As my wife and I were cranking away on living our lives and trying to manage the financial maze, we started to learn. We learned the hard way, by doing and by experimenting. But we learned the most by making mistakes.

I could only find books on investments or budgeting or living frugally or a bazillion get-rich-quick schemes. But nothing on how to organize your finances in a way that connected all the pieces together. Why wasn’t there a model to explain how personal finance works? How does one organize expenses into logical categories? How do the categories interconnect? How should I think about and organize all the stuff I own? How should I think about our “investment” in our house vs. cars vs. the stock market? How do you measure the financial impact of decisions?

I decided I needed to figure it out myself.

I started with two initial premises. First, there must be a logical order of things related to the operational aspects of personal finance, and so an operating model of how it works could be created, like the personal finance analog for a profit and loss statement and balance sheet for traditional business. Could this a useful analog? How is it different for personal finance? How do they fit together and how does that help me run my “business”?

Second, budgeting was not the answer. I already had developed this awesome spreadsheet with detailed budgets in nearly every category and kept track. We knew how much we spent on groceries, eating out, essentials, non-essentials, furnishings, 401(k)s, car payments, gas, insurance, etc. I mean, we tracked everything.

At first, I was pretty impressed with myself. Not only did I have the numbers, but I’d made some awesome graphs and charts as well. But the more I looked at it the less I liked it. The more I looked, assessed, pondered and analyzed, the more I realized it told me nothing. It did not inform the impact of financial decisions we made on our cash flow or ability to save for retirement. It did not tell me if our finances were operating in a healthy range. Was $457/month on groceries to feed a family of five high, low, or even important?

Every other machine, from a car to a nuclear reactor, featured important monitors and measures to tell you if all was well or all hell was about to break loose. Even with all the personal finance platitudes and ‘good sound advice’ out there I could not figure out how to apply them to my budget or fancy spreadsheet. For example, the rule of thumb that the mortgage payment plus all other debt payments should be less than 40% of your income made no sense to me. Whose rule? And whose thumb?

I also did not get this ‘nice-to-have’ emergency fund thing. Without a hefty wad of cash sitting at the ready, how could you control unexpected and variable expenses? There is nothing ‘nice-to-have about excess cash – it was essential.

How does one tune their financial operations to ensure they are living below their means, and not innocently making decisions to screw that up? Was I spending too much on food? Clothes? Entertainment? Beyond the obvious, what happens to my financial operations if I pay cash or finance a new car? This is the stuff I was asking myself as I looked at my beautiful pie charts categorizing expenses, debts and assets, and of course our small but growing net worth.

To gain control and peace of mind, I started from scratch to understand how to get to the point at which you have a system of control with the ability to cover any reasonable situation and know what happens in the short-, medium- and long-term when financial decisions are made. And how can you put that on autopilot? I needed to focus on kids, work, life and taking care of everything else, not updating budget categories, trends, and analyzing pie charts.

I started with the first step of tackling the basics – death, taxes and living expenses. I built out a simple linear model of cash flow. Gross Income – Taxes – Expenses You Can’t Easily Get Out Of = What’s left to spend on everything else. Not exactly rocket science.

But what’s inside of EYCEGOO? I landed on two categories: 1) Basic living expenses like food, clothes, life insurance, personal care expenses, healthcare costs, etc., and 2) Expenses associated with owned assets, like a house and car, and including auto and homeowner’s insurance, maintenance, as well as usage costs, like gas, oil changes, utilities, etc.

My guiding principle: “What would our expenses be if I lost my job and we had to eliminate the fluff?” The major stuff we own cannot easily be gotten rid of, and by virtue of owning them entail a full suite of costs that must be dealt. If we chose to own them, we choose to own their associated expenses. We also have to live: food, clothes, etc. I called all these expenses (Basic living + Asset related) Routine Operating Expenses.

From this, any money left over, I called Free Cash Flow.

Now I had to deal with the really complicated stuff – all the uncontrollable and unpredictable tangles of expenses. How do I get my arms around this? Start with the worst problem!

Gotcha expenses. Something always breaks or goes awry, and conventional wisdom is this happens about twice a year, but in real life it happens almost every month. There is no crystal ball, so I looked back at year over year of my beautiful budgets and saw a pattern: Gotcha stuff did indeed happen almost every month (broken water heater, major car repair, medical bill…), and it was very different every month, and often zero, but over the course of a year, it consistently added up to 3-4% percent of my gross income. I decided to allocate a ballparked 4% of my gross income to cover gotcha expenses. Yes, I was shocked as well. This is a lot of money. It was almost half of what I was saving for retirement, but the fact of the matter was that just living your life with a family, house, cars, and stuff required a 3-4% annual gotcha tax.

Next biggest problem, lifestyle expenses: Eating out, entertainment, sporting events, theater, hobbies, subscriptions, movies, etc. So, I looked back at our lifestyle spending, and turns out we were creatures of habit. We ate out a couple of times a week, we had a relatively fixed set of subscriptions, caught a movie or a play once in a while, I had my hobbies and she had hers. Our lifestyle spending varied month to month and by season, but the monthly average was fairly consistent. Driven by two things: Habits and largely staying in our financial swim lane. For example, we tended to avoid expensive restaurants and major sporting events. We did not shop for custom suits or high-end designer labels.

