Before you can start getting into the more complex areas of financial planning, you first need to get a handle on the basics. This means making sure you have a dependable cash flow and that you’re not spending too much of your income each month.
This is where drawing up a budget comes in. A good budget can mean the difference between living within your means and diving deeper into the red, so it’s worth making sure you get it right. This means correctly dividing up your fixed from your discretionary spending.
Fixed vs discretionary expenses
There are generally two types of expenses every household has to budget for: Fixed and discretionary. Fixed costs are those you can expect to deal with every month and won’t change very much from month to month, such as:
- Premiums for life insurance, and other types of cover
- Mortgage repayments
- Car registration
These are expenses that cannot be avoided, but can be planned for, because they tend to be similar – or identical – each time you pay them. They also tend to take up the biggest share of income. For instance, according to the Australian Bureau of Statistics (ABS), housing costs made up the largest share of total spending for Australian households in 2009-10.
On the other side of the coin are discretionary expenses, so called because you can use a little bit of discretion in how much you have to pay toward them – or whether you even need to pay them at all.
This is the area of spending that tends to get people in trouble when it comes to maintaining cash flow. A separate ABS study found that, as of November 2014, most adults working full-time made $1,476.30 a week – a sum that’s enough to cover the basic costs of living. However, depending on where you fall on either side of this yardstick, you may not have as much to play with when it comes to those expenses you choose to pay for, a fact that can put a strain on your finances.
Knowing the difference
This task is made harder by the fact that it’s not always clear what counts as fixed and what counts as discretionary spending. Lumping the latter with the former can end up leaving you with a much smaller pay cheque to work with, and a harder time saving for retirement or a property investment.
There are many costs people might view as being fixed that are discretionary, such as holidays, Pay TV or even dining out. They see them as expenses they’re unavoidably saddled with, rather than those they choose to pay.
In order to figure out which cost belongs in which category, ask yourself one question: Do I need this expense to live? It’s going to be hard to maintain the same quality of life without electricity or shelter under which to sleep. You’d be hard-pressed to say the same about a weekly dinner at a fancy restaurant, or expensive getaway. It’s discretionary recreational costs like these that the ABS says makes up a whole 13 per cent of households’ spending.
It’s not just about recognising what separates different types of expenses. You can also improve your budgeting by being diligent and planning for future costs.
Many of the fixed payments we mentioned before – such as car rego, rates and premiums for life insurance and other types of cover – are payable annually, rather than month by month. It also means they can throw your cash flow out of whack when they suddenly rear their heads one month.
Rather than letting this happen, quantify and plan for these yearly expenses. Make an allowance or provision in your regular fortnightly or monthly income, setting aside the amount you’ll need to cover this cost. That way, you can be sure you don’t overspend in the months where you’re not grappling with these costs.