Create a rock-solid budget that accounts for those inevitable small biz ups and downs.
This article was originally published on https://business.tutsplus.com/ by Andrew Blackman.
CREATE A REGULAR INCOME
The first thing Andrew recommends is converting yourself into a salaried employee. That way you can have the best of both worlds: a regular, predictable paycheck, and the ability to be you own boss.
Does that sound too good to be true? Maybe it is – to some extent. As you most definitely have already experienced, irregular income is a feature of a freelancers life. But we can treat that irregular income in a way that makes it regular for your budgeting purposes. Here is an example of how it works.
LOOK AT YOUR AVERAGE INCOME
Let’s say that your income over the past year looked like this:
| Month | Income |
| May 2014 | $3,498 |
| June 2014 | $7,010 |
| July 2014 | $1,256 |
| August 2014 | $3,425 |
| September 2014 | $5,500 |
| October 2014 | $2,900 |
| November 2014 | $4,854 |
| December 2014 | $4,204 |
| January 2015 | $1,085 |
| February 2015 | $5,850 |
| March 2015 | $6,210 |
| April 2015 | $2,208 |
It’s a mess. We know. One month you are kicking goals and earning 7k… and one month just over 1k. That ain’t living. To make it more regular, you’ll need to make an average income. Add up all those figures and they come to $48,000 for the year, divide by 12 and you are making an average monthly income of $4,000.
It’s better to be more conservative when budgeting because life doesn’t always pan out the way you imagine it will. So based on these figures, Andrew suggests planning an average monthly income of $3,500. You can always aim to increase this, but things aren’t always in your control so it’s better to have a slightly lower figure. Unfortunately, $3,500 won’t be your final paycheck – taxes! Salaried employees have taxes deducted automatically, and now you’re being converted to a salary, you need to account for this. The amount to deduct will depend on your income, as well as a whole lot of variables like how much you claim for business expenses.
There are calculators on the ATO’s website to help you, but for the purpose of this article we’re going to be setting aside $1000 a month for tax, leaving the monthly paycheck at $2,500.
SET UP A SYSTEM
Now you need to get paid. There are a few different ways you can pay yourself, but the one that most accurately mimics salaried employees is to set up two different bank accounts. Direct all your freelance income into one bank account, then transfer your paychecks into your personal bank account, from where you’ll take out cash, pay bills etc.
This system will make you feel like you have a regular income you can rely on, and you’re not overspending in the good months, and you’re not back to eating mi-goreng in the bad months. By deducting tax from your paycheck, you’re automatically setting money aside for those terrifying moments when your tax bill is due. Of course, there’s an obvious problem with this step. What if the salary you pay yourself doesn’t cover your costs? We’ll deal with that next.
WORK OUT YOUR COSTS
We’ve looked at income, so the next step is to get a handle on your costs and your expenses to get an accurate view of all your monthly outgoings. Even the small amounts can add up, so include everything. Good news is if you’ve been using Sole, the app can help you with this, making it easier to record expenses and sort them into categories.
The longer you can do this for, the more accurate your results will be. The important thing is to go with your actual, real-life spending, not your estimates of what you think your spending could or should look like. Our estimates tend to be over-optimistic, and tracking your actual spending often reveals surprises.
The goal here is to end up with a simple list of your spending in different categories, with a total. Here’s a simplified example:
| Rent | $1,000 |
| Utilities | $250 |
| Insurance | $250 |
| Transport | $200 |
| Food | $500 |
| Socialising | $500 |
| Entertainment | $200 |
| Gifts | $100 |
| TOTAL | $3,000 |
Houston, we have a problem. My monthly spending is $3,000, but my paycheck is only $2,500.
This is why you need a budget. If you weren’t keeping track of your finances, you could survive at this spending level thinking everything was fine, but it wouldn’t be setting aside enough for rainy days or paying the tax bill. It’s obvious that action needs to be taken, either searching for more work, or cutting down on expenses. Something has to give.
In this case, expenses could be cut down by $500 if you limit some of the socialising and entertaining. Paychecks stays the same, and expenses are trimmed to $2,500. However, just covering regular monthly costs is not enough. You will want to have some savings put aside for emergencies, debt, retirement, as well as major life events like weddings and holidays… which leads us into our next section.
