Business owners tend to focus on the traditional accounting method of driving up revenue: Sales – Expenses = Profit. This approach can lead to a cycle where businesses might build revenue but quickly spend it as expenses rise proportionately. This leads to less profit and owners paying themselves last, if at all. Unfortunately, too many business owners keep reinvesting in the business and put themselves last.
But what if businesses flip this traditional mindset of driving up revenue and concentrate instead on driving up profitability? The formula becomes: Sales – Profit = Expenses. This methodology, called “Profit First,” helps businesses build up a reserve from those profits and gives them an edge when sales slow. Focusing on profitability and owner’s compensation forces businesses to carefully analyze every expense and look at each client or revenue stream to make sure they are feasible and have a healthy profit margin. Small shifts in mindset create huge benefits: recession-proof businesses and happy owners in times good or bad.
What Is Profit First?
Profit First is a cash management system, designed for any size business, that guides owners on how to take profit first and distribute the remainder for expenses. This creates sustainable success. It also provides guidance on how much business owners should pay themselves. This results in better decisions on how to spend money for the business.
In addition to reading the Profit First book by Mike Michalowicz, here are key steps business owners can take to implement this approach:
Create smaller spending accounts to pay expenses. Business owners can begin by allocating money for business expenses to different bank accounts to avoid borrowing from themselves. This habit helps businesses grow fiscally through regular profit distributions. The separate bank accounts ensure businesses have money year-round to pay for expenses. These accounts include:
- Profit account: for paying debt, emergencies and owner bonuses.
- Owner’s pay: for paying the owner’s after-tax salary or wage. In addition to salary and distributions, this is for paying anything that benefits the owner, including health insurance and retirement contributions. Profit First provides formulas based on Real Revenue (Sales – Materials and Subs). For example, if a business has a real revenue of $250,000 or less, the formula tells us that the business owner should be realizing 50 percent of that in salary and/or distribution.
- Operating expenses
If it seems overwhelming to open up these additional accounts, opening up just one profit account to allocating 1 percent of profit is a start.
Determine allocation percentages. Current Allocation Percentages (CAPS) indicate where a business is currently spending revenue. Target Allocation Percentages (TAPS) is where a business owner ultimately wants revenue to go once the business is profitable. By completing a Profit First Instant Assessment, business owners can determine these targets based on revenue.
Transfer funds. Regularly transfer funds from the business income account to other accounts. This can be weekly or every two weeks. Just like exercising, it’s essential to establish a regular routine for this.
Review progress. This methodology encourages business owners to examine every aspect — especially expenses. Circumstances change and so do financial needs. Businesses should review and make any adjustments to the system on a quarterly basis.
Overcome hurdles. A business usually sets goals based on increasing revenue. Unfortunately, if the owner ignores profit goals, the increased revenue goes anywhere but to profit or to the owner. There’s always the next shiny object to invest in: a new website, marketing program, a business coach, more employees to do the increased work. Owners think they must sacrifice to build a successful business … someday. Discipline is key, especially due to keeping a schedule for regularly allocating money. They also might face temptation to dip into their profit accounts when they want to make a purchase.
Certified Profit First professionals can help guide business owners through the process to overcome these challenges and lead them to improved profitability. This includes a year-long plan to advise business owners on a quarterly basis, review progress and adjust allocations accordingly to reach their goals.
Ruth Urban is president and CEO of On the Money, an accounting and bookkeeping firm in Phoenix. As a certified Profit First professional, Urban serves as a trusted business advisor to clients, helping them build highly profitable businesses. In 2019, her firm’s profits tripled due to adopting the Profit First methodology.