However, as I dug deeper into these lifestyle expenses, two big pieces of expenses did vary a lot: vacation travel and seasonal expenses. The seasonal expenses were easy to see – for us November, December and January were a “break the bank” mess. And vacations and travel (like weekend getaways) were all over the map: visit friends in Florida, guys trip to Vegas, family vacation in Arizona. These were big expenses that typically landed in a single random month. Thankfully, we already followed a loose annual budget for these types of expenses, but it was still ‘out-of-control’.

So now I had Stage 2 of my financial operations – dealing with all these crazy unpredictable, large, small, discretionary, fun, spontaneous and budget-busting expenses.

Stage 2 had Free Cash Flow coming in and Lifestyle expenses + Gotcha expenses going out. Whatever was left (if anything) was getting invested, saved or parked. While I could get a reasonable estimate of the average monthly expense for lifestyle, seasonal, travel and gotcha expenses, there is no way to predict what any one month would be or what a quarter would be or even a year. For example, what if after a long string of big expenses, grandma dies unexpectedly and the whole family needs to go to Maine for the funeral…? Unavoidable, unpredictable, but how to prevent something like this from blowing up our finances?

The answer became Cash Reserves. Not an emergency fund, this is working capital. This is money we needed to run our personal finance operations smoothly and to be able to handle whatever life threw at us. But how much money should we have in our Cash Reserves? Based on historical spending it needed to be substantial. I knew we had some crazy months historically, but what if three or four crazy months hit in a row or a single budget-buster month? Turns out these situations happened relatively often. I did some math and concluded that if we wanted to have enough in our Cash Reserves to not have to worry about all these moving parts, it had to be around six months of our Routine Operating Expenses. That’s a lot, but a lot less than 6 months of your gross income parked in an emergency fund – just sitting in some account doing nothing.

But after I build up this nice Cash Reserves balance, how do I keep it from draining away? Easy; Money out < money in. Great in theory, but how about reality?

Well, I could estimate my annual expense for lifestyle expenses, seasonal spending, vacations and travel and gotcha expenses, and divide by 12 to get a monthly amount. Imperfect, but a start. I called these expenses in total Non-Routine Expenses vs. our core Routine Operating Expenses.

If we send our monthly Free Cash Flow (FCF) into the Cash Reserves account and subtract that average monthly amount of lifestyle, seasonal, travel and gotcha expenses, we will have a sense of whether we’re draining the Cash Reserves (FCF < Non-Routine Expenses), growing it (FCF > Non-Routine Expenses), or stable (FCF = Non-Routine Expenses).

Now if I track a six-month running average of FCF and monthly Non-Routine Expenses, we will have a gauge of what’s going on with all these crazy Non-Routine Expenses and the Cash Reserves balance relative to the money we have available to spend (FCF).

Turns out it worked great from both the longer-term trend and month-to-month activity. Our Free Cash Flow was relatively stable. For many months, our Non-Routine Expenses were low and our Cash Reserves grew and then, bam, Cash Reserves would take a major hit, then several months of growth, then another hit or sometimes two or three months of big hits in a row, but as long as we stuck to our ‘macro’ budget, it all rebalanced over time. It was awesome.

I set up two accounts: A checking account to take in all income and to pay all Routine Operating Expenses, and a Cash Reserves account (another checking account) to accept monthly Free Cash Flow and to pay all of the Non-Routine Expenses. Our 401(k)-retirement savings came out of our paychecks, so this was covered automatically.

My little system worked great until we needed to replace one of our cars, and then the whole thing fell apart. We were going to go from no car payment to a big car payment. If we did this, our Free Cash Flow would tank, Cash Reserves would go totally out of balance and be drained in less than six months. Then I realized that this is what happens to everyone…

I took a step back. OK, we have these assets that have associated monthly payments and expenses, but how to think about all these assets together and the terrible mess they can make to our nice little operating model? I came up with the following: We have three kinds of Assets: Dead Assets (depreciate over time – cars, ATVs, boats, furniture, etc.), Living Assets (Stocks, bonds, cash, etc.) and Marginal Assets (Not living or dead – OK, zombie assets). Marginal assets are the stuff that costs money to maintain their value (house, collectibles, art, etc.)

We also have the use of debt to help us buy assets (usually Dead and Marginal). So, I organized all of the Assets into these three categories and listed all of our associated monthly, quarterly or annual expenses together as Asset Burden – this is the same Asset Related Expense in my Routine Operating Expense.

Now I had a feedback loop between my assets and my operations. I buy a new Dead Asset, Asset Burden goes up, Free Cash Flow goes down, and everything else has to adjust accordingly to keep everything in balance… This is making more sense now. But what if we don’t want to have to deal with this major disruption to our financial operations? Well, the answer was: don’t let Asset Burden spike. The primary way to prevent that was to pay cash for my replacement cars instead of getting a loan and a big payment. How do I make that happen?

