How to Conduct an Annual Budget Review (and Why You Should)

What better way to start the new year than with an annual budget review? Reviewing your budget is a relatively quick and simple exercise that will pay dividends throughout the year in saved time, effort, and frustration.

I use YNAB (You Need a Budget) to map out my spending and saving plans and consider it a valuable and integral part of my money management system. While the process I outline below makes regular mention of the YNAB software, you can apply the same steps to whatever budgeting method or financial planning software you use.

If you’re not using any type of budget and you don’t have any sort of established system for planning and managing your household and/or small business finances, it might be time to hire a money coach.

What is an Annual Budget Review and why should I do one?

An annual review is not about analyzing last year’s spending.

An annual budget review is about examining and reflecting on the effectiveness of your budget, evaluating the value it adds to your money management system, and ensuring it’s optimized for the coming year.

Think of it as part New Year’s resolutions and part spring cleaning.

An Annual Budget Review is a valuable exercise and all of the steps deserve your attention — no matter how large or small your budget and no matter how formal or informal your budgeting system. Ideally the process will provide valuable insights, expose inefficiencies, and inspire new ideas.

Three Stage Evaluation Process

There are three stages or areas of inquiry that each budget category (or budget line item) will be subjected to during the review process.

1. Top Level Categorical Evaluation
2. Top Level Practical Evaluation
3. Evidence-Based Reality Check

I strongly recommend that you address each group of questions to each category over the course of the review but the order of inquiry and the process you follow can be adapted to fit your individual time and energy availability and your personal work style.

The only wrong way to conduct an annual review is to not do one.

Stage 1: Top Level Categorical Evaluation

The first stage or area of inquiry evaluates the relevancy of your categories from a holistic or meta perspective. Don’t get mired in details or specifics at this point.

Is this category still relevant?

• Is this an expense that will carry on in the coming year or does the category reflect a closed chapter in your life?
• Does the category still reflect your values or priorities?

Is the category still serving you well?

• Is the category’s purpose clear?
• Should it be combined with any other category?
• Is it properly named?
• Is it in the right order among your list of categories?
• Is it included the right category group?

Lives and needs change over time so it’s natural for your budget categories to change as well. So too, practice and experience with financial stewardship and budgeting will inevitably lead to changes in the structure, language, and layout of your budget.

Whether it’s an event of your own making or one completely beyond your control… and whether it’s a positive, happy change or an unwelcome one, Stage 1: Categorical Evaluation is intended to focus your attention on each individual category in order to evaluate the relevancy and value each one brings to your planning process. If a category isn’t helping provide clarity or intention, if it’s a distraction or creates confusion, if it interferes with your budgeting workflow, make a change. Rename the category, archive it, merge it with another category, move it to a different category group — do whatever you need to in order to improve the efficiency and value your budget brings into your life.

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Events in 2020 led to some significant changes in the 2021 Harden Household budget. For example, we made our final mortgage payment in September last year so our Mortgage category is obsolete (yay!). But now our homeowner’s insurance policies and our property taxes, previously held in escrow and paid by the bank, are our direct responsibility. So new categories were required.

Stage 2: Top Level Practical Evaluation

Next, shifting to a more detailed and pragmatically-focused vantage point, it’s time to circle back and take a second look at each of your budget categories.

Will this expense be different in the coming year?

• Did the premium change?
• Will inflation or other market changes effect the price?
• Will changes in behavior or needs affect this expense?

Since the main goal of a budget is to anticipate and plan for upcoming expenses — expected and unexpected — and to proactively strategize how you’ll absorb and address them, Stage 2: Practical Evaluation is focused on anticipating and estimating (quantifying as much as possible) changes that lie ahead.

Depending on the nature of the category — fixed or variable expense, monthly bill or sinking funds, mandatory or discretionary spending — the specific variables you evaluate may vary but each and every category should be addressed.

An annual budget review is an exercise in which you examine and reflect on the effectiveness of your budget over the past year and evaluate the value it added to your money management system.

The easiest, most obvious place to start stage 2 is to look at fixed monthly expenses like HOA fees, insurance premiums, internet and phone contracts, etc. Not all premiums, contracts, and agreements reset in January, of course, and inflation and market forces can be sudden and unpredictable. But the beginning of the year is a good time to pause and survey the horizon.

