Key Takeaways
- The expense audit is the first step to gain control over your finances.
- It helps you understand problematic spending areas and to goals.
- Use my free expense audit tool to track expenses.
- Audit credit/debit statements and cash expenditures at least once per year.
- Categorize expenses as “Needs” and “Wants”.
The Expense Audit Sets the Foundation
When you know where your money is going, you can define expense problem areas and set goals to improve your financial health and wealth. Only then can you use your money in the best possible way. Otherwise, you may set unrealistic savings goals that fail, leaving you stuck and demotivated.
Without expense tracking, our spending will creep to match our income – lifestyle creep. The natural lifestyle creep can be contained by using the forced savings method.
Understanding expenses is central to controlling spending – a pillar of Wealthy Corner. We can’t manage something that we do not understand in the first place.
Why Audit Expenses When I Can Focus on Earning more Money?
This study shows that extra income delays bankruptcy for financially distressed people.
Financial issues are usually rooted in bad spending habits. Money goes out faster than it comes in.
And income is only helpful once we can control our spending. For this reason, there is a long list of pro athletes and lottery winners who end up broke.
Money is a Tool: Use it in the Best Possible Way
But Jake, I want to be free, and this sounds restrictive. I once thought the same. But then I realized that I could see areas of spending that brought no value to my life. I cut these expenses, and vectored the money to higher value areas.
Expense tracking sets you free.
Money is as a tool that can be used to help you achieve your unique goals and aspirations. Freedom comes from putting your money to work in the best possible way to bring maximum value to your life. The expense audit is the first step to achieving this freedom.
You can use your money to travel, to start a business, or to take unpaid time to upgrade skills and search for more meaningful job. Money is not an end, but rather a means to an end.
The Expense Audit Defines Problem Areas
A clear problem definition is the first step to solving any problem.
This seems obvious, however, us humans are susceptible to jumping to solutions before we fully understand and define the problem. We can’t solve a problem that is not understood in the first place!
Do you know how much you spend on food every month? The amount will likely surprise you. You may find that you have been eating your future.
Do you truly understand how much it costs to drive that car? Once known, you will be armed with the information needed to make good decisions. You may find that your future is depreciating in the driveway.
An expense audit is the first step to set realistic expense management goals. Now lets move on to to the method to conduct an expense audit.
Conduct an Expense Audit
An expense audit consists of documenting and categorizing all spending over a two month period of time. That is it.
I guarantee you that the 2-4 hours per year devoted to the expense audit will provide a good return on investment. You only need to do this audit once per year to foster a strong understanding of your expenses. A two-month sample will capture those monthly expenses – think mortgage, car payments, phone plan, and insurance.
I recommend you conduct the audit at higher frequency if you have large changes in your expenses, such as when you move. Consider doing it more often than annually if your expenses vary throughout the year,
An audit of two months of spending will provide good expense coverage. An audit of debit and credit card statements should do the trick for most. Those of us who use cash will need to document cash spending over the course of a two-month period as well.
The Expense Audit Tracker?
Jake, I hate making spreadsheets. I don’t want to do that!
Don’t worry, I’ve built one that provides a framework for the expense audit. I use this tool for my budget. I’ve added flexibility and instructions so you can adapt it to your unique situation.
The tracker provides the following features:
- Provides common expense categories;
- Gives you flexibility to add new expense categories;
- Allocates expenses as “Wants” or “Needs” and adds them up;
- Captures income and savings; and
- Allows you to set expense, income and savings goals.
Non-Routine Expenses
You will also have to consider non-routine items such as vacations, car registration & maintenance and house maintenance. Input these large expenses into the annual expense column of the tool.
Home maintenance costs normally average 1% to 2% of the home value per year, and vehicle maintenance costs run between $700 to $1200 per year in North America.
Categorizing Expenses
The act of categorizing breaks down a large unmanageable problem into smaller pieces, increasing the likelihood of success. Smaller problems are easier to manage. I’ve built common categories into the expense tracker, and have left space for you to add your own unique expense categories.
The categories help you concentrate your effort on the most impactful areas for maximum effect. Plus, all items within a specific category have a very similar management approach.
Needs - Essential Expenses
Essential expenses, or “needs”, are those expenses that are necessary to live. There are three large key expenses that dominate expenses for the average person:
- Housing;
- Transportation; and
- Food.
Some other essentials include clothing, toiletries, medical bills, life insurance and childcare.
These expenses can’t be cut because they are essential, right?
Wrong. Housing, transport and food have huge potential for expense reduction.
These items are only “essential” up to the point where basic functional needs are met. Anything after that is non-essential. A BMW is not essential, whereas a Honda Civic might be. Housing is essential, but any extra living space above what you need can be cut.
Anything beyond the necessary functional value is on the table to be cut. We have to be very honest here because we tend to convince ourselves that our “wants” are “needs”.
Want Expenses (Non-Essentials)
“Want” expenses are goods or services that are nice to have. These non-essential expenses can be cut to zero without large impact on quality of life.
Have shelter, food, water, a bed, and electricity? Your life is better than almost all humans who have ever lived.
The importance of each expense is something only you can determine based on your unique values, goals and passions. Normally, self-development and hobby-related expenses should be cut last because they add true value to your life.
Habitual, Environmental and Material Expenses
I find that expenses can be classified as habitual, environmental or status-based spending. Each category has a similar expense management approach.
For example, you must alter your environment to change environmental expenses. An example would be a change in where you live, changing transport, utilities and home maintenance expenses for decades.
Habits must be changed to change habit-based expenses. We can alter our mindset and increase inner security to reduce dependence on material items.
Learn more about these three expense categories.
It is Time to Set Goals
You have defined your expense landscape and are primed to set expense reduction goals.
The expense review naturally leads you to a zero-based budget as you set a goals for each expense category and give each dollar a purpose. I use a hybrid between the zero-based budget and the reverse budget.
You are now ready to set realistic goals to pay down debt, build an emergency fund, save for a significant expense or set investing goals in growing wealth. All of these goals can be distilled into expense goals or income goals.
Goal setting is great, however, true success comes when you have habit-based systems in place that persist over time. An example of such a system is consistent saving and investing.
The expense audit tool becomes is a means to identify problems, set new systems and monitor and improve these new systems. Read this to see the difference between goals and systems.
Are There Expense Tracking Apps?
There are many, however Mint is the only app that I personally have experience with. It is free, connects to your bank and automatically categorizes expenses into useful categories.
The app is great if you are actively engaged in digesting and acting upon data in the report. I found I just looked at the report and said “cool”. That was that. I was not engaged with my expenses.
The good ol’ fashioned method of manually inputting your expenses forces you to be actively engaged with the numbers. I feel like I have a much better grip on my financial situation with this method.
For this reason, I no longer use any apps for expense tracking or budgeting. I think apps can be great between expense audits to ensure you are staying the course and meeting your goals.
You may have better luck than I did with expense tracking apps. Give them a try. If it works for you, great!
Conclusion
An annual expense audit is the first step to taking control of your money. It sets the foundation for expense management by helping you define problematic spending areas.
If we don’t track our spending, lifestyle creep will take over and our expenses will naturally creep to match (or exceed) our income.
I recommend you audit two months’ worth of expenses. Highlight areas that you are spending too much or too little on. This sets you on the path to set goals and develop good systems. You can also use this tool to set income and savings goals with the process I outline in this article.
If you want to see an addition to the expense audit tool, please let me know in the comments.
Jake out.