The Basics
1. What is Profit First?
Profit First is a system (and a great book!) from small business finance expert Mike Michalowicz.
2. Ok. Besides that, what’s Profit First, really?
In business, we’re always told to pay ourselves first, but we’re never taught how. Profit First rethinks traditional accounting by prioritizing profit before paying any expenses. We take income, prioritize a percentage for profit, and use whatever’s left as our budget. If there’s not enough, we have too many expenses and need to make cuts. If Profit First were a mathematical formula, it would look like this: Income – Profit = Expenses
3. I’ve heard it’s like a diet plan for finances. How does that work?
There are four key principles that are similar to the idea of dieting:
• Use small plates. Smaller plates equal smaller portions. Smaller portions equal fewer calories. Fewer calories typically leads to weight loss. In Profit First, smaller plates are dedicated bank accounts.
• Start with the good stuff first. Satisfying hunger with vegetables rather than chips leads to a healthier balance, and lower overall consumption. In PF that means paying yourself first.
• Remove temptation. If cheat foods are inconvenient to get, you’ll eat less of them.
• Find your rhythm: Don’t wait until you’re hungry to eat. Plan ahead to manage hunger, which avoids binging and results in fewer calories consumed.
The result — for Profit First and dieting — is a leaner, fitter, and more profitable business.
4. Does it really work?
Yes. It changes your mindset and educates you on your finances. Profit becomes something you plan for, rather than something you hope for, meaning you’ll budget your expenses more carefully, a la Parkinson’s Law.
5. Parkinson’s Law? What’s that?
Author and historian C. Northcote Parkinson theorized that demand for a resource changes to meet the supply of it. In other words, when we’re given two weeks to do a project it takes two weeks, and when we’re given eight weeks to do the same project, it takes eight weeks. We’ll easily spend a $10,000 budget, but we’ll also make the most of a $1,000 budget if that’s all we have.
Profit First makes Parkinson’s Law an asset. By removing your profit from your budget, you force yourself to find ways to get the same things done for less money.
The Bank Accounts
6. How does Profit First work in practice?
Think of Profit First like the cash envelope system. You cash your paycheck and then divide it into various envelopes for different purposes: Groceries, Gas, Clothes, Utilities, Rent, etc. When the envelope is empty, the money has run out for that category. The only way to spend more is to pull from another envelope.
Profit First does the same thing, but uses bank accounts instead of envelopes, allocating income across them in specific percentages. These percentages are adjusted over time, so that profit increases from say 1% to 10% over 2 years, and operating expenses decrease from 65% to 45%, for example.
7. Wait! Five different bank accounts?
Yes. But don’t panic. We can help you figure that out. The 5 Profit First accounts are:
• Income. All of your income is going to be deposited here before being distributed to your other accounts. Chances are, you already have this as your business checking account.
• Profit. This acts as a cash-cushion/rainy-day fund as well as a quarterly source of profit distributions.
• Tax. The government always gets their money, so you may as well allocate it.
• Owner’s pay. This where your salary comes from. And yes, you should always be paying yourself a salary!
• Operating expenses (OpEx). This is your business budget. What you see in this account is what you have to work with.
8. More bank accounts means more bookkeeping. Is Profit First really worth the effort?
Yes! In fact, the extra bookkeeping is negligible, and possibly even more efficient than using just one account. With Profit First you simply reconcile the deposits and periodic transfers from the Income account. All expenses and payments come from the OpEx account. And all the other accounts are typically a single transfer in and a single transfer out on the 10th and the 25th. If you’re really lost, though, we can help!
9. What’s this about the 10th and 25th?
Profit First calls this the 10/25 Rule, where you allocate money from the Income account to the other accounts on—and only on—the 10th and 25th of each month.
10. Why does it matter when or how often I do my allocations?
By allocating and paying bills twice a month, you are not only more consistent and efficient, but it helps give further clarity to your cash flow trends and statements than smaller transactions throughout the month.
11. So should all these be checking accounts?
The short answer is no, but it depends on how exactly you’ll use those accounts. As a general rule, savings accounts yield interest but limit your number of withdrawals, while checking accounts allow unlimited withdrawls (and allows you to issue checks!) with the drawback of not yielding interest.
Since the Income account accumulates all deposits until they’re allocated, incoming funds “sit” for approximately 28 days a month—plenty of time to generate interest. So setting up the Income account as a savings account and all the other accounts as checking accounts allows the most flexibility for withdrawals and writing checks, while accumulating the most interest. Win, win!
