Recently, I was reading a business finance book called Profit First by Mike Michalowicz. It’s a book I had been curious to read about business finances, which I enjoyed, but I also took away a lot in terms of helping personal finances.
The book comes about because Mike found himself and the people he worked with struggling to pay themselves in their own businesses. The expenses of their business always made taking home an actual paycheck for themselves feel impossible. His solution was to create a system where you pay yourself first and that the amount you have left over is what your business must be restricted to.
I often like to refer to the money equation. The simple idea that shows money doesn’t have to be too complicated to work.
Income-Expenses=Margin; where margin is the money you use to reach your goals and spend in ways that matter to you. But to have margin, you have to control your expenses to not only fit inside your income but leave enough to support your ideal life.
Do you remember your Algebra from school? Using the ideas in profit first, you can take our same money equation but flip it around so that the results are the same but the priority changes, it looks like this:
Income-Margin=Expenses
Now our formula puts a greater emphasis on deciding how you’d like to spend your margin first, then leaving what’s leftover for your expenses.
I like it. If you keep hoping your inflated expenses will go away so that you finally have enough to save for your vacation, it isn’t likely to happen. You now have a change of priorities and a better way to think about what you can afford or what you can’t.
On the other hand, just saying you want to prioritize taking a big vacation this summer doesn’t mean your expenses will leave you with enough money to do it. We’ve got a little more work to do, but it’s a start.
In Profit First, after establishing that we want to prioritize profit over business expenses, Mike introduces the idea of ideal percentages that your business will run on.
If we think of this in terms of personal finances, the idea of taking your income and using percentages as a way to break down your spending isn’t new. The first time I saw this idea was Ramit Sethi’s Conscious Spending Plan presented in his book I Will Teach You To Be Rich. But he didn’t come up with it either. He credits Richard Jenkins, former editor of MSN Money, for creating the “60% solution.” So assigning percentages to your income has been around.
But here’s what I found to be the real magic in Profit First. It’s the idea that you should assign percentages to your money as it stands today as a starting point.
Now you can see where you are today, while slowly adjusting to where your finances should ideally be.
Personally, I’ve done some regrouping of our categories to help facilitate this.
Expenses- These are all of the expenses for your life that happen on either a monthly basis or irregularly. It’s the amount of money you need to keep everything going.
Debt- The amount of debt you’ve already committed to that you are responsible for in the form of a monthly payment or amount owed.
Saving- The amount for which you’re saving up for things. This isn’t owed or bought. It’s big-ticket items over your monthly spending capacity that will take some saving up.
Investing- The amount of money that comes out of your take-home paycheck each month. If you are contributing to your workplace’s 401k 403b, or if you’re contributing to a pension, it won’t be a part of your budget each month. Budgeting here will be if you’re contributing to a Roth IRA each month, which I recommend. You may have some combination of the two.
Spending-The amount of money you set aside to spend on everything else. Eating out, shopping, stuff you want, impulse purchases- these are all the things you’d like to use fun money for.
I think these are good broad categories to look at your spending by percentages.
Using a budgeting tool like YNAB, you can experiment with aligning your categories into groups like these. Then, add up all of your expenses for each group and divide that number by your total income for the month. That will give you the percentage of your budget allocated for each category group.
To make things easier, I created this Google doc where you can input your expenses and it will calculate your percentages for you.
So what percentages are ideal?
That’s going to vary largely by what’s important in your life. If we follow the four steps of Finding Margin, each step will tell us to:
- Create a life that’s worth supporting financially. Build a life that we want to spend money on.
- Control expenses each month to reach your goals.
- Start saving more for retirement until we reach 15%.
- Extinguishing the cycle of debt every opportunity we get.
Given these steps, we want establish a baseline, start saving more for retirement until we reach 15%, work to extinguish the cycle of debt, and then ensure that our category groups reflect our values when it comes to spending money.
More on that next week.
For the moment, fire up that spreadsheet, make a copy, and figure out what percentage of your income your category groups currently take up.
Next, we’ll start looking at what we want to change.
Leave a Reply