In addition to premiums, subscriptions, annual fees, etc, you should also consider smaller or more personal changes. Will there be changes in your family dynamics — marriage, new kids, growing kids with growing appetites and growing needs? Any chance you’ll move or change jobs or buy a new car? Have you been thinking about adopting a pet or starting a new hobby?

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My health insurance premiums always change in January, as do Fang’s Medicare supplemental plan premiums. Contribution limits on IRA and HSA accounts change annually so monthly allocations need to be recalculated. The cost of renewing our car registration will go down as our car ages but our property taxes and annual trash bill inevitably increase each year.

Additionally, as a result of the Covid-19 pandemic, I shut down my office space and moved all of my client contact online. And Fang is facing serious health issues. So while I focus on care-giving and work and we protect our health by continuing to shelter in place, all of our shopping and errands will be done by our younger child and their partner. This means that many of the day-to-day non-fixed spending shifts we experienced in 2020 will continue for the foreseeable future.

Stage 3: Evidence-Based Reality Check

In the final stage of your Annual Budget Review you’ll look back at past activity and make necessary adjustments for the coming year.

I recommend that this be the final step in your evaluation process — whether you walk each category in turn through all three stages before moving on to the next category or you walk your entire budget through a single stage before moving to the next stage.

Is your system maximized for accuracy and efficiency?

• Does the category have a target or goal?
• Is your allocation intention clear and easy to follow?
• Is your logic logical?
• Can you defend the premise (of the target/goal) and remember the purpose (of the category)?

Are your allocations based in reality?

• Are your allocations realistic?
• Are you engaging in self-sabotage, self-delusion, or wishful thinking?
• Are you harboring underutilized dollars?

Stage 3: Evidence-Based Reality Check is the most granular and detailed of the annual budget review. And unlike the other stages which are both forward-focused, here you’re looking back over past activity. Bear in mind, the point is to increase the accuracy, and therefore the efficiency, of your upcoming budget allocations, not to dig into the details of past activity. Don’t let yourself get distracted or mired down in minutiae.

A non-negotiable and fundamental financial tenant of personal finances is that you must spend less than you earn. Therefore, a vital part of a budget review must include an audit of whether your projections aligned with reality. Over the past year, if you consistently underestimated costs or overspent in categories, you inevitably spent time and energy playing Whack-a-Mole to bring your budget back into balance. On the other hand, there’s nothing to be gained if you build oversized surpluses in little-used or low-priority categories.

If you’re a YNAB user, this stage of your review will make heavy use of the Inspection Pane (the right side column on the Budget screen). In particular, you’ll be analyzing two lines: Average Budgeted and Average Spent. If you’re using some other budgeting application or method, a little data mining and manual calculations might be required to gather the necessary information for this stage of the review process.

Were your projections in-line with reality or were they wildly unrealistic? Also, as you make plans for the coming year, can you make sense of your original plans and intentions back in January 2020? A year from now when it’s time for your 2022 review, will the plans and intentions you’ve just now created still make sense?

If you use a different budgeting application or are more of a back-of-an-envelope budgeter, the concept still applies: are your categories clearly defined, do you know what your targets and/or goals are, and is there logic behind those targets, and will you remember you logic six months from now?

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My Durables category, which I define as any household good I expect to last longer than twelve months and which had previously averaged around $45 per month, was much more active in 2020 than I’d anticipated.. I baked. I bought cloth face masks. I replaced a broken toilet seat, bought two fire extinguishers, and replaced our bath towels. I hung up clothesline when my clothes dryer broke in April. And when my beloved 60-year-old KitchenAid stand mixer crapped out, I bought an electric hand mixer. In short, 2020’s shenanigans resulted in a nearly $20 monthly shortfall (average budgeted $48.89 while my average spent was $67.47). Since I don’t know what 2021 will bring and since I know from personal experience that it’s important to me to be able to replace durable goods wherever and whenever I deem it necessary, I decided during my annual review to increase my monthly allocations to match 2020-level spending. If my average spending drops, I’ll be able to build a buffer for Durables but if it stays high, I’ll have reduced the odds I’ll spend time and energy every month finding money to cover overruns.

