10-10-80 principle

Summary: Creating a viable budget requires mathematical analysis.

The word “budget” originally meant a small pouch. By the end of the sixteenth century, people used the word to refer to the contents as well as the bag. The connection with finance dates back to at least 1733. In general, a budget is a balanced plan for spending and saving that includes expected incomes and expenditures. Individuals or families use budgets to manage earnings; pay bills; save for events like retirement, college, or vacations; and to plan for large purchases like a car or a home.

Businesses manage revenues and expenses for materials, taxes, advertising, and payroll using budgets. They may also have smaller budgets for individual projects. City, state, and national governments use budgets to distribute incomes from taxes and other sources among expenditures like infrastructure, social programs, national defense, and debt. Mathematicians play a large role in developing mathematically sound budgets at all levels, especially accountants and actuaries. In the past, budgeting in classroom settings was confined largely to home economics classes, but now budgeting activities are often used to teach various mathematical principles in context.

Some budgets are created using known amounts. Other times, the values are forecasts of income or expenditures based on data or mathematical models. Budgets themselves can also be used for modeling and production. For example, a static budget is a fixed budget created before any input and output values are known, while a flexible budget can be adjusted based on information about actual activity. A metric called “flexible budget variance” compares flexible budgets to actual results to determine the effects of economic variables on business operations. Sales volume variance compares flexible budgets to static budgets to determine the effect a company’s activity had on its operations. Budget accuracy ratios also quantify differences between various budgets or actual production. These can be used to create more accurate future budgets and to plan operations. Budgeting concepts can also apply to resources other than money. Lisa Sullivan, a senior budget analyst working for the U.S. Department of the Navy, regularly uses algebra, statistics, mathematical modeling, and operations research to explore resource allocation problems that affect budgeting. She often works on unique mathematical problems that do not occur in private industry, such as determining the optimal number of Navy surgeons needed in wartime.

Budgeting Basics

Creating a spending plan can be complicated; however, the easier the plan, the more likely it is to be followed. One of the simplest budgets used is the 10-10-80 principle. John D. Rockefeller, the first person in the world to amass a fortune of $1 billion and the wealthiest American ever when adjusted for inflation, is reported to have used the 10-10-80 principle. The crux of the principle is simple: give 10% of your earnings to charity, save 10% of your earnings, and live on the remaining 80%.

Anytime you receive income (for example, paycheck, gift, or prize), first multiply that amount by 10%. Finding 10% of an amount is a relatively easy process: move the decimal point to the left one place value. For example, if you received earnings of $342.57, multiplying by 10% would yield $34.257 (rounded to $34.26). Based on the 10-10-80 principle, you should first give $34.26 away to charity. Many people donate this money to religious institutions or charities such as the Red Cross or the United Way. One argument for giving, besides being altruistic, is to show ourselves that we have control of our money. By freely and willingly giving some of it to others instead of tightly holding onto it, we gain confidence that we have enough and can therefore live on what we are given.

The next 10%, or $34.26 in this example, is given to yourself into some sort of savings vehicle like a savings account or a money market fund. Ideally, this money is never needed as it becomes part of your long-term savings. This money may go toward retirement or an emergency fund in case of job loss or major disaster. Many people are tempted to use this long-term savings for expenses like taking vacations, buying a car, or replacing an appliance. However, these foreseeable expenses should be budgeted as part of the remaining 80%.

Once you have given 20% of your income away (10% to others and 10% to yourself), the remaining 80% can be used for living expenses (including short-term savings). How that 80% is spent can vary depending on many factors including how many people are being supported (for example, you do not need to buy as much food for a single adult as you do for a family of five). Usually the biggest expenditures are for housing and transportation.

Combined, these two categories should not account for more than 50%, or half, of your income. Of course, the less you spend on these the more you have to spend on other areas. Housing, by itself, should account for less than 35% of your income. In the previous example, 35% of $342.57 is $119.91. Set aside this $119.91 to cover any housing expenses you have.

Housing expenses include not only the obvious rent or mortgage but also utilities (heat, electric, plumbing, sanitation, telephone, and Internet), insurance, property taxes, and property maintenance (property maintenance is usually about 5% of the property value each year).

If housing and transportation together should be 50% (or less) of your income, then 15% should be used on transportation. In the example, 15% of $342.57 is $51.39. This amount becomes earmarked to cover all transportation expenses. These expenses include car payments, insurance, license, gasoline, parking, and maintenance (car maintenance is usually about 10% of your transportation costs).

If you spend 50% of your income on housing and transportation, this leaves a mere 30% for everything else. If you have been spending more than you earn, you probably have credit card debt or other personal debt. Ideally, your debts (not including housing or transportation debts) do not account for more than 5% to 10% of your income. What remains should be used to pay for food, life insurance, medical insurance, medical and dental expenses, clothing, entertainment, short-term savings (for vacations and replacement costs), and other miscellaneous spending.

Bibliography

Johnson, Kay. The Mathematics of Budgeting: Mathematics for Everyday Living. Erie, PA: Meridian Creative Group, 1999.

Joshi, Mark. The Concepts and Practice of Mathematical Finance. 2nd ed. Cambridge, England: Cambridge University Press, 2008.

Shim, Jae. The Art of Mathematics in Business: Analyzing Facts and Figures for Smart Business Decisions. Sterling, VA: Global Professional, 2009.