Profit First Method: What It Is And How To Use It For Your Small Business
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Are you the type of business owner who thinks of paying or rewarding yourself when your business finally starts turning a profit? Unfortunately, you are not alone.
I do get it, really. For a business idea that you love and want to see grow into something meaningful—your legacy, perhaps—it’s not difficult to see why you’d take all the possible sacrifices to make that dream a reality. Including not paying yourself until your business is profitable and can afford to pay you what you deserve.
But where does that leave you financially; personally, that is? At the end of the day, you have personal bills to pay and personal goals that require saving and investing. If you don’t have full-time employment with a guaranteed monthly salary, your business is possibly the only earning avenue to help meet your personal financial needs. And if your business is not profitable, you’re in a worse situation.
This is why I believe the Profit First method comes in. I have been fascinated by the profit first method for a while now after listening to the audio version of the book. While it’s quite an intriguing workaround against the traditional accounting method, it can be the answer to business owners struggling with profitability and their compensation.
In this article, I will take you through the basics of the Profit First method, including how it works and how you can implement it for your small business. Let’s get started!
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The Profit First method was developed by Mike Michalowicz after a failed business venture. Besides simplifying accounting for his business, his key goal was to ensure he got paid and always had funds to pay Uncle Sam. So, what’s the Profit First method and how did it help the inventor?
It is a cash management system designed to guarantee your business’s profitability and your payment as the business owner, regardless of the gross turnover.
The system uses predetermined allocations to set aside profitability funds, owner’s pay, and funds for taxes before covering any business expenses. This strategy ensures that profitability and your compensation as the owner is not an afterthought as is common with the traditional accounting method.
How the Profit First Method Works
As mentioned, the Profit First method amplifies that profit should come first. Instead of calculating profit as what’s left after expenses, you set aside a portion of your income as profit from the start. Then, you use what’s left to pay for operating expenses.
Profit First Formula:
Sales (Revenue) - Profit = Expenses
However, it’s not that straightforward. You don’t just set aside the funds in your mind or notebook. You’ll need to set up five distinct bank accounts. Each account serves a specific purpose, making it easier to allocate and manage your funds.
Here’s a breakdown of the five key accounts:
- Income account – current account
- Owner’s compensation account – current account
- Tax account – savings account
- Profit account – savings account
- Operating expense account – current account
1. Income Account
This is the account where you deposit all the revenue your business generates. While most, if not all businesses, already have a primary bank account, it’s not just used as an income account. The primary account is also used to make all the payments.
However, with the Profit First method, the Income Account only acts as a holding account where funds are collected before being allocated to other accounts. The balance of this account will be zero after the allocations are made.
2. Profit Account
Next, you have the Profit Account. As the name suggests, it is the account you use only for transferring a percentage of the income generated that acts as a profit.
This account is strictly for profit and is not to be used for any other expenses. Regularly transferring a fixed percentage of your revenue into this account ensures that your business remains profitable regardless of the revenue you generate.
3. Owner’s Compensation Account
This account is for your salary as the business owner. Remember my intro about business owners who put all their time and money into a business and never get a payday, even for years? Well, this account helps ensure you are always compensated as a business owner.
4. Tax Account
Are you an anxious business owner during the tax season? This account is your answer to never worrying about paying Uncle Sam.
The Tax Account is dedicated to covering your business taxes. Allocating funds to this account regularly helps you avoid any unpleasant surprises when tax season arrives.
5. Operating Expenses (OpEx) Account
Finally, the remaining funds are transferred into the Operating Expenses Account. This account covers all the day-to-day business expenses, e.g., rent, payroll, marketing expenses, etc.
Having an operating expenses account ensures that you only spend funds in this account to meet your operating expenses. This helps encourage disciplined spending and avoid unnecessary expenses.
How to Implement the Profit First Method
Now that you understand how the profit first method works, are you ready to implement it for your business? Here’s a step-by-step guide:
Open Multiple Bank Accounts
Your first step is to set up the five distinct bank accounts as outlined above. This separation of funds helps you manage and allocate your money more effectively.
Keep in mind that the recommended profit and tax accounts are savings accounts, not current accounts. The idea is that these funds don’t just lie idle waiting for the day you pay taxes or need to invest in something for your business. Having these funds in a savings account ensures your business is also earning interest returns.
Determine Your Current Financial State
Next, assess your current financial situation. The goal is to understand the current allocation of your revenue. That is, how much of your earnings goes into operating expenses (OpEx), tax, owner’s compensation, and profitability. Mike refers to these as your Current Allocation Percentages (CAPs).
This assessment will help you set realistic allocation percentages for each account.
Allocate Income According to Profit First Percentages
Your next step is to decide how you’d like to allocate revenue. What percentage of your income would you want to go into OpEx, taxes, owner’s compensation, and profitability? These are referred to as your Target Allocation Percentages (TAPs).
The goal is to ensure you are compensated, and you have funds for taxes and profitability. Especially if your business is currently struggling with profitability, meeting tax liabilities, and even your compensation.