On the other hand, my Fitness & Well-Being category tells a different story. This is a small discretionary category for non-medical, non-bicycle-specific garments, gear, and gadgets. In January 2020 I set a monthly funding target of $20 based on 2019 spending. Then the pandemic hit and life happened and I ended the year with $0 average spent and a $172 carried balance. Should I leave that money untouched or could it put to better use elsewhere? Durables, for example. Should I adjust my monthly target or leave it at $20 per month? I considered whether I had deferred any fitness or well-being spending in 2020, the most I’d spend on any one purchase at any one time, and how much a monthly target would strain my total monthly obligations vs my anticipated income.

Documentation is Everything

“Saving time by taking time” is a life lesson I continue to struggle with even after 56 years. Believe me when I tell you, taking the time to leave yourself a trail of notes documenting your thought process and logic during the review exercise is everything.

In my many years as a YNAB user I’ve developed my own shorthand or nomenclature for category-name hints — a combination of symbols, numbers, and dates. Category name notations serve multiple functions: they help me make quick allocation decisions, reassure me that my targets/goals are fact-based, and save me from expending unnecessary energy rethinking my logic (I’m a notorious self-doubter and double-checker).

In addition to my category-name notations, I also make liberal use of the Notes field at the bottom of the inspection pane. This is a good place to document the logic behind monthly budget goals or category targets. It’s the math class equivalent of “showing your work.”

These same documentation principles can be applied to whatever budgeting application or method you use — whether it’s a spreadsheet, a bullet journal, or a software application. If you invest time and energy into performing an annual review of your budgeting system, take the time to document the reasons for your adjustments and plans for the coming year.

Putting it all together

In the screenshot below, you can see an example of the interplay between all of the various elements of an annual budget review.

The category in question is Kids Activities & Supplies 500.

Stage 1 evaluation is easy here – the specific types of expenses in this category have changed quite a bit over the years but it has served me well and it continues to have relevance. Even though our children are grown and gone, they continue to be one of our highest values and priorities if one of our smallest, least frequent expenses.

Stage 2 evaluation is only barely relevant. This is not a fixed expense nor is it a category heavily impacted by inflation. Expenses in this category tend to be highly situational and therefore not predictable. For this type of category, I prefer to keep an earmarked envelope of “cash” on hand. You’ll sometimes see this referred to as “sinking funds.” The “500” in the category name is a note to myself to cap the balance at $500. You can see that I don’t have a monthly target noted in my category name nor do I have a YNAB Goal set up for this category. Instead, I decide each month how much to allocate based on the category’s carried balance and how much money I have left over after funding other things.

Stage 3 of the review is where things got interesting. You can see that an examination of the data in the inspector pane revealed a large discrepancy between my Average Budgeted [$24.52] and Average Spent [$42.23] over the last 12 months. I was able to absorb such a large monthly difference because I’d started 2020 with a $500 carried balance. A quick look at my spending history for this category revealed that the COVID-19 pandemic had reawakened an otherwise dormant category. Our son and his partner took over all of our shopping and errands in March and, in gratitude, we paid for a few things to express our appreciation. I bought them a Costco membership so the could keep us stocked with frozen salmon and Fresca flour tortillas while picking up my prescriptions. After dealing with a dead battery, we paid for a battery-powered jump-starter doohickey. And we paid his annual auto registration fee since almost all miles driven in 2020 were done for us.

Finally, you can see how I’ve used the Notes field to document the evolution of this particular category over the years as my children have grown, gone to college, and become independent. In order to preserve the past context and logic of a category, I prefer to add to my notes rather than overwriting them.

In Conclusion

As a budget geek (personally) and a budget coach (professionally) I’ve made a regular habit of conducting a comprehensive Annual Budget Review in January and a quicker, less extensive review again around mid-year. I’ve found that an Annual Budget Review forces me to both view my budget holistically and consider elements in isolation that I otherwise don’t in my day-to-day budgeting activity.

Whatever your budgeting method — whether you’re a YNAB user like me, have a series of bank accounts, or maintain a paper spreadsheet — planning and managing your household and/or small business finances can be a delicate balance between shortcuts, routine, and automation on the one hand and intention, attention, and responsiveness on the other. Striking and maintaining this balance is an iterative process: plan, implement, evaluate, adjust, and then begin again. An Annual Budget Review is a critical element in maintaining your money management system. Don’t skip it.

[Friendly reminder from your favorite money coach: January’s a great time to pull your first credit history report of the year.]