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28 Feb 2011

Slaying the Variable Income Dragon

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by Jesse Mecham

Do you struggle managing your money because your income is all over the place?

Do you go from cash windfall to cash shortfall within a few minutes?

Are you a freelancer… a commission-based salesperson… a small business owner (that, as we all know, pays himself last — if at all)… a contractor…realtor…

Do you deal with the Variable Income Dragon on a regular basis?

It’s time to slay it.

Variable Income Struggles

One of the top reasons why people tell me they can’t budget is because they operate on a variable income. (Yes, I’m constantly asking people why they don’t budget. I’m a huge hit at parties.)

The basic money equation is Income – Expenses, right? And you build a plan around that. Well, how in the heck are you supposed to plan if half of the equation can be anywhere from $1,000 to $10,000 in any given month?

And don’t tell me you just work off the averages. That doesn’t work. If you plan against a $5,000/month average and you happen to be on the “dip” end of that average for a few months in a row… it doesn’t work.

So you give up.

Or, worse yet, you forecast your income and set up a plan against that. And then, when your income doesn’t hit your (overly-optimistic) forecast, you give up: “I can’t budget. Maybe if I had a steady salary, then it would make sense.”

And the dragon has won.

A Variable Income Makes Budgeting even MORE Critical

Those people that have it “easy”, that are paid the same exact amount every single month, they’d do well budgeting and following the YNAB Way. But you, with your variable income, you absolutely need a budget. The impact that proper planning will have on your up/DOWN finances will be huge. You’re basically looking at a situation where the return on your effort is proportionate to the variability of your income.

In other words, if your income is crazy, your budgeting will have a crazy (good) impact on your state of mind. You have a bigger dragon to slay, and you’ll find it very rewarding.

First, You Need Room to Fight

If your back’s against a wall, you need room to fight. This is Rule Four and we talked about briefly the other day.

Break the paycheck to paycheck cycle immediately and get to a point where you don’t have to touch this month’s paychecks, draws, disbursements–whatever you call them. What you earn this month, you spend next month.

If your income is only slightly variable, this change alone is enough to alter your whole budget paradigm. You don’t deal with forecasting (and being wrong), you only deal with your known number–what you earned last month.

So for some of you, perhaps this is where your fight ends. Congratulations.

For others with big swings in income, the fight has just begun.

Mount Your Offensive

You’ll get to a point where you pay yourself the difference when you have a lower-than expected month. And when you have a better-than-expected month, you’ll shave some of the extra off to use later. It’s basically the Buffer principle (one month’s expenses), but on steroids. Let’s call it your Variable Income Fund. We’ll need to do this in steps.

Step 1: Establish your baseline expenses.

You need to know what you need each month to live “normally.” And by normally I don’t mean you do one of these:

“Well, let’s see, if we really cut back, we could just eat the canned beans in the refrigerator, and cook rice each night. We would NEVER eat out, NEVER have any type of entertainment, and not do ANYTHING fun for the entire MONTH.

And we’d walk to work.”

No you won’t. You’ll eat beans and rice the first night, skip the fun activity the next night, rationalize some meat the third night, and rationalize going out with friends the next night because it happens to be their birthday and it’s just this one time. And you’ll drive to work every day.

Your baseline expenses are what you would need to live however you live right now, with no changes. Though bear in mind when working out your baseline, that you absolutely MUST remember your True Expenses (your Rainy Day funding requirements from Rule Two).

For the sake of our example, let’s say your baseline is $5,000.

Step 2: Determine the size of your Variable Income fund.

This is completely up to you. Everyone should be operating with at least one month * baseline expenses so they can be following Rule Four. Beyond that, it’s purely a function of 1) your income variability and 2) your preference.

If your income fluctuates from $4,000 to $6,000 each month, you have a deviation of +/- $1,000 per month ($2,000). If you can look back at your earnings and establish that you never have more than two months at the -$1,000 point, then perhaps 2 months * $2,000 = $4,000 is enough. However, if you can go for five months at the -$1,000 dip, before hitting the +$1,000 mark for a while…you’ll need to factor that in.

I wish I had some formula where you could just drop your numbers in, but your preferences play a big role here as well.

