 years and has a gross income of $50,000. He keeps his annual fixed expenses really low to be $10,000 because he has roommates, is a great driver for a low auto premium, and paid off his car.
Now, assume his boss, Mary Anne, recognizes that John Doe has been consistently putting in long hours, achieving results, gets along well with coworkers and supervisors, and his clients love him. So one day, she recommends that John receive a promotion and gives a 20% raise to him! How great is that!
John instantly takes off work that day he receives the news (he hasn’t taken a vacation in 2 years!) and goes to his house to celebrate and gets on Excel to think about what this raise will mean to him! He comes up with these results:
Did you notice the change in net income? His gross income increased by TWENTY percent but his net income increased by TWENTY-FIVE percent. As his income increases and keeps his fixed costs constant (John isn’t buying new houses or cars just yet!) John is able to increase his net income by an even greater percentage than his increase in gross income.
This is a beautiful thing and that extra 5% increase in net income will mean he will be able to access the power of compound interest even faster because 1) he increased his income and 2) he kept his fixed expenses the same. Champagne for everyone! (BYOB).
- Two components to expenses – variable and fixed
- Two magical concepts to budget better with – Margin of Safety and Operating Leverage
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