Zero-Based Budgeting: A Step-by-Step Guide

The "zero-based budgeting" system was designed in the 1970s by an accounting manager with Texas Instruments; Peter Pyhrr. The system was designed to promote intentionality in spending and scrutinization of individual expenses. This is the optimal system for folks who want to live purposefully and spend meaningfully, which is why I have developed my budgeting template to be compatible with it.

The zero-based budgeting system gives every dollar earned a purpose. In traditional budgeting, when someone inevitably overspends in a given category, there are no clear consequences. The owner of the budget simply says "oops" and hopes to do better next time, typically pulling the money from another source unconsciously or even putting it on a credit card and adding it to their debt. With zero-based budgeting, since every dollar is accounted for, when you overspend in a given category, you are required to transfer money over from another specific category, or else go into debt. It makes you conscious of the decision you are making.

For example, I overspend on my clothing budget when I buy a pair of shoes I see. I now have to adjust my budget or else go into high-interest credit card debt. I choose to reduce the budgeted funds in my "savings" category to compensate. I am now consciously aware of the fact that I am choosing to delay my long-term savings and financial stability to have those shoes. This system allows us to hold ourselves accountable and be realistic about the kinds of tradeoffs we make every day.

With this framework, we are forced to become intentional with our spending. Just by setting up the budget (which typically requires reviewing several previous months' expenses), we face hard truths about our spending. I cannot tell you how many times folks I work with have been shocked by the data. People realize for the first time that a single car payment is more than their family spends on going out together all month, or that their "eating out" spending is more than twice their health and well-being expenses. In self-reported surveys of long-term happiness, no one has ever listed "fast food," or "nice cars" as a correlative of long-term happiness and fulfillment, but that is not what many people say with their spending. When we don't plan for spending, we spend mindlessly, and when we spend mindlessly, we will almost always sacrifice long-term joy for short-term happiness.

So, how do we use a zero-based budget? Below is a step-by-step guide for getting started using my budgeting template.

Step 1: Develop a Realistic Sense of Your Income and Expenses

This is a labor-intensive but essential part of developing a personal zero-based budget and usually reaps profound insights into your spending. In this step, I recommend reviewing 3-6 months of your previous expenses to help guide you as you budget for your future expenses. You can do this by reviewing previous credit and debt transaction histories, bank statements, pay stubs, and money transfer apps. You may also be able to connect financial accounts to other free budgeting software to have all of the transactions across all of those financial accounts displayed in one place by date. Currently, the free version of Rocket Money does this, but the world of online, subscription-based budgeting software is changing all the time, so you might have to do some research to find something currently available.

I recommend making 3-6 copies of my budgeting template (there is no additional cost for copying the template once it has been purchased) and filling out a template for each month's income and expenses. Through this process, you can also keep the categories of expenses that are relevant to you, delete irrelevant categories, and create custom categories to personalize the budgeting template to fit your lifestyle and expenses. It will also show you a pie chart of your largest expenses so you can more easily recognize categories to target to reduce your spending. Reducing larger expenses will have more of an impact on your savings than reducing smaller expenses, so they should be approached in that order.

Pro tip: Make sure to cancel unwanted subscriptions and ongoing expenses as you discover them while categorizing your past transactions.

Step 2: Set a Budget for the Gross Income You Project to Receive this Month

Using the information collected in Step 1, start by projecting your gross (pre-tax) income for the upcoming month. For Salaried employees, this should be fairly straightforward, but be sure to also consider projected side-hustle income, months with bonus pay or more paychecks than usual (for example, employees paid bi-weekly will get 3 checks in one month twice a year), and any other income from things like investments.

For folks who have hourly, self-employment, or contracting income, I recommend looking at the past 6 months of income, removing significant outliers (this would mean months where you received 75% or less of your 6-month average income), and budgeting to receive the lowest monthly income from that previous 6-month period. If you fall into this category, step 3 will be vital as you are very likely to have surplus income in many of the months you are tracking.

