When I was at Virginia Tech, their football team’s defense was a sight to behold, particularly their special teams. They blocked more kicks than anyone else in the country, enough that we were almost surprised when the other team managed to get a kick off. Very often, blocked kicks became immediate scoring opportunities. I even saw them intercept a two-point conversion attempt and run it back for a safety.

And on one particular day, the defense and special teams were in full force, working the magic we had come to expect of them. Except there was one problem: the offense didn’t show up.

Despite the sacks and despite the blocked kicks, they weren’t putting points on the board because they couldn’t do anything on offense. As one announcer said, “Special teams will only get you so far.” And Virginia Tech lost that game.

In personal finance, people who only play defense can expect to meet a similar fate. Steve at Brip Blap has often written about the importance of expanding your means, and I agree with him.

Most people focus purely on reducing spending. That’s financial defense. It’s critically important (and most people are losing that game), but it’s not the only game. There’s also the often ignored game of financial offense, or earning more than you spend, rather than spending less than you earn.

One of the most popular bits of financial wisdom is to keep your eye on the Latte Factor, which is the tendency for small purchases to add up unnoticed over time. And it’s good advice. By controlling your small expenses and investing the money you save, you can end up with lots more money than you would otherwise, perhaps a difference of millions of dollars over a period of decades.

I’m not knocking this at all. I think frugality is the most important key to financial independence. In Where Have All The Dollars Gone?, I talked about the method I used to plug my financial leaks early on, basically just keeping extremely close tabs on the Latte Factor. But there are some problems with only playing financial defense.

In The 4-Hour Workweek, Tim Ferriss says:

“This book is not about saving and will not recommend you abandon your daily glass of red wine for a million dollars 50 years from now. I’d rather have the wine. I won’t ask you to choose between enjoyment today or money later. I believe you can have both now. The goal is fun and profit.”

When you save money today in hopes of spending it later, you’re deferring a lot of your enjoyment to a future date that may never arrive. You might not live that long. Or the economy might collapse (I don’t mean a stock market correction, but something like the dollar no longer being accepted as currency). It doesn’t make sense to put all your chips on something that may or may not ever happen.

Another thing is that you quickly run into diminishing returns. The more you save, the harder it becomes to save more. You can cut out the frivolous expenses pretty easily. Then you can use some self-discipline to live below your means. But when you’re spending several hours a day looking for coupons, you have to ask yourself if it’s worth it.

Another thing is that by trying so hard to reduce your expenses to zero, you’re cutting yourself off from life. If your goal is to sit perfectly still to minimize the energy you use, oxygen you breathe, heat you generate, etc., then what good are you? Why invest so much effort into being a bump on a log?

To be fair, increasing your income is easier said than done, and I’m not going to propose how to do it in this post. I’m just suggesting that you develop both your financial offense and defense. Control your expenses, yes, but instead of trying to be totally passive to minimize your consumption, work on maximizing your output. Create value, make money, boost enjoyment, engage in life.

Photo by Stacey Lynn Photography

Photo by action datsun

“Where have all the dollars gone?
Long time passing
Where have all the dollars gone?
Long time ago
Where have all the dollars gone?
Gone to Starbucks, every one
When will I ever learn?
When will I ever learn?”

- Pete Seeger, “Where Have All The Flowers Gone?” (paraphrased)

To balance your household budget, you have to be able to accurately track your expenses. So you might make a spreadsheet listing your taxes, 401(k) and IRA contributions, mortgage, insurance, food, utilities, etc., and add them up to find your total expenses. When you see that your expenses are less than your income, you breathe a sigh of relief. You’re in the black! Or are you?

There’s an invisible force wreaking havoc on many household budgets, turning black ink to red ink and vanishing with hardly a trace. They call it The Latte Factor. David Bach, author of The Automatic Millionaire, coined this term to refer to our many small expenses that add up to large amounts over time. A coffee here, a magazine there, and before you know it, you’ve spent a staggering amount of money without realizing it.

When I finished school and landed my first job, I whipped up a spreadsheet to track my expenses. I entered every expense I could think of, and they all added up to less than my salary, so I thought I was running a profit. And yet, that didn’t seem to be the case when I saw my bank account balance dropping every month. On closer inspection, I found that I had missed $600 of monthly expenses in my spreadsheet.

