I want to introduce you to a new way of thinking about how much money you make. It paints our incomes in a more realistic light and hopefully inspires you to make more frugal choices. Our personal financial situations can often be improved just by having a realistic understanding of where our money is going. Just as I advocate a personal financial statement instead of a budget for monitoring spend, I think calculating your discretionary dollars per hour is superior to gross income as a measure of “how much you make”.
I think it’s easiest to illustrate with an example, so let’s calculate discretionary dollars per hour for Samantha Hypothetical.
When asked how much she makes, Sam thinks immediately of the salary she earns at her entry level accounting job. It’s obviously way too taboo to say out loud, but in her mind she thinks “$60,000”. We use salary as a baseline way of deciding how much to spend on certain things. Rules of thumb have sprung up telling people they should spend 30% of gross income on housing and 10% on a car.
Even though the rules of th(d)umb don’t take into account her personal situation or future goals, Sam accepts them because they are easy and other people are doing it. So she rents a $1,500/month apartment downtown and finances a $30,000 Camry over 5 years, making $500 payments every month.
Where she’s at so far
Sam has been using her gross income to figure how much she can spend, but before we go any further we need to take out those pesky items that come out of her pay before it reaches her bank account – taxes and insurance.
Sam is single and living in the bustling metropolis that is Omaha, Nebraska. She pays $5,500 in federal income tax and $1,500 to the state. And don’t forget social security, that’s another $3,800. After taxes her annual income is $49,200.
Insurance and 401k
Sam has most of her health insurance covered by work, but ends up chipping in $100 a month. She also follows another rule of thumb, and puts 10% of her pay aside for her 401k. Great job Sam! After these items ($7,200) she is left with $42,000 of annual take-home pay. She “spent” 30% of her gross income and she’s not even living life yet!
Going forward in the example it’ll be easier to think about Sam’s spending in monthly terms, so let’s also use her monthly take-home pay – $3,500 ($42,000/12).
The Big Ticket Items
Before she does anything Sam needs to secure a roof over her head and wheels to get her to work. She followed the rules of dumb to a tee and every month, automatically, $1,500 goes out of her bank account for rent and $500 for a car. This leaves her with $1,500 to spend on other things.
Other Fixed Costs
It’s amazing how many expenses Sam has that are paid automatically every month. She’s got a $100 cell phone bill, another $100 for internet/Netflix/Hulu/Amazon Prime, and another clean $100 for utilities (water, gas, and electric). She also carries comprehensive insurance on her new car, another $100 a month coming out without a thought.
Sam worked summer jobs and internships all through college and avoided the huge student loans others her age are burdened with. School wasn’t free though, and she does have $200 in minimum loan payments every month.
That’s a total of $600 in fixed spending every month. After these come out she still has $900 left.
Not fixed, but unavoidable
Ok so Sam’s automatic spending is all taken care of, but she still has some basic needs that haven’t been met yet, I mean, she’s gotta eat. She prepares a lot of meals at home and usually packs a lunch, which equates to $400 a month at the grocery store. She also needs to fill up her Camry with gas twice a month, another unavoidable $50. Additionally she has all the basic small necessities to pick up: shampoo, laundry detergent, etc. On average this is another $50 a month, bringing her total not fixed but unavoidable costs to $500 a month. She is now left with $400 a month. Let’s jump back to an annual look; after all her monthly living expenses Sam has $4,800 remaining.
Sam’s family lives in Georgia, so twice a year she travels home for a visit. There isn’t a cheap option flying from Omaha to Atlanta, so she typically pays $400 for each trip, or $800 total.
She works in a corporate office and needs to keep up appearances. In a year she spends $1,000 on clothes, makeup, haircuts, and dry cleaning to maintain a professional look.
Sam has a great family and group of friends. She is invited to birthdays, weddings, and one of her visits home every year is for Christmas. She spends another $1,000 buying gifts and going out for special occasions.
After annual unavoidable costs Sam is left with $2,000.
Because of the way she has designed her lifestyle, Sam has $2,000 to spend as she sees fit. This sounds like a decent amount, but keep in mind Sam is yet to go out for a meal, take a vacation, go to a concert, buy a new phone, or do anything fun and spontaneous. She also may have to cover an emergency that comes up, be it a broken t.v., flat tire, or medical expense.