Step 3: Make Contingency Plans for Months with a Surplus or Deficit of Income

This is a step that many folks miss to their detriment. A zero-based budget is very specific, but life is rarely as precise, so, to accommodate for the variability of income, we need to have a written plan for any income surplus or deficit experienced in a given month. This can be all toward one category (eg 100% of surplus funds go towards credit card debt) or split into percentages (eg. 25% of surplus will go towards "entertainment," 25% to "savings" and 50% to "pay off debt."). You should also make plans for the inverse (eg. "if I make less than my projected income, I will cut my coffee budget until it's half, then my vacation savings budget, then my hobbies budget," etc).

For this planning, if you are in high-interest debt, I would typically recommend putting everything surplus into debt payoff, but consider the goals that would be motivating. It may be that, if 100% of the surplus was allocated to debt payoff, then you would never work extra, but if 80% was towards debt payoff and 20% went to discretionary fun then you would happily work an extra 10 hours a week picking up extra shifts or doing odd jobs and you would have a significant net gain. Remember to negotiate with yourself. In planning, we tend to imagine ourselves as financial robots, but in reality, we are people and may need to incentivize ourselves to take consistent steps in the right direction. You will find spaces for writing down these goals in my budgeting template and they will serve as a reminder and a motivator on your financial journey.

Anytime you need to modify your budget due to additional income or expenses in a given category, make a note of it and review these notes in step 6.

Step 4: Budget Your Monthly Expenses.

Using the data you collected in Step 1, now create a budget for your expenses during the upcoming month. It is good practice to set goals based on your past spending and to reference a calendar for the coming month to plan for any unusual expenses like holidays/birthdays, large maintenance or repair expenses, or upcoming trips/vacations.

Remember that every dollar of your budgeted gross income should show up in your expenses. This includes everything on your pay stub; health insurance, retirement savings, regular savings, etc. If you haven't already in Step 1, you can add, delete, and change the categories from those provided to customize your template to fit your life and expenses. The more accurately you track your income and expenses, and the clearer your categories for tracking, the more you will benefit from this practice.

Pro tip: If you use a "misc." or "unbudgeted" category, try to keep less than 5% of your expenses here, as this information does not help in planning. If an expense occurs more than once, make a category for it. You have space for 150 individual categories.

Step 5: Start Tracking Your Spending

The best way to track spending is using the "cash basis" accounting method which records income and expenses when they are paid out or received. So, if you get a promotion that pays out a guaranteed bonus, don't record the bonus when you get the promotion, record it when it is paid out to your account.

When recording income and expenses, the best philosophy is to record them right when they happen. If you buy groceries, then right when you get back into your car, add them to your "Transactions" tab. When you eat out, add it to your transactions before you leave the table. Mastering this practice will result in the most accurate and comprehensive budget with the least effort.

Waiting to until the end of the week or month to add transactions into your budget often results in confusion and inaccurate reporting. A big reason for this is pending transactions and cash. Cash payments are often forgotten or the amount is misremembered. Pending transactions may not show the full amount paid for several days until the payment is finalized (this is often the case with expenses that include tips like eating out or service expenses). When this happens you are required to either produce the receipt or work from memory which often leads to inaccuracies or frustration which decreases your use of budgeting templates thereby forfeiting their benefits.

Pro tip: When it comes to personal budgets, do NOT record expenses that will be reimbursed. This results in skewed data both in your income and your expense records. Instead, put it in the "financial to-do list" section of the template to request reimbursement from your employer, or to text your friend if they haven't paid you back after a few days. Any "reimbursement" that results in a net gain (for example, mileage reimbursements that exceed associated costs) can be added as additional income.

Step 6: Review and Make Changes

So it is the end of the month and you now have all of this data. You used my budgeting template so you are confident you have documented every transaction and they are all categorized accurately. What do you do with this information now?

Firstly, check in with yourself and asses how you felt about your spending and tracking that month. Do you feel like your expenses got away from you? How disciplined were you in documenting income and expenses as they happened?

Next, look at your overall expected monthly income and expenses. How accurate or inaccurate were your projections? When there was a surplus or a deficit? If there was a surplus or deficit, did you follow the plan you made in step 3?