Getting Started
12. How do I determine what percentage goes into which account?
It starts with an Instant Assessment, which you can do on your own, or you can work with a Profit First professional firm (like ours). It requires analysis of the company’s P&L and balance sheet, and a review of the owners’ personal tax returns. From there, we can develop your specific allocation percentages. We use industry benchmarks to establish goals for what those percentages should be for a high performing company, and create a map for achieving those goals over time.
13. Should I be using Total Income or Real Revenue?
Total Income is the top line revenue of a business. It represents all cumulative sales. Real Revenue is the Total Income minus the cost of materials and subcontractors. Think of it as the difference between gross and net gains.
The rule of thumb is if you’re a service-based business with full- and part-time employees, base your Profit First process on Total Income. If you are a manufacturer, retailer, restaurant or a service provider, or otherwise spend a significant portion (20% or more) of your operations on materials and subcontractors, do the Profit First Process based on Real Revenue.
14. Is Real Revenue the same as Gross Profit?
No. Gross Profit is the total revenue minus Cost of Goods Sold (COGs). COGs can include materials, subcontractors, employee labor, project costs (e.g. project related travel), and ancillary costs (e.g. shipping costs).
Real Revenue is a simpler calculation and less subjective. It is total revenue minus materials and subcontractors. For example, a home builder may have $10M in annual revenue, but requires materials and subcontractors that cost $7M a year. This builder really has $3M of “real revenue,” and needs to operate like a $3M company rather than a $10M company.
15. Since Profit, Owner Pay, and Tax are all for the benefit of me, can’t they all be in one account?
While the money allocated to these accounts do all benefit the owner(s), the use of the money is distinct. The Owner’s Pay is for your salary or regular recurring distribution; the Profit account is more like a quarterly bonus or a rainy day fund; and taxes, of course, are different from either of these monies. The accounts need to be kept separate so that you can instantly tell what money is allocated to what purpose.
16. Why is the Tax Allocation 15%? That seems pretty high.
The Tax account is intended to pay both corporate and personal taxes. When the owner has periodic taxes due, quarterly or otherwise, the business “pays” for the owner’s taxes. And since the money is being allocated on the 10th and 25th, the taxes should be reserved well in advance to offset any panic when taxes are due.
17. Shouldn’t I run up expenses to cut taxes?
That is one of the most damaging myths of money management. Running up expenses to reduce taxes is the same as spending ten dollars to save three, it is very damaging to the business. The goal is to run the business as profitably as possible (that is the only way to achieve financial freedom), and you should work closely with a Profit First Professional to additionally reduce your tax liabilities as much as you can.
Is it for me?
18. My business isn’t profitable yet. Is Profit First doable for me?
Absolutely! Even better to get those good habits hard wired from day one. In fact the sooner you start with Profit First the faster you will master financial discipline and ensure that your business runs efficiently. Plus, by paying yourself first, you are more sustainable and therefore more motivated to keep growing.
19. My business is already profitable. Can Profit First still help me?
Of course. Who doesn’t want to be more profitable? By using Profit First, your business will progress more quickly to meet your long term goals.
20. My business is in debt. How do I pay it off and still take a profit?
Pay all the minimum fees out of your Operating Expenses. Then use any remaining money you have in the OpEx account to pay off your smallest debt as fast as you can. No matter what, keep doing the profit allocation of Profit First every 10th and 25th. This sounds crazy since traditional GAAP accounting would be having you pay debt first, but you MUST build the habit of always taking your profit first. Then when you do your quarterly profit distribution, take 95%-99% of that distribution money and use it to crush one of your debts. The remainder (1%-5%) is used for you to celebrate. This process has you constantly chipping away debt while remaining profitable.
Final Thoughts
If you know Go Figure even a little, you know we are deeply committed to helping business owners better understand their financials, so they can experience peace of mind around their company’s money.
By adding Profit First to our services, we’re putting more focus on helping business owners take home more of what they earn. And one year later, we’re even more excited about Profit First’s potential for you and your business and for the opportunities it’s giving us to create deeper, more meaningful — and even more fun — relationships with our valued clients.
Most commonly asked questions sourced from GoFigure staff, “ProfitFirst” and ProfitFirst Professional assets by Mike Michalowicz. If you still have questions and want to learn more about how it could work for your business, email hello@gofigureaccounting.net.