So let’s talk about someone with big swings in income. Let’s say they can be anywhere from $1,000 to $12,000 per month. With an average of $5,000 over the last twelve months. We’re looking at a -$4,000/+$7,000 range and that can make the Variable Dragon tough to slay. You just need to do a little math, and keep your eye on the target.

If your focus is the $5,000 baseline, and you recognize that you have a deviation of $11,000 ($1,000 at the bottom end, $12,000 at the top), and again you look at trends and realize you could have several months in a row at the low end of the deviation…you need to adjust accordingly. What would I personally do? I’d probably look at around $20,000 for my Variable Income Fund (I’m quite conservative, as a rule).

Step 3: Implement the Plan

You’ll have a target amount for your Variable Income Fund. For our discussion, let’s go with $4,000. Save that money.

In YNAB, this would be simple. You wouldn’t put the money in any separate checking account or anything like that (who wants to manage one more account?). You would set up a category in YNAB called “Variable Income Fund” and you’d budget the $4,000 there.

Now, what if you have a month where you only bring in $3,000? But your baseline is $5,000? You’re $2,000 short, so you’d pull $2,000 out of your Variable Income Fund category and use those funds to budget and live your normal month.

The next month, you bring in $4,500. Still short $500 from your baseline of $5,000. So you borrow another $5,00 from your Variable Income Fund category. After the $500 is deducted, it’s sitting at $1,500.

Now you’ve had two months of easy cash flow, zero stress, etc. You’ve been able to live perfectly “normal”. As a result, you were able to turn down two clients that would have been a big time drain and not worth much money — because you had some wiggle room! And then you landed a big client because you were patient and able.

So the next month, with that big client providing a lot of work, you bring in $6,500. $1,500 above your baseline requirements of $5,000. Nice. Stick the $1,500 surplus in your Variable Income Fund and it now has a balance of $3,000.

The next month, that big client is still paying off and you bring in $7,000–$2,000 above your baseline. Your Variable Income Fund only needs $1,000 to get it back up to the $4,000 target amount, so you add $1,000 to it and call it good. The extra $1,000 can be used for something else entirely.

A few options for that extra $1,000:

1) Did you feel comfortable with the target amount of $4,000 for your Variable Income Fund, or were you still stressing unnecessarily? You may want to adjust it accordingly.

2) Are your Rainy Day Funds adequately funded?

3) Are you saving for long-term goals (retirement, kids’ college, weddings, etc.)?

4) Do you feel like doing something cool with some/all of it? (Examples are endless here.)

The Right Weapon for the Fight

YNAB is the right weapon for the variable income fight. Its simple interface allows you to manage your Variable Income Fund with a few clicks. You won’t find anything simpler, or more effective.

Consider Angela’s response (she hails from Los Angeles, California) as part of our Success Story submissions. Her husband was an unemployed New Home Plumber. Variable Income is just part of their life:

This is the exciting part. Over the past four years, I was able to pay off debt. We exclusively use cash now. Our credit cards have a zero balance. We have no car payment, no outstanding debt except our mortgage. Previously our credit cards would go from $400 or so to zero, and then a bounced check. I was able to go from a paycheck to paycheck situation to a one month living expenses in savings (about $4,000), and being one month ahead in our checking. But here’s the exciting part: to date, my husband has been essentially unemployed for almost two years. Because of YNAB, we were not devastated. In these two years, because we had a clear picture of our finances, we have been able to stay off credit cards, we have not touched our savings, and we are living within the income my husband brings in through side jobs.

Unemployed and picking up side jobs, my favorite part came next:

We know what we have, we are not surprised by our bills, we know when we can say yes and when we need to say no. We have had more real living in the past year than we ever have with trips to South Dakota, Magic Mountain, even Disneyland, because we know what the decisions to spend will mean to our overall financial picture. YNAB has truly given us freedom.

And big-time kudos go out to her husband for doing whatever it takes to provide.

With a plan in place, and the right weapon for implementation, your variable income worries will all but disappear.

Slay that dragon!

Your Next Step

Remember, budgeting is not restrictive. You won’t be spending less, you’ll be spending right. You can do this! Today. Right now. What do you have to lose? Except all that debt and stress. (Ok, so kind of a lot.)

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