The percentages are not standard and will vary from one business to the other. However, a common starting point that’s recommended might be:
- Profit Account: 5%
- Owner’s Compensation Account: 50%
- Tax Account: 15%
- Operating Expenses Account: 30%
These percentages are just a starting point and are not set in stone. You can always adjust over time as your business grows and changes.
Schedule Regular Fund Transfers
The final step is to transfer funds from the Income Account to the other four accounts regularly, such as weekly or bi-weekly. Consistent transfers help maintain the structure and discipline of the profit first method.
Mike, the inventor of the Profit First method, recommends doing this every 10th and 25th of the month. However, you can always choose different days. Whatever option you choose, ensure that you do not miss key tax and statutory deduction deadlines.
Make Necessary Adjustments
As your business grows and evolves, your financial needs will change. That’s why it is important to review and make the necessary TAPs adjustments regularly. Here are some tips for adjusting your percentages:
- Review financial performance regularly – analyse your financial statements quarterly to assess how well your current allocations are working. Look for areas where you might need to increase or decrease percentages.
- Increase profit percentage gradually – as your business becomes more profitable, consider gradually increasing the percentage allocated to your Profit Account. This ensures that you’re consistently building a financial buffer for your business.
- Adjust for tax liabilities – monitor your tax obligations closely. If you find that your current allocation isn’t sufficient to cover your tax payments, adjust the percentage allocated to the Tax Account accordingly.
Balance operating expenses and owner’s compensation – ensure that your Operating Expenses Account covers all necessary business expenses without compromising your salary. If operating costs rise, you might need to adjust your Owner’s Compensation percentage or look for ways to reduce expenses.
Traditional Accounting vs. Profit First Accounting
Unlike the Profit First method, which prioritises profits, the traditional accounting method treats profits as an afterthought. This method focuses on covering all business expenses first and then determining what remains as profit.
Traditional Accounting Formula:
Sales (Revenue) - Profit = Expenses
While widely used, traditional accounting has its challenges:
- It treats profit as an afterthought – in traditional accounting, profit is whatever is left after expenses are paid. This often leads to businesses realising they have little to no profit after all costs are covered.
- Expense-driven – this approach tends to prioritise expenses, which can encourage unnecessary spending. Businesses might spend on non-essential items, assuming they can use whatever is left for profit.
- Lack of financial discipline – traditional accounting can lead to a lack of financial discipline, as there’s no clear structure for setting aside money for profit, taxes, or owner’s compensation.
Benefits of the Profit First Method
Implementing the Profit First method can transform the way you manage your business finances, providing numerous advantages that contribute to your financial health and overall success.
Here are some key benefits of using the Profit First method in your business:
Ensuring Profitability from Day One
One of the most significant benefits of the Profit First method is that it guarantees profitability from the very start. Setting aside a portion of the business revenue before spending on anything else ensures your business always generates profits. If your business has always been posting a negative bottom line, this method can help you remedy that.
Improving Cash Flow Management
I have said time and again that cash is king, and one of the best ways to ensure this king is taken care of is through strategic cash flow management. Without this, your business might be posting profitability but still be on the verge of collapse.
How does the Profit First method help? The Profit First method helps you manage your cash flow more efficiently by ensuring that funds are allocated correctly and consistently. For instance, if you have set aside the 10th and 25th of every month as your payment dates, it ensures you don’t make unplanned payments between these dates. Additionally, it also helps ensure funds allocated for other accounts, like profit and tax, are not used to meet operational and other unexpected expenses.
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Preparing for Tax Obligations
Tax season can be overwhelming, not just in the preparation of accounts but also in meeting tax liabilities. If you are not adequately prepared, meeting tax obligations can put quite a toll on your business finances.
The Profit First method ensures that you’re always ready for tax payments by allocating a specific percentage of your revenue to a dedicated Tax Account. This proactive approach helps you avoid the stress and financial strain of unexpected tax bills, ensuring that you have the necessary funds available when tax season arrives.
Encouraging Better Financial Habits
Do you struggle with money management? The Profit First method is an excellent option. It instils better financial habits by promoting a disciplined approach to money management.
When you regularly allocate funds and adhere to your set percentages, you develop a routine that prioritises financial health. This disciplined approach helps you avoid unnecessary expenses, focus on profitability, and make informed financial decisions that support the growth and sustainability of your business.
Reducing Financial Stress
Managing business finances can be stressful, especially when you’re unsure if you’ll have enough funds to cover all expenses. The Profit First method alleviates this stress by providing a clear framework for financial management.
Allocating funds to different accounts assures you that you have money set aside for profit, taxes, and your compensation. This reduces financial anxiety and helps you focus on growing your business.
Final Word
Adopting the Profit First method can transform your business finances by ensuring profitability from the outset. When you prioritise profit and allocate your income into distinct accounts, you create a structured, disciplined approach to financial management. This method helps you maintain a sustainable financial system, reduce stress, and improve cash flow management.
For a deeper dive into Profit First, consider exploring the book “Profit First: Transform Your Business from a Cash-Eating Monster to a Money-Making Machine” by Mike Michalowicz.
