Profit First Explained
The Profit First accounting method is an approach to cash flow management that helps owners ensure they take/make a profit from their business. Most Business owners are terrible at paying correctly or taking profit from their business, but It doesn’t have to be like that.
In Mike Michalowicz’ book” Profit First” Mike uses a method that is being implentments with success by accountants, business owners, and the financial independence community. This Method is changing the paradigm around budgeting and cash flow.
What is the Profit First Method?
The Profit First method is a system in which business owners take a percentage from each sale as profit. Most owners and accountants use the traditional method of taking expenses from sales, and leaving the remaining amount at the end of the year as profit. (most of the time there isn’t any)
Traditional accounting method:
Sales – Expenses = Profit
The Profit First banking method pulls profit first and leaves the rest to be used to pay expenses.
The Profit First accounting method:
Sales – Profit = Expenses
From each sale you’ll be accounting for your profit, taxes, and pay. After these 3 are taken from sales the company can use what is left to pay the rent, salaries, material costs, and utilities.
It will be uncomfortable at first to run your business this way, especially if you have done the reverse for any period of time. Putting your profit first makes you aware of where the money is going and how much is leaving for expenses.
How Does Profit First Work?
Using the Profit First Banking Method, business owners take their profits out of sales before expenses rather than paying themselves with what’s leftover after expenses, as discussed earlier. To do this they transfer predetermined percentages of sales, deposited into the incoming sales account, to bank accounts specified for profits, taxes, operating costs, and owner’s salary.
What each of these percentages are, is determined by Target Allocation Percentages, aka “TAPS”. Your Current Allocation Percentages, aka “CAPS,” are how your Gross Revenue is currently being allocated.
What are the Profit First Percentages?
I’m Sure you are asking “well, what are the percentages and how are they determined?”
The chart below by Mike Michalowicz will help you understand what your target allocations should be based on your business’s gross revenue range.
TAPS by Mike Michalowicz
Here is another link on how you should determine your TAPS — including a helpful formula based on your state’s tax structure.
5 Accounts you’ll need for Profit First Method
The 5 Profit First Accounts are Profit, Tax, Business Income, Owners Compensation,and Operating Expenses (OpEx). Money is deposited into the income account and then transferred to the other accounts based on the percentages for your business inside Mike’s chart above.
Owners Compensation, and Operating Expenses should all be opened using 3 separate checking accounts. The Profit and Tax accounts should be opened as savings accounts that make it difficult to get to them, and could even be at another bank, so they stay out of sight and out of mind. Not being able to view these accounts is best practice for most people who need to spend everything they make. These 2 accounts (Profit and Tax) will only be touched once per quarter to pay profit out and quarterly sales taxes. 50% of what is in the profit account is paid out to the owners each quarter and 50% of what is in the tax account is paid out to the IRS.
By doing this the business always has money to pay taxes at the end of the year if you end up owing more and the business still always has a profit.
Lowering the amount you spend on expenses to what is available is what is most difficult about this concept, but if you have made money stretch further before when times were had you can do the same to make this accounting method work and the business will always have enough for taxes and profit for the owners.