Now, look at your notes for categories where you overspent. Why did you overspend there? Do you have a pattern of overspending in that category? If so, it may be time to make changes to your budget for next month. If changes need to be made, that is perfectly okay! It is much better to be realistic about your spending and plan for it than struggle under an idealized budget and burn out from the practice entirely. It is like dieting. Maybe it would be ideal to eating less than a certain amount of calories, just like it might be ideal to spend less than a certain amount on certain things, but if stepping on your scale, or looking at your budget, is causing you to want to quit, then it would be SO much better for you to change your goals to be more realistic than to quit the practice altogether. Reaching 80% of your goal can be life changing, where quitting and allowing yourself to spend recklessly will only result in long-term consequences to your financial health and happiness.

When reviewing your spending by category, you should also ask yourself, am I spending according to what is meaningful to me? There will be some mandatory expenses that are necessary for survival. There is a minimum amount you can spend on housing, you may need a car to get to work even if you don't care about what car you drive, and you have to pay taxes, although you won't likely consider taxes a "meaningful" expense. However, these expenses are more in your control than you might think. You are not trapped. You can downsize your housing, sell your car and share one with your spouse, and/or look into legal tax avoidance strategies (NOT illegal tax evasion strategies) like pre-tax retirement or health savings options for reducing your income. If you find your spending does not accurately reflect the person you would like to be, then change it. No matter your situation, you are never beyond help. You always have options.

If you are cutting back on your expenses, either because your spending is more than your income and you have to, or because you want to make more room to spend or save meaningfully, always start with your biggest expenses and work your way down to the smaller expenses. People often get too caught up trying to cut out things like the occasional coffee or movie ticket, but these are often small drops in the bucket compared to our much larger housing, transportation, and food expenses. Do research and get creative. You may be able to save hundreds or thousands of dollars a month without doing anything drastic. Maybe instead of having to sell your dream home, you can review your homeowners' insurance to make sure your coverage is appropriate, you're getting all the discounts you qualify for, and you're partnered with the best company for you. Small changes to large expenses often have a much greater impact than big changes to small expenses, and many times they have a significantly smaller impact on your quality of life.

Step 7: Plan for the Next Month's Expenses

Zero-based budgeting doesn't call for you to simply copy last month's budget and use it for the next month. It asks you to look at next month as a completely different month. Planning for the month's expenses can not only prepare you financially, but it will also set you up right to thoughtfully enter the new month prepared. Start with your fixed expenses, and then go through each day, highlighting events that may come with unique expenses or income. Use your previous months' expenses as a reference point, but each month is different and should be approached with some semblance of a clean slate. Remember, a budget is not a prison. It should allow you to design your life to ensure that you can enjoy what is most meaningful to you, while also being adaptable enough to accommodate the spontaneity of life.

Pro tip: If you, like me, are married or planning for a household, then make it a habit to have monthly meetings to review your last month's expenses and prepare for the next month's. Try to find ways to make this exciting, especially if not everyone is equally thrilled about budgeting and financial planning. Make it a monthly "Bourbon and budget" night, go to a movie afterward, or get your favorite to-go dinner to eat during the meeting. Make it an event and always remind yourself and each other your "why" for being disciplined with your finances, be it buying a dream home, retiring early, or finally escaping bad debt.

Wrapping Up

The best budget is the one that you can stick to. If you are reading this article, you are likely in a period where you are focused on and motivated to get your finances in order, but you will not always feel this way, so it is important to develop a system that is easy and works for you so you can stick with it even when you are less willing to commit time and mental energy into following it. Creating habits, like adding transactions right when they happen, and reviewing your budget consistently, will provide you with a structure to adhere to and follow even in life pulls you in other directions.

Please consider downloading my budgeting template if you have not already as I have engineered the template over several years of personal use and using it has saved me countless thousands of dollars so far. If you have purchased the template already and have questions about its use, please feel free to email me directly through the "contact me" tab of this website. Thank you!

"The unexamined life is not worth living" -Socrates

"What gets measured gets managed"

“Spending money to show people how much money you have is the fastest way to have less money.” -Morgan Housel

“Spend extravagantly on the things you love, and cut costs mercilessly on the things you don’t.”

-Ramit Sethi

"A budget is telling your money where to go instead of wondering where it went.” ― Dave Ramsey