Get to Know the Profit First Method
What if there was a way that you, the small business owner, always got made money? That's a real thing, and it's called the Profit First Method.
Right off the bat, we want you to know we're going to talk about accounting… where are you going? Don't walk off — this is going to be good!
Defining the Profit First Method
The best way to illustrate it is to think about what most people do at home. You get a paycheck, and then you start paying the bills. Once you've paid the big stuff (rent, utilities, car insurance, Netflix – the essentials), you have some money left over and you're going to use that for groceries, going to the movies, getting your hair cut, and the other bills during the month. If you play it smart, clip your coupons and stay out of trouble, you might have a few bucks leftover at the end of the month. Some people save that, some people use it to treat themselves, but for a lot of us, that surplus isn't a common occurrence. At the end of the month, the bank account is scraping close to zero.
The Profit First Method does it all in reverse. If you used the Profit First Method in your home, you'd get that paycheck and the first thing you'd do is take out that bit of cash that you wish you had leftover at the end of the month, THEN you start paying the bills. How cool is that? With the Profit First Method, you'd start every month with a win!
Why use the Profit First Method?
Implementing Profit First will guarantee you:
Financial Organization
Peace of Mind
Guaranteed Profit
Confidence in Financial Decisions
Mike Michalowicz and the Origin of Profit First
I thought that Profit First was Mike Micahlowicz's first book, but it wasn't. It's just his most popular. The reason is that it tells the very real, raw story of Mike's experience with building and selling businesses, success and financial failure. Through his experience he discovered a way to do it differently, Profit First.
How Mike Michalowicz Came up With the Idea of Profit First
Growing a business often comes at the cost of profit and cash flow. Many businesses use growth as an excuse to not be profitable. Mike was no different. Building his businesses he realized he only made money when he sold the business.
After losing all of his money from the sale in unsuccessful investments, he decided their had to be a different way. That was the birth of the Profit First Method.
The Three Fundamentals of Profit First
Use Small Plates (Parkinson’s Law)
Parkinson's Law, defined by historian C. Northcot Parkinson in 1955, states that work expands to fill the allotted time. This principle applies to all aspects of human behavior, not just public administration. Deadlines help us stay focused and meet our goals. However, as entrepreneurs, we often have many competing priorities. The danger lies in neglecting important tasks until they become urgent. It is ideal to prioritize and address important matters before they reach a critical stage in order to effectively grow our businesses.
In Profit First, we apply Parkinson's Law by limiting available spending money. If there's no cash, you can't spend it. Mike Michalowicz calls this "Use Small Plates." When trying to lose weight, smaller plates ensure proper portions. Big plates hold more food. We want to eliminate the big plate and the temptation to spend.
Serve Sequentially (Prioritize)
Our brains have natural inclinations and tendencies that can be both beneficial and limiting. One of the advantages of Profit First is that it aligns with these inclinations and tendencies.
The Primacy Effect is our bias to remember and focus on the first information we receive. We prioritize profit as the first thing. This may seem small, but it's important. People who haven't implemented Profit First often say they're not making any profit. They have it backwards. You're not making profit because you're not using Profit First.
If profit margin is not prioritized, it will always be considered secondary. It is important to commit to making profit a priority in order to avoid reasons for not having any.
Mike suggests prioritizing the vegetables on your plate first before indulging in the tastier options. Similarly, he advises focusing on profit first before allocating resources elsewhere.
Remove Temptation
My wife and I often ask ourselves if there is anything sweet in the house before going to bed. Usually, the answer is no. In those cases, we don't bother getting dressed and going to the 7-eleven to satisfy our craving. Why? It's because the temptation is not easily accessible. However, if there is ice cream in the freezer, one of us will definitely make a trip to the kitchen.
Profit First achieves this by creating a barrier to accessing profit. We accomplish this by opening a separate profit account at a different bank without online access. When funds run out, it becomes more difficult to dip into the profit account. Transferring money online is not an option. Some individuals take additional precautions by requiring a second signature for the profit account, adding another layer of protection. Having to involve a business partner or spouse to sign a check for money transfer makes it challenging. Setting aside money upfront also eliminates the temptation to use it.
Separate Bank Accounts for Business Finances
There are five bank accounts associated with Profit First.
Deposit/Income: All your money goes here first, including cash deposits.
Profit: Start with transferring 1% of each deposit into this account.
Tax: Work with your tax preparer to determine the amount to transfer into this account to pay for your taxes.
Owner’s Pay: Transfer to this account for your personal finances
Operating Expenses (Opex): Your remaining balance in the deposit goes into this account to pay for your business expenses.
Setting Up Separate Bank Accounts for Business Finances
I would start by using your existing business account as your deposit account. Alternatively if you have a bunch of automatic payments coming from the existing account, then make it your Opex account.
The Profit account should be a savings account, while the other accounts can be either business checking or savings, depending on the cost and number of transactions.
I recommend a business bank rather than a credit union. Credit unions, while inexpensive or really not set up for business banking.
Advantages of Using Separate Bank Accounts For Business Finances
You HAVE to have separate bank accounts to implement Profit First successfully. Many business don't set up all five accounts. If you do nothing else, start with a separate profit account, and start transferring a small amount of each deposit into it. You will be amazed after three months how much is in there.
Disadvantages of Using Separate Bank Accounts For Business Finances
It may seem like a hassle to have so many bank accounts. That's fair. There is additional bookkeeping, but the juice is worth the squeeze, I promise.
By far the biggest challenge is the making of transfers on a regular basis. Many banks allow you to automate this process.
Accounting Methodology for Profit First Method
Many CPA's don't like clients using the Profit First method because it doesn't align with their traditional way of doing things. Remember, this is your business, if your accountant won't work with you, find a different accountant!
Traditional Accounting vs. The Profit First Model
Traditional bookkeeping and accounting produces the typical financial statements of the income statement, balance sheet, and cash flow statement. Using Profit First doesn't keep you from preparing and using this reports.
The traditional accounting paradigm starts with income, deducts expenses, and what is left over is profit. Sales - Profit = Expenses. Profit first is about changing your mindset to prioritize profit. It is not about changing the traditional double entry accounting method.
Target Allocation Percentages for Revenue, Profits, and Expenses
Target Allocation Percentages (TAPS) are like a budget for your business. Working with a Profit First professional, you establish TAPS on a quarterly basis to improve your profit and cash flow over time.
Your TAPS will change each quarter as your business progresses towards your financial goals. Using these percentages, you will make transfers to your various bank accounts from the deposit account on a regular basis.
Your TAPS will be computed using Real Revenue, rather than percentage of revenue. Real Revenue is your total revenue less your flow-through expenses like cost of materials. This allows you to focus on what your business can actually control.
Mindset Shift Necessary to Implement The Profit First Methodology Successfully
In order to effectively utilize the Profit First tool, it is important to first address one's mindset. A tool can only be effective if used by someone who understands how to properly utilize it. For example, if you were to place a hammer in my hand, I may end up with bent nails and bruised thumbs rather than successfully connecting two objects.
Why a Mindset Shift is Necessary to Implement The Profit First Model Successfully
Implementing Profit First can assist with all the mentioned issues. Failing to take control of your mindset and beliefs about profit and money will result in failure. If you do not value your work and believe you deserve to be well-paid, you won't be. Thinking that making money as a business owner requires compromising your identity will become your reality.
Conclusion
We've had multiple clients tell us that implementing Profit First was the best business decision they ever made. They wish they had done it sooner. Don't be that person, start today!