Eventually, I realized the answer was staring right at me. All those Dead Assets were shedding value every year and would eventually need to be replaced. So, if we set aside money to do that (at a rate roughly equal to their rate of depreciation) then when the time comes – voila! No impact on our beautiful operating machine and we can keep spending the same amount of money on vacations, entertainment, 401(k), etc.!

But I started to take it a step further. We wanted to add a deck on the house and we would need to paint the house in a few years. So, I made a list of what expenses would incur over the next 3 to 5 years on replacing Dead Assets or tuning up Marginal Assets, buying new furniture, etc. Did some quick math to figure out a monthly amount to sock away to cover these Asset Management and Replacement costs. Then when we need the money, it’s there, and we don’t blow up the operating engine.

One big problem – turns out this was a lot of money. So, yet again I went back and looked at 10+ years of history of what we spent on replacement cars, house upgrades, new stuff and whatever else, and it was in fact a ton of money. But how did we pay for it all back then? Apparently, with chaos, consumer debt and robbing Peter to pay Paul. It was so complicated. Plus, over time my Asset Burden just crept higher and higher forcing us to be constantly adjusting our finances – seemingly every month.

I asked friends and neighbors: “Over the last 3-5 years, how much do you think you’ve spent on home improvements or replacement cars or furniture – big stuff?” The results were not too far from my own numbers. Turns out we’re incredibly normal in this category of spending relative to others in our economic strata.

So, I crunched more numbers, thought some deep thoughts, and realized I effectively had three mouths to feed with our income: 1) Our Operations Engine (Routine and Non-Routine Expenses), 2) our 3-5-year cash needs, and 3) our long-term investment (retirement/college fund for the kids) needs.

Crunched some more numbers and realized the big lie we’re all told... In fact, there is no possible way you can afford to contribute 40% of your gross income to debt payments. In fact, if debt burden becomes this high you can get by serving your operating needs, but not much else. Maybe a few bucks for retirement, but nothing for the 3-5-year expenses or for a college fund for the kids or for having enough for a decent funding of Non-Routine spending, which is the fun stuff! Not to mention there is little room to build or protect Cash Reserves…

Here is what I learned through all of this:

• Don’t listen to anybody who tells you how much debt you can afford because all they are thinking about is ensuring that they get paid – nothing else. These are the Debt Merchants and they are not our friends.
• The real expenses that need to be understood if we want to truly ‘live below our means’ are big lumpy, and largely hidden from view, like replacing a car, painting the house, gotcha stuff, etc.
• Asset Burden can creep up on you and the higher it gets the more it squeezes everything else. If your Free Cash Flow is small you start feeling really poor, really fast and managing your finances becomes a monthly drama and roller coaster.
• If you have to replace aging stuff with more debt on top of debt – the whole thing falls apart – not because your budget failed, but because you had a structural failure of your Personal Finance Machine and just didn’t see it happening.

After tweaking and playing around a bit more with my model, here is what it finally looks like. If you spend too much on Dead and Marginal Assets leveraged with too much help from the Debt Merchants, then your Personal Finance Machine grinds to a halt and your misery index skyrockets. The funny thing was that I always focused on the wrong things. I focused on my budget and spending, when the real source of control was the decisions I made on the big stuff like cars, houses and debt.

I added a couple of savings accounts to send my 3-5 year money into and readjusted non-routine expenses to fit into our REAL expenses (hidden and visible). It was a bit uncomfortable for a while. But we stuck with the plan, and eventually got some raises, etc. Soon enough we were cranking.

We operated like this from then on. We bought used cars with cash. Not junkers, but 3-5-year-old cars that we could beat the heck out of for 8-10 more years. We kept our Operations Engine operating in peak form by keeping our Asset Burden low and Free Cash Flow high. When we upgraded out house we made sure we didn’t destroy our operating machine by listening to what the bankers said we could ‘afford’. We kept an eye on our Cash Reserves and automatically moved money between these accounts (per the plan) at the beginning of every month, and that was it. We just lived our lives and money management and details just faded into the background. Not because they were not important, but because they were just ‘handled’.

Did this mean that life was perfect? Of course not. We argued about leather or cloth furniture or where to go on vacation or why the credit card bill was so high that month.

But we never argued about not having the money to pay our bills, fund our retirement, deal with a major car repair or accident, replacement cars or repainting the house. The money was always there. It was not a miracle – it was understanding how our personal finances operated and using that knowledge to stay on track.

From the time I got this figured out in my mid-30s, I never tracked how much I spent on groceries or gas or lattes ever again. It no longer mattered because I now knew what did matter – the machine. I had wasted 10 years of my life counting pennies, when dollars were walking out the door.

Now, looking back at the arc of our lives, developing and using the Personal Finance Machine was key to this incredible spot we’re in financially today.

To be clear – all along the way we never really sacrificed or wanted for anything. Not because we had massive incomes or because we lacked ambition or did not want to increase our standard of living. It was because we knew what we could afford right now and what the consequences would be of living beyond our means. We felt this great sense of confidence, control and security in knowing our system helped us avoid all of the minor and most of the major financial gotchas of life.