MAKE WORST-CASE PROJECTIONS
We’ve looked at both income and expenses now, but only in the past. A budget is a forward-looking document, making projections into the future and helping you estimate how much you’ll make next month or three months from now. In this step, you will use the information you have gathered so far to make some projections into the future.
Again, Sole Accounting App can help you budget and forecast, but if you’re still doing it old-school, Andrew recommends using an Excel spreadsheet with the example below giving you an idea of how to lay it out. Andrew has done it month by month, listing income and expenses in the past (shaded grey), and the same items projected into the future. There is a separate column where he tracks actual income and expenses for the current month. When the month is over, he’ll copy those numbers and over and start fresh for the next month.
Example: Freelance Budget – Spreadsheet
Income is projected for the coming months, entering the dates when you think payment will come in, and assuming the worst. For example, Andrew is completing a $1,000 assignment for Client 3 in May, and expect to get paid about a month later. But to be on the safe side, he is putting it in the budget for July.
By looking at the projections, you can see that you’ve got May covered, but will need to hustle to bring in more income for June and July.
PLAN FOR ONE-OFF ITEMS
You’ll also notice that the “expenses” category includes a couple of extra lines, for “Vacations” and “Major one-off items”. This is where you plan for holidays (because trust us, you will need one), and other big expenses that don’t fit in the regular categories.
Because these items fall out of the regular budget, you will need to save up for them. You can do this with an emergency fund. In personal finance, people usually talk about an emergency fund as being for things like your roof caving in, but it could also cover fun stuff like unexpected invitations to holidays on the other side of the globe.
For this to work, you’ll need to save a some extra dollars each month to add to the emergency fund. Based on the expenses calculated above, we’ll budget $6,000 for the emergency fund, so that’s an extra $500 a month. You might want to put aside another $500 for future savings (debt, retirement, being too ill to work), so you need to aim to increase average monthly income from $4,000 to $5,000. This way you can still pay yourself a $2,500 paycheck and cover the tax bill, but you’ll also have enough left over to pay off debts, build up an emergency fund, and have long term savings.
DIVERSIFY
This is not something you hear very often in the context of budgeting, but Andrew has found it to be absolutely essential. Getting regular work from one client is fantastic, but what happens when you lose that client? When companies need to cut costs, the freelancers are often the first to go. Unlike with regular salaried jobs, there’s no job security, no compensation, no notice period (unless it’s a very regular job and it’s specified in your contract).
If that job represents 90% of your income and you get the dreaded “We’re sorry but..” email, you’ll most likely go into full-scale panic mode. Your bills will still be piling in, but now you’re going to have a fraction of the income. This is where diversification comes into play. You should try and diversify your freelance income stream among a few regular paying clients. Try not to let any single client account for more than 50% of your income.
That way, if you get the ‘Dear John’ email, it will suck – but not be vertigo-inducing. You’ll still be able to pay the rent and other essential expenses while you search for more work to replace the contract you lost.
STAY ON TOP OF THINGS
With your financial position as a freelancer so unpredictable, you need to keep on top of your incomings and outgoings and know where you stand each month. If you have a nice juicy emergency fund set aside and are pulling in a regular income that allows you to cover your regular expenses and add to your savings, then you can afford to be more hands-off. But if you’re depending on getting new work each month to cover your rent and pay down debt, you’ll likely find yourself glued to that spreadsheet or app more often than you’d like.
No matter how much time you spend, the key thing is to record every item of income (you’ll need to do that for tax purposes anyway), and have an accurate view of your expected expenses. Then monitor regularly to make sure that you have enough coming in to pay your paycheck, and that the paycheck covers all your expenses.
NEXT STEPS
Just keep in mind the most important principles:
- Pay yourself a regular paycheck.
- Have a realistic grasp of your costs.
- Make projections, and assume the worst.
- Don’t forget to plan for taxes, vacations and emergencies.
- Diversify your income as much as possible.
- Keep everything updated, so that you know exactly where you stand.