Profit First – Are You Embarrassed by Your Profit? Here’s What to Do

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Profit First – Are You Embarrassed by Your Profit? Here’s What to Do:

 

Many business owners, especially new ones, struggle with cash management and generating profits from their business. 

Struggling entrepreneurs can turn to the Profit First Method, which best-selling author Mike Machalowicz introduced

This method is perfect for those who want to “transform their business from a cash-eating monster to a money-making machine.”

Most of us start a business with a vision of gaining financial freedom while doing what we love, only to end up as slaves to our companies. 

Statistics show that approximately 50% of businesses fail in the first five years (and 70% by year 10), while others hover on the brink of survival, burning more cash than they bring in and accumulating debts (especially in a post covid world).

Profit First is more than a book about budgeting; it is a clever accounting hack that presents a counterintuitive approach to profit generation and money management.

Any traditional accounting book will tell you that profits are left after subtracting your expenses from your revenue.

Revenue - Expenses = Profit

However, the Profit First approach proposes that you take your profit from your revenue first, and what’s left is your budget for your expenses.

Revenue - Profit = Expenses

Profit First - The Mindset

Flipping the accounting equation presents a shift in mindset and business approach for entrepreneurs: make business profit your focus, not an afterthought. The book aims not to change how accounting is done but to instil a different perspective in developing good financial habits.

Michalowicz’s reframing of the profit equation is more of a psychological benefit than a mathematical one, as it forces entrepreneurs to think differently about their spending habits. It is similar in principle to Parkinson’s Law, which says, “work expands to fill the time available for its completion.”

For example, when we are given a project with a deadline a month from now, we often procrastinate with the tasks thinking we have a lot of time, and we spread out the completion of the project in a month. However, if the management gave the same project to us, but with a shorter deadline, like a week from now, we can accomplish the same work in that amount of time. Moreover, a project with a shorter deadline would often yield better results.

Michalowicz took that principle and applied it to finances. 

Business owners typically spend money and take whatever is left as profit. Even with a budget, entrepreneurs still tend to overspend. However, by putting a cap on what you can spend by taking out the profit first, you become more conscious of your spending habits. In a way, it forces you to think deeply about every spending decision and challenges you to innovate because you limit your resources.

A little pressure goes a long way in terms of discipline and control.

profit first book cover tny

Profit First - The Principle

The Profit First system is tailored to four dietary research principles: use a small plate, change meal sequence, remove temptations, and build a rhythm.

Using smaller plates is a psychological “trick” to reduce food intake. In the Profit First method, you take the profit first and split the balance into small accounts. By reducing the amount of available cash, you are left with no choice but to be innovative and frugal with your spending.

Change meal sequence by consuming the most nutritious food first so that you’ll be full by the time you get to the less healthy options. In the case of your business finances, by setting aside the essential part first--the profit-- you only spend what you can afford.

When you are on a diet, you remove temptations by putting away junk food and all your guilty-pleasure snacks. With your finances, put away your profit, keep it in a bank, so you won’t be tempted to use it.

Lastly, build a rhythm. Don’t wait until the end of the quarter, or the end of the year, to do your accounting and assess your financial position. Do it regularly in smaller intervals, do your income allocations, and pay your bills twice a month. The smaller the numbers seem, the less tempting it will be to go on a spending spree.

By managing your business finances in shorter scheduled intervals and creating smaller spending buckets, you don’t fall into the trap of thinking, “I have a lot of money. I should increase my spending.”

The Method of Profit First

Profit First helps you develop a sustainable system of growing a business finance model that creates long term success. 

The system is implemented this way: account for your profit, taxes, your pay, and use what’s left for business expenses.

Step 1: Create smaller spending buckets

The idea is to split your expense budget into smaller spending buckets by setting up bank accounts for your business's specific core functions. There are five core accounts: Income/revenue account, Profit account, Operating expenses account, Owner’s pay account, and Tax account.

Moreover, you might need a few other accounts depending on your business and financial goals (for example, VAT if you are VAT registered) 

Step 2: Determine your CAPs and TAPs

Your Current Allocation Percentages (CAPs) show where your real revenue is being spent right now. In other words, it shows what your business' daily expenses are.

The Target Allocation Percentages (TAPs), on the other hand, detail where you want your real revenue to go once your business becomes profitable and gains optimised efficiency. It is essential to set your TAPs to work towards your business and financial goals.

Step 3: Transfer your cash

As Profit First is more of a habit formation method, establishing regular rhythms for transferring funds is necessary. How frequently you want to do it is entirely up to you, but the key is to stick to your schedule. It is not recommended that you leave more than two weeks between transfers, and most businesses allocate weekly. 

Step 4: Make Payments

Use the core accounts you set up to pay your bills. Make sure you use each account for its specific purpose.

  • Profit Account: Accumulate a small amount off your top line to reduce debts, build an emergency fund, and receive a bonus. This account is your top priority because it is the goal of the profit first method.

  • Owner’s Pay: This account is dedicated to your after-tax salary. Do not give in to the temptation of using this to re-invest in your business. Dedicate this to yourself and your family.

  • Tax Account: Use this account to set aside money for your tax and superannuation obligations.

  • Operating Expenses: This is the only account you should use when it comes to business operating expenses. Spend it wisely.

Step 5: Review

You can review the system in longer intervals, preferably every quarter. The Profit First method should be regularly reviewed and re-evaluated to fit your business model and current financial situation. It is a method of being mindful of your finances, after all.

 Hello! 

I'm Annette Ferguson

Owner of Annette & Co. - Chartered Accountants & Certified Profit First Professionals. Helping online service-based entrepreneurs find clarity in their numbers, increase wealth and have more money in their pockets.

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