Budgets don’t work, but organizing does - here's why

Many people think budgets are an important tool in managing money, but very few use them or, if they do, find real value in them.

The reason people try to budget is to try to improve control of their spending, and they believe knowing exactly where they are spending money will help them. While that seems logical, it’s flawed and rarely works in practice because spending and decisions cannot be discretely programmed down to the dollar or the minute.

We live in a fluid, complex world of variables, including circumstances, decisions, feelings, opportunities, habits and events. We have some influence over our circumstances, opportunities and events, and a high level of influence over our decisions, habits and feelings. But overall, our days tend to play out in ways we cannot precisely predict or control, which can frustrate even the most disciplined budgeter.

I would argue, knowing how much you spent last week, month, quarter or year on groceries is nearly useless. What is more useful is knowing your grocery spending’s average and monthly variation. Standard deviation is a statistical measure of variability. Standard deviation can be used to predict how likely a future result will fit within a range around the average based on historical data.

For example, if your average monthly cost of groceries over the last 12 months was $450 and had a standard deviation of $50, then there is about a:

  • 68% chance (one standard deviation) your next monthly grocery bill would be in the range of $400 to $500
  • 95% chance it will fall between $350 and $550 (two standard deviations)
  • 99.7% chance any given month will fall within three standard deviations (+/- $150)

That’s just one category – groceries. If you apply this approach to the 15-20 spending categories individually, you’ll get a range too wide for practical use in controlling or predicting spending. So how do you keep all this straight? There are simply too many uncontrolled drivers (circumstances, opportunities, events) and discrete budget categories to keep track of. This is why detailed budgets don’t work in practice. Every month every category is randomly either over or under budget. Does this make your budget a failure? No, just your budgeting system.

Let’s say you have a big month for groceries, and you spend twice the average. What does this mean? Are you out of control or did your parents suddenly show up for a two-week visit? Next month, you had to drive to Omaha to visit a sick friend. Now your gas bill is double for that month. Do you have a problem? Have you blown your budget? No. For both the groceries and the gas bill, we are looking at useless, uncontrollable spending noise.

So, I recommend skipping the time and hassle of these “micro” budgets and, instead, manage your “macro” budget.

Here’s how. Simply organize your spending categories into two baskets of expenses: NEEDs and WANTs.

  • In the NEED basket, put all necessity-related expenses like mortgage, utilities, phone, groceries, etc., and all asset-related expenses like car payments, insurance, gas and maintenance.
  • In the WANT basket, put stuff like eating out, entertainment, mini vacations, seasonal expenses, hobbies, sports, subscriptions, etc.

Each basket will have its own average monthly amount and its own natural variation or standard deviation. The NEED basket will be much less variable than the WANT basket, because it has more expenses that are fixed or vary by smaller amounts. Even still, the NEED basket still might vary by +/- 50% or more from the monthly average. In contrast, the WANT basket by definition can vary wildly because your habits around “lifestyle” can vary greatly month to month and because some categories may be zero for many months and then hit big one month. Therefore, the WANT basket has a much larger standard deviation. But it is also much more discretionary and easier to constrain if and when you want to tighten control of your spending.

The beauty of this approach is the relative monthly variation of these larger baskets is usually smaller than the statistical range of the individual budget categories on their own. This is because when grocery spending is higher, randomly, you may be spending less on gas or utilities, or whatever else. So, when you include more items in the basket, the relative monthly variation of the total can be less than each individual category. To be clear, the amount you spend each month and the variation month to month in total is the same regardless of whether you budget 20 categories or two. The difference is that what you are tracking and attempting to manage becomes much easier to see and respond to.

It’s the variation in spending most of us need to get a better handle on, not just the average. And this method makes it much easier to see overall variation and address harmful spending trends rather than getting sucked into reacting to the monthly “noise” with 15-20 spending categories.

I call this more simplified approach to budgeting “Macro Cash Management”.

To start with, organize two checking accounts: NEED and WANT. Then, put about 2 times your average NEED spending in one account and about 3-4 times your average WANT spending into its own separate account. These accounts get replenished from your monthly income. Then simply track spending and account balances at this level, knowing each will fluctuate around the account average. Keep in mind, WANT fluctuations will be bigger, and take longer to recover in the event of a big negative month, like going on vacation.

The beauty of using this method is you stop chasing your tail and wasting your time tracking detailed categories that don’t matter. Instead, you can focus on what’s happening over time and make adjustments to your overall spending and habits at a more manageable and controllable level.

It’s the uncontrollable variation in our month-to-month spending that destroys the idea that a successful budget is one where you spend exactly your disposable income each month. This is simply impossible and attempting it will cause no end to misery, futility and failure.

But what is possible is to have your overall average monthly spending over time closely approximate your monthly disposable income, or whatever target you’ve established. To avoid getting caught in a budget crunch, you need to know the variation or standard deviation of your monthly spending to maintain a cash buffer to cover whatever the month might actually turn out to be.

So, I recommend skipping the time, frustration and hassles of tracking the  “noise” around 15 or 20 individual budget categories and, instead, manage your spending with the macro budget categories NEEDs and WANTs. This will help you more effectively stay within your budget and identify when bad behaviors are causing you to trend away from your long-term averages.

Bottom line is this:

  • Detailed budgets don’t work because they can’t. Our expenses are too variable to track and budget at the micro level
  • If we elevate our budget categories to more practical and usable buckets, we can make budgeting work for us instead of the other way around.
  • Understanding the variation in our expenses is more important than the average, because it tells us how much we need to have in Cash Reserves to protect against random variations
  • If we focus at the macro level, we can much more effectively track and manage spending variations and see when we are getting off track
  • We need to fund our NEED and WANT accounts based on both the average monthly spending and the fluctuations or standard deviation around that average
  • By definition the WANT account will have greater fluctuations and therefore require a larger balance
  • Managing monthly cash flow this way is effective, easy and gives us much more control

Learn more about how to set up your checking and savings accounts to use Macro Cash Management system at www.manufacturingwealth.com.

Editor's note: This is an edited version of the original blog post.