To cover all these things Sam has $2,000. To calculate her discretionary dollars per hour we now have the numerator, but we still need a denominator. For simplicity, let’s use 2,080 as her hours worked. This is 52 weeks times 40 hours a week.
Sam’s gross hourly pay is $28.85 ($60k/2,080). But her much more relevant discretionary dollars earned per hour is $0.96 ($2k/2,080).
Think about that a moment. Sam has a great job, lives in an inexpensive part of the country, follows all the financial rules of thumb, is by all accounts very responsible, and still her discretionary take-home pay is only 96 cents an hour.
What does this mean?
It means when framing the decision to treat yo’ self on small luxuries you need to consider the actual cost in terms of your time. When Sam buys the new Fitbit for $300 it feels like a very small cost. I mean she makes $60,000, what’s the big deal about $300? The big deal is that she doesn’t take home $60,000. Her paycheck might say she makes $28.85/hr but really we know she only makes $0.96/hr of discretionary income, and a Fitbit is definitely discretionary spending.
Add in sales tax and Sam has to fork over $321 for that Fitbit. This accounts for 334 hours’ worth of discretionary earnings ($321/0.96). At quick glance it feels like an affordable luxury, but really Sam is trading 2 months of work for a Fitbit. 2 months!
How does it affect you?
I’m not saying don’t buy Fitbits or do anything fun ever. I’m merely advocating that you take the time to figure out where your money is going. It is worthwhile to spend the time calculating your discretionary dollars per hour in order to inform your spending decisions.
Maybe it is completely worth it to Sam, or you, to spend 2 months at the office in order to buy a Fitbit. In that case go nuts! Going through these calculations though will help you understand what is left over for luxury spending after you’ve taken care of everything else. It will inform your decisions and help you make choices that align with your situation and goals.
What to do about it
Calculate your discretionary earnings per hour. Do it! It will change your life. Follow the example of Sam, but substitute in your own numbers.
What if I don’t like the result?
You likely won’t, it’s depressing. This exercise also shines a spotlight on a major pitfall of budgeting; it doesn’t have a big enough impact. A popular thing to do to save for the Holidays is to have a No Spend November, aka crash budget.
If Sam were to commit to a No Spend November she would lock in a month of having absolutely no discretionary spending. She wouldn’t go out, or order in, or do anything. She would abide by the total deprivation that is a budget and save $167 for her trouble. Not too shabby!
Conversely she could live in an $800/month studio apartment instead of her downtown loft and drive a used car with no loan instead of a financed new car. This would cause her to save $1,200 a month every month. This not only crushes the $167 saved through deprivation, but it’s easier and recurring.
The problem with budgeting is that it feels hard but offers little in the way of results. The better strategy is to reduce the fixed and automatic costs in your life and give yourself a raise! Don’t focus on your gross hourly wage, instead key in on your discretionary hourly wage. It’s much more meaningful and you actually have control over it.
Once you reduce fixed costs and raise your discretionary income you can better align your spending with your actual values. You can choose to spend your increase in earnings or sock it away for future you. The key is avoiding rules of thumb when making financial decisions and taking a more active role in your financial life. Having the right information allows you to make impactful decisions instead of feeling trapped by circumstance.
It is a lot harder to reduce fixed and automatic spending, that’s why people try to simplify it by using arbitrary percentages – 30% of income. I mean no one tells you to spend 1% of income on coffee. But when trying to save, coffee is one of the first things people go after. We’ve all heard the advice to “drop your $5 latte and save $150 a month”. That tip is easy to say and easy to implement.
A lot more difficult, and a lot more effective, would be to move to a smaller apartment and save $150 a month that way. It’s much more cumbersome up front, but more effective in the end. The latte deprivation causes us to make a daily choice to deny ourselves. Moving, however, takes away the need for daily self-restraint. Once we’re in our new place and settled we are unlikely to contemplate moving every day.
I hope you take the time to calculate your discretionary earnings per hour. If you need help or have any questions give me a shout. If you do go through the effort, let us know what you learn. Thanks for reading, and as always, live in a small house and drive a small used car.