Profit First accounting — or Profit First bookkeeping — is a relatively new concept in the business world. Usually, business owners would think about how to spend money on the business before ever thinking about what they were going to take home. This sounds great for the business, but it may not actually be good if the owner can’t bring home the bacon.
In this post, we’ll talk about the Profit First accounting method and how it’s different from traditional ideas about profit and investing back into a business.
What Is Profit First Accounting?
Entrepreneur and author Mike Michalowicz first spoke of the concept of Profit First accounting in 2014. He wrote the book “Profit First,” where he explained this revolutionary idea of looking at profit first. Profit First bookkeeping is a modern concept in accounting because it suggests the opposite of what has been done for centuries.
In a nutshell, Profit First bookkeeping prioritizes allocating funds to the business owner before designating budgets for business expenses. This means paying yourself before even thinking about what you can spend on the business.
How Does Profit First Work?
The traditional accounting systems that we have used for hundreds of years tell us to take our total sales and subtract our expenses from that amount. That’s where we get our profit. Profit First accounting teaches us to reverse that order. We are to first subtract a desired profit from the total sales, then figure out what can be spent on the business.
Traditional bookkeeping treats profits as what you have left after you spend for the business. Profit First accounting says that you are more important as the business owner, so you get taken care of first, then what’s left over can go to business operating expenses.
What Are the Profit First Percentages?
The system of Profit First accounting cannot work without knowing the amount of profit to subtract from sales. Usually, as Michalowicz’s book suggests, you as the business owner would designate a percentage for this. This makes it a bit more fair than actually dictating an amount, which can end up being 80% or more of the sales. That can mean other people not getting paid and even having to close down the business.
So, you would ideally decide on a percentage for profits. Then you would determine what percentage of that goes to your pay as the owner. You would also want to add in the percentage of tax you would need to pay. Then you can see what’s left over for business expenses. If you’re not sure what to allocate, you can begin with a range. For example, you can tag profits at between 10% and 20%, and owner’s pay at between 10% and 40%. Then you can figure out the rest.
As you get used to the Profit First system, you can adjust your Target Allocation Percentages. They are not inflexible numbers that you must abide by. The percentages will depend on your particular business. Usually, though, the percentage for profits and expenses will grow as the business makes more money, and the owner’s pay percentage will get smaller.
What Are the 5 Profit First Bank Accounts?
The Profit First accounting system recommends that a business owner maintain five separate bank accounts.
These accounts are Income, Profit, Owners Pay, Tax, and Operating Expenses.
You will notice that they are the same as the Target Allocation Percentages, plus one for all the money that will be coming in from sales. The Income account is the first receptacle of all proceeds from sales. From here, you would transfer money into the other accounts based on the percentages that you determined.
Not all banks support the Profit First bookkeeping method, so ask about it when choosing your bank.
For example, the best bank for a Profit First business will not charge fees for going below a certain balance. This is so that you can move money around accurately without extra costs or figuring out which account the maintaining balances should come from. You don’t want any additional hassles or complexities that can mess up your system. Choose a bank that will help you easily manage your money in these five accounts.
Example Of Using Profit First Accounting
Let’s use a simple example for the sake of understanding the profit first concept. Here are the givens in our scenario:
Monthly Sales = 100 for a product that costs $100 = $10,000
Profit Percentage = 30% = $3,000
Owners Pay = 20% = $2,000
Tax = 10% = $1,000
Operating Expenses = 40% = $4,000
Every time you make a sale, Profit First bookkeeping dictates that you record 30% of that $100 as profit.
That means $30 per sale, or a total of $3,000 for the month.
Then you would record the owner’s pay, which is $2,000 for the month at a rate of 20%.
If your taxes are about 10%, then your budget for expenses sits at 40%. That leaves you with $4,000 to pay rent, utilities, payroll, reinvest in your business, and all that jazz.
How Does It Help Me as a Business Owner?
When you separate out profits and pay yourself first, you instantly make your business more profitable, even if you are just starting out. It helps you to reduce expenses so that you do not overspend. This also makes you more careful with how you spend. Parkinson’s Law states that work expands to fill whatever time you have available to complete the work. When applied to Profit First accounting, that law means that you run your business based on a fixed budget for expenses instead of watching expenses grow because you have a bigger budget. This way, you will never underpay yourself.
Contrary to traditional thinking, business expenses are not unavoidable. If you get creative and use Profit First as a discipline, you can reduce your operating costs and keep the business lean.
Note that we are not talking about pinching pennies here. Profit First is not about robbing the business to pay the business owner. That makes no sense. However, you can be more egalitarian in the distribution of money. This actually benefits the business more in the end. After all, if you are not getting enough pay as the owner, you would probably not keep that business alive for long. Just be more intentional and strategic about what you are spending on so that you get the greatest impact for your business from each spend.
Businesses don’t need to follow the same old methods forever. Profit First works, and it can help you be more profitable faster so that you are happy and the business can keep growing steadily as you learn to be wiser with expenses.