The four pockets method of budgeting
There is a simple and effective way to manage a budget that works very well with a little practice. It a very good method for anyone who has never budgeted. One does not need to record expenses for this to work very effectively. You can get your expenses controlled tightly enough that the extra incremental benefit obtained by recording all expenses is not worth the effort. This does require that thought goes into every purchase and lifestyle choices. Bear with me while I set out this can be done.
The primary purposes of budgeting are:
- covering all expenses as they fall due
- putting money aside to save for a goal
- keeping an emergency fund in case things go wrong
- having sufficient cash to pay the bills
You may be wondering “What are these four pockets of which I speak”. They are
- daily expenses such as lunch and treats such as a daily coffee or a daily beer
- weekly expenses such as groceries, rent, entertainment and weekly train passes
- periodic expenses such as insurance and utilities
- savings to be invested to generate more income
Your next question might be how do I use these “pockets” to manage my budget? Allow me to explain.
The first pocket. Daily expenses
There are some things that one buys every day such as lunch on a work day. Get into good daily spending habits my monitoring and questioning your every expense every day. Cut down those expenses until you are making no wasteful purchases and no impulse buys. Decide what you are going to buy every day and how much you can spend every day and stick to your expenditure limits.
Allow me to present a hypothetical example of daily expenses. Assume, for the moment that you are consistently buying the following every day, or at least on most days.
- train tickets to and from work for $6.20 a day which amounts to $31.00 a week
- lunch every working day for $8.00 amounting to $40.00 a week
- a coffee at the beginning of each work day for $3.00 amounting to $15.00 a week
- a coffee at lunch each work day for $3.00 amounting to $15.00 a week
- a chocolate bar every day for $2.00 amounting to $14.00 a week
- several bags of lollies every week for a few dollars each amounting to $9.00 a week
- a packet of cigarettes at $21.50 a pack, every day amounting to $157.50 a week
- the total of all this is $281.50 each week.
Now consider each those expenses and ask yourself if you really want each of those items. You may wish to buy things you don’t actually need but do want as your little daily treat to add your quality of life. This review might lead you to decide to stop buying train tickets each day and buy a multi-trip ticket to save a little on train fares. You could take a cut lunch each day. If you don’t want to do that you could scout around the snack bars near work in the hope of finding a cheaper place that can provide a good lunch. You may decide to cut the lunch time coffee. You may wish to keep the morning coffee as your daily treat but that should be your conscious and considered decision. Reconsider the chocolates and lollies and perhaps eliminate, cut down or find cheaper supplies. You may consider attempting give up smoking and if that fails you could consider switching to tobacco to cut the expense. Assume, for this exercise, that one changes a packet a day to three pouches of tobacco at say $90.00 a week including papers and filters.
Set yourself an amount you can spend each day and stick to it. Let us assume you decide to buy a weekly train ticket and get all your tobacco once a week. Your daily expenditure might then be as follows:
- lunch every working day at $8.00
- a coffee at the beginning of each work day for $3.00
- allow $2.00 a day for chocolates and lollies
- that is a total of $13.00 which you can spend every day
Once you have your daily expenditures right down you really have no further savings to make so you don’t need to be recording those expenses for review and analysis. If you spend less you can keep the change to save for a little treat as a reward or you can save it or add it to a weekly expense such as entertainment. Your daily expenses on a work day will differ from your daily expenses on a day off as you are presumably not buying your lunch. You decide if you want to have a different expenditure limit on weekends or simply use the lunch money for something else. The important point is to get into good daily expenditure habits and stick to them. If you are treating yourself to things you don’t really need know how much it is costing you. You know that $2 for lollies is not necessary but you know you are spending it as a conscious decision.
You may protest that you can not live on that and ask about entertainment, groceries, bills and so forth. These items come out of the second and third pockets. Buying your train tickets and tobacco weekly transferred those expenses to the second pocket.
The second pocket. Weekly expenses
There are some things one buys every week or fortnight or month such as weekly train tickets, rent and groceries. List all of these items and the estimated costs. Review the list to decide which one you need or at least really want to keep. Stop buying those that that that you don’t really want. Go through the remainder, one at a time, asking how you could reduce that expense or find alternative ways of satisfying your need to buy that item. Over the next few weeks work on controlling those expenses to get them down to what you really need. You are establishing a sustainable weekly budget to meet these costs as economically as possible. As time goes on you will progressively find better ways to reduce and control these costs. You are giving yourself a weekly allowance to cover these costs.
