Posted by: John Vandivier | September 22, 2013

1 Essential Aspect of Budgeting

This article covers one essential aspect of an efficient budget.

“A Clean Slate”

An efficient budget needs to start with a clean slate. This can be done through an inventory wipe or through discount accounting.

A clean slate means that you adjust your budget to account for what you already have on hand. Let me give you two examples of why this is important. I will also show two ways to do this accounting through these examples.

Inventory Wipe

Let’s say you run some numbers on how much food people eat at your house and you find that it costs $50 per week to feed everyone. This does not necessarily imply that you should budget $50 per week because you may already have food on hand. This can also be called inventory if you are a business. If you do not account for this food you already have on hand there will be several possible inefficient outcomes. The least inefficient outcome is that at the end of the week you have a little money left over. The most inefficient outcome is that you go ahead and buy all of the food ahead of time and by the end of the week it has still not been used. It spoils and you just burned some money.

Some people would say that having a little extra cash at the end of the week isn’t so bad. I agree that it’s not really bad, but think about the opportunity cost. Think about what you could have done with that little bit of money if you knew ahead of time that it would be extra. Maybe you could have avoided paying some extra interest or late fees on a credit card. Maybe you could have bought slightly higher quality food. Usually there is something better you could have done and that is why this is important. In particular it gets important when we are dealing with businesses, but I use the household analogy to keep it simple.

The inventory wipe is the first way to take care of this problem. What you do with this solution is you simply ensure that there is no food on hand at the time you budget! For me and my wife this would mean that if we are doing a budget on Monday, today is Saturday and we still have food on hand for two days, we simply make sure that for the next two days we eat the food at the house. No going out this weekend or whatever. Ideally there will not even be a slice of bread left on Monday at the time we budget. That would be a perfect inventory wipe.

Discount Accounting

Russia's budget for 2006-2007

Russia’s budget for 2006-2007 (Photo credit: Wikipedia)

Sometimes an inventory wipe is not possible. Maybe it’s not Saturday when me and Tina have two days of food left, maybe it’s Sunday. Maybe we aren’t dealing with food. We could be talking about gas in your car. You aren’t going to literally use every last drop of gas. That’s not a problem! What we would do is simply evaluate the inventory on hand and reduce the budgeted amount by that much. This is called discounting the budget.

When we discount our budget we have to use what are called real terms. In other words I need to look in the fridge and figure out how many meals the food there will make, not how much was paid for the food there. The number of meals is the amount in real terms while the price of that food is the amount in nominal terms.

After I figure out how many meals I have on hand I need to look at my budget. Now we need to turn this into nominal terms because budgets are made in nominal terms. It doesn’t matter what I paid for the food in the fridge in the past, what matters is what I was planning to pay for food in the budget. If I budgeted $5 per meal and I have a couple meals in the fridge I should reduce my budget by $10, eat those two meals before they spoil and then start using my budget money. I only reduce the budget by $10 even if I bought that food for $100. It doesn’t matter what happened in the past, it matters what’s in the budget.

For the gas example I would need to figure out how much gas I have on hand, figure out how much that is worth and deduct that from my budget. My car is kind of cool because it tells me on a digital display how many miles per gallon I am getting and how many gallons I have left until empty. Some people aren’t so lucky because there are many cars that only have the needle tick display. The reason I bring that up is because sometimes you’re going to have to get creative about how you measure these things and it’s going to involve some estimating with what is sometimes a large degree of possible error.

This brings up my last point and it is one which is very important. It is better to be safe than sorry! While you might be a tough guy that can rough it and skip a meal if you didn’t budget enough for food, I’m not sure you’re a tough guy who wants to rough it and push your car a few miles to the nearest gas station if you didn’t budget properly for gas.

Hope these tips helped!

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