If you like excelling financially, I hope you have heard of Profit First. Small business owners like you are transforming their companies into consistent, profit-generating operations. This concept, founded by small business finance expert Mike Michalowicz, is slowly growing in followers. Once you become familiar with its fundamentals, it’s easy to understand why people are attracted to this philosophy.
This article will help you better understand what Profit First is and how people have succeeded by using it.
What is Profit First?
That wonderful Accounting 101 class in school explained that the Generally Accepted Accounting Principles (GAAP) define profit as the difference between a business’s sales and expenses. This formula works because the mathematics is sound, but it also fails to consider human behavior.
In GAAP Sales – Expenses = Profit
GAAP says to take profit only after subtracting all of the company’s expenses from the company’s revenue. Since profit takes the back seat, many businesses get stuck running a company that only earns on paper. (Perhaps this is YOU!)
With minimal profit, businesses end up surviving from sale to sale, with tired owners striving to out-sell and out-grow their expenses. And at the end of the day they realize that their profit hasn’t grown one bit. Many times, out-selling and out-growing only results in an even larger amount of debt than when you started.
With Profit First, you modify this formula a little by switching expenses with profit. The resulting formula, Sales – Profit = Expenses, is mathematically similar since you only swapped two variables. However, in this new equation, you take profit from your sales FIRST, and then you use the remaining cash to take care of expenses.
Setting a fixed amount for profit and collecting it right away can do wonders for an entrepreneur’s mindset. By claiming your financial victories early on, you are motivating yourself more by already feeling what it’s like to be successful, and of course, this momentum creates even more momentum to be profitable.
What does the Profit First concept mean for businesses?
Business owners have the habit of maximizing resources to make sure that their investment is utilized correctly. Parkinson’s Law, named after historian C. Northcote Parkinson, states that the demand for a resource increases to meet its supply. For instance, if you allotted $1000 for a project to be finished in one week, you can expect the full amount to be used up and the project to be completed in exactly a week. People are generally wired to use what’s available to them, which sometimes works against them.
The Profit First movement uses this same habit to serve the purposes of the business better. By taking profit first from the equation, the remaining money meant for expenses considerably lessens. The business will then be forced to find methods to lessen expenses, such as finding cheaper ways to do the same things as before, without affecting the profit that has already been accounted for.
What accounts should I set-up to use in Profit First?
For the Profit First method to work best, it is ideal to open five separate bank accounts that your business will use for different purposes – INCOME, PROFIT, OWNERS PAY, OPERATING EXPENSES, and TAXES. Your Business should allocate cash into smaller spending buckets. Each bucket can only be used to pay for the designated expenses with that cash.
While having multiple accounts can sound overwhelming at first, keep in mind that today’s technological advancements have made it quite easy to access your accounts online. You can view transactions, monitor changes, and transfer funds from one account to another simply with an app on your smartphone.
For this setup to succeed, you need to ensure that you have enough discipline to respect the purpose of each account. Once you have allocated the money to an account, there should be no reason to move it again unless extremely necessary.
Why does the Profit First System work?
The Profit First system works because it makes sure that no matter what happens, the business will be able to accomplish its responsibilities – all the while returning a steady profit. By allotting money to cover various aspects of your company, including your own compensation, you are giving the business a safety net in case things go south.
With the traditional GAAP formula, there is a tendency to spend more than you should. When that happens, you are losing money that can potentially go to your profit or compensation.
In the Profit First method, if the remaining money after the allocations is not enough to pay for your expenses, then it means you can’t afford to pay for your current expenditures. Cutting expenses should be done until your income is sufficient to meet your monthly transfers while being able to pay off all your bills afterward.
This system is not fool-proof; in fact, it’s the opposite since it relies strongly on human behavior to succeed. The allocation of the funds between accounts and the adjustment of expenses as necessary sound like simple tasks, but it requires a lot of commitment from the business owner to stick to these actions without moving the money for other purposes. As long as the owner remains disciplined and strong-willed in his (or her) belief in this system, there is a high chance of success.