There are three steps to creating a budget: 1) identify how your money is currently being spent, 2) evaluate that spending to see if it meets the financial priorities you specified in Lesson 1, and 3) track your ongoing spending to make sure it stays within those guidelines (or to understand how your budget needs to be revised).

If you happen to use Quicken, Microsoft Money or other such software, you're in luck. These programs generally make it easy to draw up a budget and monitor compliance.

In Quicken, for example, every time you make a deposit, write a check, pay a credit card bill or dispatch an electronic payment you are asked to assign it to a particular category, such as "salary," "clothing," "groceries," "child care" or "health insurance." You can also create subcategories, dividing "auto" expenses into "fuel," "insurance" and "service." The program comes with a set of categories that handle most of the basics. You can edit the list to create categories that make better sense for your particular household. And if you're away from home, you can track expenses at the Quicken website and then download the transactions to your hard disk later.

The drawback, of course, is that entering and categorizing all of your income and outflow is a truly tedious chore. (If you don't believe it, try tearing apart the multitude of individual expenses on a fat credit card bill.)

You can reduce the tedium to some degree by judicious selection of categories. Let's say you are only worried about tracking your spending for recreation and leisure pursuits. You could create categories that cover those types of expenses, and let everything else accumulate under "miscellaneous revenue" or "miscellaneous expense."

The problem with that approach is that you forgo the opportunity to spot problems in other spending areas that you may not even be aware of. So a better solution is to track expenses using electronic banking. That way, you can download your payments and deposits directly from the bank, rather than having to enter them by hand. The downloaded banking transactions generally show up without any categorization -- meaning you'll have to add the categories by hand. But if you use a credit card that is issued by a bank that permits electronic access, then the downloaded charges from your card sometimes do come with categories attached (they aren't always right, so check them).

Either way, once you've got your spending tracked by category, then drawing up a report requires only a few clicks of the mouse.

Even better, such programs often have an automatic budget-creation feature that scans your spending in the past in order to estimate how much you'll spend going forward. In Quicken (we use this as a model simply because it happens to be the market leader), you can use the budget-builder to produce monthly spending reports in categories you select. Here's an example for spending on health care and pets.

You can also produce graphs that show how much you're making and spending compared to your expectations, as the following example shows:

If your finances aren't wired, you can still get a good handle on your spending the old-fashioned way. Start by getting all your records together from the last 12 months, including pay stubs, loan proceeds, withdrawal slips, canceled checks and itemized credit-card statements. Then go through them and compile totals for your income and expenses in a set of categories that make sense for you.

At the end of this exercise, you may still have a sizable lump of spending that's undocumented -- typically, the money you withdraw in cash and then spend on day-to-day needs. If this portion of your budget is more than about 5 percent of your total spending, you ought to go through one further step to understand where it is going. That is, keep a journal for the next four weeks, either by hand or electronically, in which you record every nickel you spend. You can use those results to extrapolate how your cash is being spent throughout the year.

Now that you've got a good picture of where your money is going, you can proceed to evaluate which parts of that spending should be raised or lowered. You might start with our Instant Budget Maker calculator, which compares your spending to that of other families like yours.

Next: Evaluating expenses