How to use the profit first method to increase your profitability

What is the Profit First method?

The Profit First method requires the owner to set aside a percentage of all sales as profit.  The remaining sales dollars are allocated to pay other expenses. The owner then uses a bank to set up separate accounts and deposits sales dollars for profit and other costs.

Mike Michalowicz created the Profit First method to help owners improve cash flow management and operate a profitable business.

The method is similar to some personal finance strategies. Many individuals “pay themselves first” by transferring money into a savings account as soon as they receive income. The Profit First method segregates business profit as sales are generated.

Profit First formula

The Profit First formula is:

• Sales (revenue) - profit = expenses

For this discussion, sales and revenue are the same. The Profit First formula differs from the income statement formula:

• Sales (revenue) - expenses = profit

Profit First focuses on profit rather than solely on revenue growth. The owner should work to control expenses to consistently generate profits and cash inflows.

How does the Profit First method work?

To illustrate the Profit-First method, assume that Summit Equipment manufactures and sells fitness equipment. The company generates $100,000 monthly revenue and wants to implement the method.

Relay is a resource that explains the Profit First steps:

1. Determine your profit margin

Use industry research and your business forecast to determine a profit margin. Assume that Summit uses a 10% profit margin.

2. Set up the five Profit First accounts

Summit Equipment sets up five bank accounts. The first bank account used is the Income account. All sales dollars go into the Income account before funds are allocated for other purposes. Here are the other four accounts:

• Profit
• Taxes
• Owner’s Pay
• Operating Expenses

Summit needs to allocate funds to the four accounts at least monthly, and many businesses allocate funds every two weeks. Once funds are transferred, Summit can pay expenses using a debit card, check, ACH, or other methods.

You'll want to find a low-cost banking option that automates account transfers for effective money management. Also, confirm if the bank has a minimum balance requirement.

3. Determine your allocation percentages

Summit Equipment uses these target allocation percentages:

• 10% Profit 
• 15% Taxes
• 10% Owner’s Pay
• 65% Operating Expenses

4. Allocate revenue to each account

These are the dollar allocations for $100,000 monthly revenue:

• $10,000 Profit 
• $15,000 Taxes
• $10,000 Owner’s Pay
• $65,000 Operating Expenses

5. Pay expenses from the appropriate accounts

Finally, expenses are paid by transferring dollars from the appropriate bank account. 

Payroll and inventory purchases are paid using the Operating Expenses account. Total operating expenses cannot exceed the $65,000 allocated from revenue, and this control allows Summit to maintain the company profit level.

Who is Profit First best for?

The Profit First method is best for businesses that generate a profit, control expenses, and fund each bank account with discipline. Generally, it is a tool for controlling costs and generating reliable cash inflows.

Is the Profit First method right for every startup?

The Profit First method may not be a fit for some startups. Startups with a small profit margin or operating at a loss cannot implement Profit First as a financial management system. A startup may not produce the revenue needed to fund the accounts used in the Profit First accounting method.

The Profit First method requires the business to fund a profit bank account with sales dollars. A VC-funded startup may focus on rapid revenue growth without the immediate need for profit. 

Benefits of Profit First

The Profit First method offers several benefits for your business:

• Clear, disciplined process: The method provides a clear path to prioritize profits using a disciplined approach.
• Expense control: Profit First businesses should constantly monitor and work to reduce expenses to maintain profits. Businesses avoid wasteful spending and innovate to control costs.
• Cash flow stability: When costs are controlled, the business is less likely to use credit cards or other expensive methods to secure more cash. The company has more cash flow stability.

Parkinson’s Law can be applied to business management in several ways. One application is to budgeting and expenses. 

Assume that your company has a $20,000 travel budget. According to Parkinson’s Law, the staff will use up most or all of the budget, even if the spending isn’t useful. The Profit First method limits the dollars available in each category and forces the owner to justify each dollar spent.

