No matter who we are, salaried or self-employed, categorising income will benefit everybody.
Generally people earn income in the form of salary, sales, investment returns etc.
For effective money management, it is essential to create a break-down of ones income.
How such a break-down will help in effective money management?
We will not answer this question right here. Lets proceed with the identification of categories first.
Effective money management will be discussed simultaneously.
To begin with, let me ask a simple question, what we do with our income?
Different people use their incomes in a different ways.
But all in all, we can categorise the use of incomes in the following ways:
- To manage day-to-day spending needs
- To manage short term goals
- To manage long term goals
- Tax saving investment
Why categorising income is effective
As a rule of thumb, money allocated between ‘Expenses’ and ‘Investments’ should be 50-50.
But from my personal experience, such a distribution is not easy.
Even today (I consider myself low in debt), my expense vs investment proportion is 52-48.
Majority people has the proportion between expense and investments completely skewed.
It is not uncommon to find a proportion like 80-20 in favour of expense.
This is where categorising incomes will come into help.
Categorising will help one become aware of the income utilisation.
If more than 50% is going in expenses, it means you are over spending.
The ‘degree’ of over or under-utilisation of expenses is also evident when categorising of income is done in a proper way.
Expense Vs Investment
When I first used the concept of categorising income for myself, the allocation between expense and investment was as high as 81-19.
This is where I first became aware that how much extra expenses I have exposed myself to.
But over a period of time the proportion between expense and investment has come down to 52-48 levels.
If I can do it, anyone can.
I am one of those impulsive spenders who does nothing for extended period of times, but suddenly indulges into big purchases.
I have still not changed this habit, but for sure the spikes have been toned down.
How I achieved this?
Two things that contributed most in my balancing act was:
(1) Creation of categories and sub categories of my income.
I allocated every penny I was earning to expenses and investments.
(2) Reducing my debt load by nearly 75%
How to categorise income?
#1. Prepare expense line items & quantify it
Preparation of expense line items is simple?
At the outset, this sound rather a simple exercise.
But actually its not so simple task.
The target is to list down all cash flows (expense, savings & investments) which consumes our income.
Suppose My income is $1,200 each year ($100 per month).
When I started listing and quantifying my expenses, to my complete surprise, I could account for only $60 each month.
Where the balance money was going?
In those times, I was virtually living hand to mouth.
There were almost no savings. Whatever savings I was doing were like bare minimum (forced).
It means everything was being spent.
When I could identify only $60, I became confused and anxious.
I wondered, where my money was going all these days? I was not able to even remember where I was spending them.
This is what is called as impulsive spending.
When people spend money without budgeting & tracking, they end up being an impulsive spender.
This is an undesirable state of mind.
I seek help from my family. After deliberation with family, the $60 figure went up to $70. But still there was a big gap.
It took me nearly a whole week to figure out where my money was going.
While I was doing this exercise I made a pledge to myself that, henceforth I will start recording all my expenses.
#2. Prepare an income breakdown
Once you have all the expense line items quantified, you are ready to break down your income.
The first step is to do a total of all expense and investments.
Check if this total value is equal to the total income or not.
If the total of expense + investment line items is more than your income, this situation is not manageable.
It is better to have a re-look into the quantification of expense + investments line items.
Total Income = Expense + Investment.
Today, any money that flows out (expense or investment) of my bank account (accumulated income) has a clear tag attached to it.
The money that flows out is either tagged as expense or investment.
The idea of such tagging was that, I should remain constantly aware of my Expense-Investment proportion.
Target is to keep the proportion within 50-50 range.
What we have done here in step #2 is categorising income.
This break-down of income is saved in our excel sheet.
Every time $100 is credited in my savings account, I exactly know how much of it is allocated for entertainment, bill payments, investments etc.
In normal terms we call this categorising income as preparing a budget and cash flow.
What we have done here is exactly the same.
But I feel that, viewing budgeting and cash flow preparation from this angle helps to unearth the real meaning of the same.
The bigger purpose of preparing a budget and cash flow can be this.
It should help in more effective money management.
Categorising income the way it is explained here also allows Effective Money Management.
In fact for me, it worked very well because I have combined budgeting with cash flow preparation (income vs expense balancing as explained in step #2).
This is also true that only categorising income is not sufficient.
Once done like this, effective money management will become a reality.