Profit first
Transforming businesses from cash drains to profit engines
Description
The traditional GAAP formula for calculating business profit is: Sales - Expenses = Profit. However, this approach often leaves profit as an afterthought for many small business owners who base decisions on their bank balance. The Profit First Accounting (PFA) method challenges this by prioritizing profit. In PFA, a predetermined percentage of profit is taken from each sale first, and the remaining amount is used to cover expenses. This means securing profit first and then operating the business with the remaining cash.
As Michael Michalowicz, the proponent of PFA, puts it, it's about choosing between treating profitability as leftovers or securing a healthy share upfront. He asserts that the PFA system, when followed, can make any business permanently profitable from the next deposit onwards.
Table of contents
01Establish a profit first mindset
As many small business owners can attest, the key to success isn't just about the amount of revenue generated, but rather how much of that revenue is retained as profit. It's crucial to prioritize profitability and make it the primary objective of your business.
The Profit First system can significantly enhance any business by shifting the focus to profitability. Starting a business with just a brilliant idea, your unique skills, and available resources is indeed a remarkable feat. However, there comes a time when the business becomes a daunting, cash-consuming entity.
Cash flow issues are a common problem for many small businesses. The typical solution is to aim for growth - increase sales, attract larger clients, and boost revenue. However, growth is only part of the solution. If your costs increase proportionally with your growth, your financial situation won't improve. The real key to a healthy small business is increased profitability, not just growth.
Many small business owners resort to what's known as "bank balance accounting". This involves checking your bank balance daily to gauge your financial health. If there's money in the bank, you feel secure and relaxed. If not, you scramble to make more sales to generate cash. This is known as the "Recency Effect", where decisions are made based on the most recent information available.
02Implement your profit first framework
The Profit First philosophy is a financial management approach that aligns with your natural way of thinking and operating. It involves setting up four distinct bank accounts and managing your cash flows between these accounts in a deliberate and intelligent manner. The ultimate goal of Profit First is to prepare your business for profitability and maintain it. This philosophy draws parallels with the diet industry, which is well-versed in the challenges of human behavior.
Most diet programs can be distilled into four core principles:
- Use smaller plates – This encourages smaller portion sizes, reducing calorie intake and aiding weight loss. - Serve sequentially – Prioritize nutrient-rich vegetables before other foods. If left till last, they may not be consumed. - Remove temptation – By keeping junk food out of reach, you're forced to eat the healthier options available. - Enforce a rhythm – Rather than eating when hungry, which can lead to overeating, consume small portions at regular intervals.
Profit First adapts these principles to financial management:
- Use small plates – Instead of a single bank account, Profit First recommends four separate accounts: profit, owner's pay, tax, and operating expenses. This provides a balanced view of your available cash. - Serve sequentially – Funds are first allocated to the profit account, then the owner's pay account, followed by the tax account, and finally the operating expenses account. If there's not enough left for expenses, it's a signal to reduce overheads. - Remove temptation – To discourage dipping into your profit and tax accounts, these should be held at a different bank, ideally with restricted access. - Enforce a rhythm – Payables are managed twice a month, on the 10th and 25th, promoting good financial habits and providing a clearer view of cash flow. The Profit First methodology encourages you to prioritize profit, rather than treating it as an afterthought. It requires setting up four distinct bank accounts: an operating expenses account (likely your existing business checking account), a profit account, a tax account, and an owner's salary account. It's beneficial to set up the tax and profit accounts at a different bank, ideally as savings accounts, to reduce the temptation to dip into these funds.
03Utilize profit first to eliminate debt and optimize your business
Prioritizing profit in business management is essential, and a key hurdle in this journey is often debt. To ensure sustained profitability, a strategic approach to eliminating debt is crucial.
Once debt is out of the picture, the Profit First method can be effectively implemented to fine-tune your business towards continuous profit generation. The essence of successfully adopting the Profit First strategy is to embrace small, correct steps and consistently repeat them. Instead of opting for a massive overhaul, the focus should be on steady, gradual changes.
Starting from your current situation, you can begin making progress towards your desired state. For example, an immediate assessment might reveal goals for the upcoming quarter such as increasing profit by 3%, reducing operating expenses by 5%, and raising the owner's salary by 2%. At the quarter's end, reassessing your situation will show whether you've met your goals and improved your situation.
The process emphasizes making small, successive steps in the right direction over several months, rather than attempting large, dramatic changes. This builds momentum for change and keeps you moving forward.
The primary goal is to establish a new, automatic routine. The changes should be so minimal that they're barely noticeable, with automatic allocations set up immediately and adjusted each quarter until they align with the target allocation percentages. Starting slow is key, but it's crucial to never regress. It's better to take a small step towards your target Profit Percentage than to make a big leap and retract it a month later.
04Incorporate advanced strategies into your profit first framework
Once you've mastered the fundamentals, you'll discover that Profit First offers an excellent blueprint for elevating your business. There are countless advanced techniques or strategies that can be incorporated into your Profit First system. Profit First is a sturdy growth blueprint for businesses of all sizes and types. There are numerous ways to expand on the basic Profit First blueprint. Some recommendations include:
Accountability Groups: To regularly enhance your self-discipline, join or establish an accountability group. This is a group of like-minded individuals who meet regularly to share updates and exchange ideas. The mere knowledge that you'll have to report your progress to your peers will increase the likelihood that you'll follow through on your commitments.
Profit Pods: A profit pod is a group where you instruct others about the Profit First principles and assist them in implementing them. You create a group of individuals undergoing the same transformation and actively provide mutual assistance. The concept here is that you learn more by teaching the principles than by simply practicing them.
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