Some of those costs will be a fixed amount. If your rent is $200 per week payable every Monday then that is your weekly rent budget until your rent changes your you move house. Others such as groceries are not of fixed amount and are thus limited by the amount you allow yourself.
Let us assume you start with the following weekly expense budget:
- rent $200 (fixed)
- train ticket $27 (fixed)
- tobacco $90
- entertainment $40
- groceries $60
- miscellaneous $40 (you need to work on this to identify what you buy and what to do about it)
Your budget for these weekly expenses is $457 and the budget we previously worked out for “daily” expenses is $91 giving total expense of $548 for the week. That is how much you can spend this week. Work on these budget items every week and improve your habits until it can be reduced no further.
Your grocery expense can be expected to vary a bit from week to week. You may spot a large bag of potatoes at a cheap price which will boost your expense in one week and reduce it in the following weeks. You could toss the change in a tin in weeks when you are under budget to give you a bit of flexibility. If the amount you can set aside is large then your budget may be excessive. I am talking about a sum of $10 to $30 held in reserve.
You may consider keeping some cash in reserve in case friends unexpectedly invite you out and you don’t want to refuse as you have nothing in your budget. Stay home one week to keep $20 or $30 in reserve. Save the money from your existing budget.
The third pocket. Irregular expenses
The third pocket is your irregular expenses such as quarterly utility bills, annual insurance, clothing, gifts and so forth. Write down a list of all such expenses and assign estimated costs. Add up all your estimated irregular expenses for the year. Divide that by 52 weeks and that tells you how much to set aside each week to cover these expenses when they fall due. You might use a separate bank account for this. If this fund builds up you have presumably overestimates these expenses and transfer the surplus to your investment funds. if it is not enough then you need to either change your budget or find a way to further reduce your expenses.
Each of these expenses must be managed. Using heaters will dramatically increase your power bill so you may wish to consider the options of throwing out your heater and air conditioner, installing insulation in your ceiling or solar panels on the roof.
I find a useful method of controlling clothing expenses is to restrict ones self to replacing old clothes when they are due to be thrown out. Once you have enough jackets or shirts there is no real need to buy more. Simply replacing them puts a brake on buying ever more items.
The fourth pocket. Savings, your goal
This is the amount you put into savings every week. This is the amount you wish to maximise whilst maintaining a reasonable standard of living given the income level you currently have. This is your goal and a fixed amount really should be set aside every week. Simply saving whatever happens to be left over at the end of the week will almost certainly lead to little if any savings. Take this amount out of your pay packet and learn to live on what is left. Your employer gives you a pay packet and then you give yourself a smaller pay packet AFTER you have deducted the amount you plan to save. Invest this amount, don’t take any of your investments for spending. Reinvest all of your investment income. Put any bonus or tax refund into investments instead of spending it.
Why does this method work so well?
The elements of an effective budgeting process are:
- it is a quantified spending plan expressed in monetary amounts
- there are effective controls on expenditure
- expenditure is monitored to detect and explain any and all variances.
This method is a spending plan. You know how much you can spend each day on your daily expenses. You will know whether you are exceeding budget when you are contemplating a purchase. You have your weekly budget and the amounts you can spend on each category of expenditure. You will know whether you are exceeding budget when you are contemplating a purchase. There is an allowance set aside each week to cover irregular expenses. There are a limited number of irregular expenses and these do need to be managed carefully and minimised. You will see your accumulated balance for these items falling if you are overspending, or have underbudgeted.
The big test is whether savings goals are being met. Savings should be treated as a fixed expense and taken out of salary first. And then you live on what remains of your salary. The idea is to work on reducing your expenses to increase the amount you can save.
It takes some weeks to really get into the desired habits to maintain this method of budgeting. The advantages are simplicity and immediate knowledge of when the budget is being exceeded. Try it.
That is the four pockets method of budgeting. A good and effective method for those who do not wish to record every expense forever. You can drive your expenses right down by using this method. I did.
A good way to get your budget off to a quick start is to write down all your expenses for the first couple of weeks to get an accurate fix on what you are spending. See here