I decided that I needed a better system to see where the dollars were really going. I needed two spreadsheets, one to track my budget (a high level view of where my money was going), and one to track my expenses (the amount I was actually spending). Open up the sample worksheets Budget.xls and Expenses.xls, or follow along with the HTML versions at the bottom of this post.

These are hypothetical numbers for a single person. I have no idea if they’re reasonable, but they’ll get the point across. Of course, you’ll need to replace them with your own numbers.

First let’s look at Budget.xls. At the top we have our monthly salary of $5,000. Then the monthly expenses are split into two parts. The first part consists of our fixed expenses. These are things that are fixed in the short term, like taxes, mortgage, and insurance. (I also put 401(k) and Roth IRA contributions here. While technically not fixed, everyone should strive to max out on these). Everything is expressed as a monthly value regardless of how frequently the bill is actually paid.

The second part of the expenses consists of our variable expenses. These are the discretionary expenses that vary according to our spending habits each month: electricity, food, gas, etc. I like to separate these from the fixed expenses because we have control over them in the present moment; every day we make choices that determine our variable expenses. To estimate them, just take your best guess based on your most recent bills.

Now you see the problem. The expenses we’ve entered here are not everything we’re spending. We’ve forgotten all the lattes, scones, movie tickets, etc., and maybe a few big expenses such as car maintenance.

That’s why we have a line item called “Miscellaneous.” This is a magical fudge factor, defined as all variable expenses not already listed, which is $346.16 in this case. Let’s come back to this later. For now, just assume that $346.16 is correct.

Now we can calculate our total expenses, and by subtracting expenses from income we see that we have $85.51 left at the end of the month. Had we not accounted for The Latte Factor we would have come up with $431.67. Our $85.51 may be less encouraging, but it’s much more accurate.

In addition to seeing how much money is left at the end of the month, we might like to see what percent of our income we’re saving. Our investments here consist of a 401(k) and a Roth IRA, and I assumed a 401(k) match of 5% of our salary (if you want to get technical, the 5% 401(k) match should be counted in the Income section at the top, but we won’t do that here). This works out to us investing 39.2% of our income. (At this point I’m seeing that these numbers aren’t realistic, but like I said, they’re just hypothetical numbers to make a point.) Considering our investments plus the $85.51 we have left at the end of the month, we’re saving 40.9% of our income.

Now, back to that magical fudge factor, the $364.16 in miscellaneous expenses. Where did we get that number from? That’s what the expenses spreadsheet is for.

Open up Expenses.xls. This is a list of our monthly variable expenses over the last 12 months. We want to look at the average over the last 12 months to smooth out any anomalies such as holiday spending. To find your expenses for a given month, just look at your checkbook. Add up every check you wrote and every electronic debit you made during that month, but don’t count fixed expenses like your mortgage payment.

Expenses.xls tells us that our average monthly variable expenses are $836.16. Now look at Budget.xls. If we did our budget perfectly, the variable expenses we listed would add up to exactly $836.16. But of course, there’s no way we accounted for everything. Surely we missed some things, and that’s why we need to set the miscellaneous expenses to [$836.16 - the variable expenses we've accounted for = $364.16]. It’s set up as a formula in Excel, so it will automatically update to reflect any changes we make to our expenses, and the total expenses will come out exactly right. That’s why I called it magical.

Now Budget.xls accurately reflects how much money we’re spending, only we don’t know exactly where the $364.16 in miscellaneous expenses is going. But if we think about it and realize that we spend $150 a month on lattes, we can add a new line item for lattes, and then the miscellaneous expenses amount will automatically drop to $214.16. The closer we get the miscellaneous expenses to $0, the better we can see exactly what we’re spending money on, but the “remaining income” value is accurate no matter what.

After I got my budget under control, I eventually stopped tracking my expenses so carefully, and I haven’t used these spreadsheets in years. However, back when I was bleeding red ink and not knowing why, I found this system to be very helpful in answering the question: Where have all the dollars gone?

Budget.xls

Important: the “miscellaneous” line item is determined by setting up an Excel formula to calculate [average monthly variable expenses - those variable expenses already listed]. The value for the average monthly variable expenses comes from the expenses spreadsheet.

Expenses.xls

(Excluding fixed expenses)

(This post appeared in Carnival of Personal Finance #142 – The Homeless Edition, hosted by The Bag Lady.)