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Make a profit every year with the Profit First Formula
We see a lot of business owners at Wave who haven’t yet mastered their cash flow, and aren’t sure if they’ve actually made any money until the end of the year. Even worse, sometimes they haven’t made money, but by the time they realize that it’s too late to correct. That’s a stressful place to be, and it doesn’t need to be that way.
At Wave, it’s our mission to help our customers become more sophisticated and confident when it comes to managing the financial side of their businesses. A lot of small business owners struggle with this—hey, you probably didn’t start a business because you loved accounting—so we make a point of sharing tools that can help make it clearer and easier.
One of the tools we often recommend is the book Profit First by Mike Michalowicz. It’s a well-written book that teaches business owners how to “transform any business from a cash-eating monster to a money-making machine.” Profit First focuses on a cash flow management system that ensures you’ll take a profit and get paid, no matter how small that income might be.
Putting profit first
So what is profit? Check any business textbook, and you’ll find that your profit is whatever’s left over after you subtract your expenses from your revenue: Sales – Expenses = Profit. While it makes sense to cover your expenses first, there’s no guarantee that you’ll make a profit with this formula.
The Profit First Formula flips the equation, giving profit the focus it deserves: Sales – Profit = Expenses. You might wonder what difference this really makes—isn’t it just semantics? Kind of. But what Michalowicz is trying to highlight for you is more psychological than anything: you have to approach your business thinking profit first, not profit last.
The profit first method
The goal of the Profit First Formula is to develop a system for building your business in a sustainable way that creates long term success. First you account for your profit, taxes and your own pay, and then what’s left over is what the company has to spend on everything else.
We usually think of expenses (e.g., cost of material, rent, salaries, utilities) as unavoidable, when they can actually often be eliminated, avoided, or delayed. When you discipline yourself to set aside a percentage of revenue for profit and only spend what’s left to cover your expenses, you’re forcing yourself to spend more wisely.
Doing that can be uncomfortable. It might mean you have to delay some of your spending on growth in the short term, even when you want to keep pushing forward. But, it also means that when you doencounter a great opportunity to grow your revenue and profits, you’ll have the resources to invest in it without endangering your business. If you put every spare dollar back into your business, you might think you’re planting seeds for growth—but you’re actually putting yourself at risk for a future crisis.
How to put the Profit First Formula to work
Create smaller spending buckets
The first step you need to take is to get more granular with how you allocate your cash by creating smaller spending buckets. To make this easier, you’ll need to set up bank accounts based on the core functions of your business:
- Income/revenue account
- Profit account
- Operating expenses account
- Owner’s pay account
- Tax account
In addition, you might need a few other accounts depending on your business and the goals you want to achieve. Most businesses can get started with these five accounts and build out from there.
Determine your CAPS and TAPS
This is more technical part of the system. Your Current Allocation Percentages (CAPS) show where your Real Revenue is being spent right now—what your business is buying day-to-day in its current format. This is often the most interesting part of putting the Profit First Formula into action, since most business owners rarely pay close attention to that information.
The Target Allocation Percentages (TAPS) detail where we want your Real Revenue to go once the business in running at efficiency and profitability. You won’t hit these numbers overnight, or even this year in many cases, but you can’t work towards them until you know what they are. It’s important to note that depending on the size and nature of your business some of these numbers might deviate significantly from those outlined in the book.Below is a table outlining various revenue dependent scenarios. We can see that higher revenue often increases profitability and operating expenses while decreasing owner’s pay, for some businesses. These should be used as an example and may be different for your industry or business type.
Transfer your Cash
Establish a rhythm for transferring the funds that are accumulating in your income account to your other accounts. How often should that happen? It’s completely up to you. Almost every business owner starts out thinking they need to follow to the 10/25 rhythm outlined in the book, but this isn’t necessary. Some business owners do it every two weeks, while others do it weekly. But once you establish your rhythm you need to stick to it!
Use your profit first accounts to pay your bills. The key is to ensure that each account is only used for its designated purpose.
- Profit account: This account accumulates a very small amount ‘off the top’ that can be used for debt reduction, emergencies and for you to receive a bonus for all your hard work. The Profit First Formula is about generating profit, so this account comes first!
- Owner’s pay: This account is used to pay your after tax salary or wage. Fight the temptation to ‘re-invest’ this into your business because it’s your salary. You need to get paid!
- Tax Account: Use this account to meet all your tax and superannuation obligations.
- Operating Expenses: This is all the money your business has available for operating expenses. Get creative and spend it wisely because all the other accounts are spoken for.
At the end of each quarter the system should be reviewed and adjusted. The Profit First mindset shift will challenge you to re-evaluate every element of your business model as well as your personal financial situation. As your situation changes, so too will your need for cash and your account transfers should reflect these changes.
Not using Wave yet but ready to grow your business?
Wave’s financial management software will help your run your business better, so you have more time to think about growth. Simply visit waveapps.com, click on “Create your free account,” and enter your email. You’ll be up and running in seconds. Download a copy of Fearless Accounting with Wave to get started with confidence.