Disadvantages of Profit First

The Profit First method also has disadvantages that make the process challenging for some businesses.

• Low-profit margin businesses: Firms with high overhead costs and small profit margins will struggle to implement the Profit First method.
• Large debt balances: A company with a large debt balance cannot reduce expenses enough to use the Profit First method. Debt payments are fixed and cannot be reduced in the short term.
• Startups: Many startups focus on rapid business growth and generating cash flows. Immediate profitability is not a goal.

Traditional accounting vs. Profit First

Traditional accounting requires businesses to use the income statement. As explained above, the income statement formula is:

• Sales (revenue) - expenses = profit

Revenue is matched with expenses that are incurred to generate revenue. Profits are calculated at the end of the period (month or year). 

The Profit-First method sets aside a percentage of all sales (revenue) as profit and funds bank accounts to pay expenses. Traditional accounting determines profit last, while the Profit-First method determines profits when sales are generated.

Current allocation percentages (CAPs)

Owners use a two-step process to allocate revenue into different bank accounts. First, they evaluate the current amounts spent on operating expenses, taxes, and owner compensation. In addition, they note the profit generated on each sales dollar (profit margin).

Target allocation percentages (TAPs)

Target allocation percentages (TAPS) are based on businesses with good financial health and similar revenue. The allocations also take into account the company’s industry. 

For example, the NYU Stern School of Business tracks profit margins by industry, and this data can be used to determine a target profit level. The allocation percentages determine the amounts deposited into each bank account.

Alternatives to the Profit First method

Owners can use several other methods for financial management:

Zero-based budgeting

This budgeting method starts at zero each month. Managers allocate costs to specific activities, and every dollar spent is analyzed. Zero-based budgeting identifies wasteful spending so that the costs can be eliminated. 

This method effectively avoids the Parkinson’s Law issues discussed above.

Accrual accounting

The accrual accounting method is required to comply with Generally Accepted Accounting Principles (GAAP). Revenue is matched with expenses that are incurred to generate revenue. 

Accrual accounting posts revenue and expenses when they occur and ignores cash inflows and cash outflows.

Cash flow forecasting

Business owners can produce a monthly cash flow forecast using this formula:

• Beginning cash balance + cash inflows - cash outflows = ending cash balance

If a month ends with a negative cash balance, the owner should consider obtaining financing to operate the business.

FAQs about the Profit First method

How do you calculate Profit First? 

The Profit First method requires the owner to set aside a percentage of all sales as profit.  The remaining sales dollars are allocated to pay other expenses. The business owner sets up separate bank accounts and deposits sales dollars for profit and other costs.

What are the 5 Profit First accounts? 

• Income account
• Owners compensation account
• Operating expenses (OpEx) account
• Profit account
• Tax account

What are the Profit First Percentages?

The Summit Equipment example above uses the most common target allocation percentages. Here is the range of allocation percentages businesses typically use for the Profit First method:

• 0% to 20% Profit 
• 15% to 25% Taxes
• 0% to 50% Owner’s Pay
• 30% to 65% Operating Expenses

What is the Profit First 10/25 rule?

The 10/25 rule refers to dates when funds are transferred from the revenue account to the other accounts. Many Profit First businesses transfer funds on the 10th and the 25th of each month. Companies that use the 10/25 rule often pay suppliers shortly after each of the two dates.

Wrap-Up: All about the Profit First method

The Profit First method can be a game-changer to manage costs and consistently reach your profit goals. Owners need business banking services and financial reporting tools to implement the Profit First method.

Successfully generating accounting information necessitates clean data; however, obtaining this level of data can require numerous hours. Leverage technology to save time.

Manage all of your spending and cash using Rho’s automated platform. Rho is a business banking platform that offers the tools companies need to manage their cash and grow their businesses.

Backed by 24/7 customer support, Rho offers business checking accounts, treasury capabilities, and enterprise-grade spend management – accounts payable, corporate cards, and expense management – with no monthly fees.

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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.

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