What Is Profit First Budgeting?
Profit First isn’t just one thing; it’s many. It’s a book, written by Mike Michalowicz; a novel accounting system; and in essence, a way of life that focuses not only on healthy actions that lead to strong business but also attainable behaviors that don’t require a huge personality makeover first. Below, we have summarized some takeaways from Michalowicz’s book.
The premise is simple: Before paying expenses, take your profit first.
Michalowicz is a serial entrepreneur who has created several successful businesses. But the Profit First system was born out of complete failure, at a time when he had lost every penny to his name and was unable to provide for his family.
The culprit? He had created businesses that generated lots of money, but they were also, as he puts it, “cash-eating monsters.” Michalowicz had received big deposits, and the first thing he did was spend the money on cars, homes, and an expensive lifestyle—in addition to writing checks to cover business expenses.
Eventually, his business took a hit and sales plummeted. But the bills—lots of them—didn’t stop.
His business grew, but it grew in an unsustainable and unhealthy manner.
Unfortunately, due to all of the expenses and spending decisions, he wasn’t able to cover the offset of a dip in sales and lost it all.
This is, of course, a summarized and very condensed version of his life and the setbacks that gave birth to the Profit First concept.
He points out that what he and many entrepreneurs didn’t know was “the difference between making money (income) and taking money (profit). These are two very, very different things.”
For many, growth is the focus of running a business. But not all growth is the same. Healthy growth, that is the kind that leads to freedom, is likely what you’re after.
According to Michalowicz, business owners’ job is “to maximize profit, regardless of the current size of your business.” In other words, he says entrepreneurs need cash.
According to Michalowicz, money problems occur when one of two things happen: Sales slow down, which leads to less revenue. Less obvious a problem is when sales speed up (often related to an incessant need to grow).
“As your income climbs, expenses quickly follow,” he states in his book. “Big deposits feel great, but they are irregular. Consistent incoming cash flow is hard to sustain. A great quarter can trick you into believing your business is on a permanent upswing.”
This means you may not be ready for a decrease in cash flow, which can lead to issues, such as struggling to cut expenses quickly enough.
This becomes a key principle in Profit First, a system is designed to make sure you always have some cash available.
The wrong way to look at accounting, according to Michalowicz
The wrong way is what Michalowicz calls “bank balance accounting.” This is when you look at your bank account and based on what you see, you make spending decisions.
This can lead to a perpetual “survival trap,” where you may end up repeatedly looking for the quickest way to get your hands on some cash. When there’s not enough, one may resort to drastic measures, including taking on new debt.
Expanding business haphazardly can also take you further from your mission. For example, in an effort to grow your business, maybe you begin to dabble in anything and everything, which means you can’t stay true to your values or master your niche.
Generally Accepted Accounting Principles (GAAP) is the standard for accounting. It looks like this:
Michalowicz believes that this places too much emphasis on growing sales and not enough on profits.
The Profit First Methodology
The first order of business in Profit First is to place a much larger focus on profits, and not on sales and expenses.
The Profit First formula is:
For Michalowicz, the GAAP formula requires a level of discipline that not every business owner can attain.
Instead, he believes the Profit First equation fits in with basic traits of human nature since we tend to not save first, spend impulsively, and make decisions based on what we see in the bank account. It’s why Michalowicz likes this method so much: You don’t have to change who you are in order to be profitable.
The four core principles of Profit First
The core principles have their basis in behavioral science and healthy eating.1. Smaller plates
Smaller plates can lead to smaller portions.
For your business, this could mean that you simplify, reduce expenses, and are austere. More money leads to spending more money; less money leads to innovation.2. Change the sequence
If you fill up on veggies first, you’re less likely to eat other things on your plate that might be less healthy, such as dessert.
For your business, you can make profits the star instead of expenses. Take profits first. This may help to lower the amount of money available to you (after taking profits, taxes, owner’s pay) to spend on expenses.3. Remove temptation
If you’re trying to eat healthier, a great way to avoid chips, soda, or candy is to not buy them or get rid of what you have.
When you get paid, remove the temptation to spend that money. Immediately move it into your profit bank account, a separate account. The goal here is to make it harder to access and spend.4. Develop a rhythm
The longer you eat healthily and exercise, the easier it becomes to do. Likewise, the Profit First strategy may become easier to commit to if you stick with it.
The Profit First Accounts
According to Michalowicz, setting up different bank accounts is an important part of the Profit First method. It’s similar to the envelope system—a budgeting system where one places money for different expenses, such as rent, car payment, insurance, and more, into different envelopes.
Income account: This is where you receive payments. From here, you’ll send money to the four other accounts.
Profit account: Put 1% to 2% of deposited money into this account. The point is to leave this amount in here, where it’s “out of sight, out of mind.” You should not touch this money and count on it being there. If it’s in your personal bank account, it becomes too easy or tempting to touch, according to Michalowicz.
Why 1% to 2%? Michalowicz says that with such a small amount, you won’t even feel it. But, over time, the money in this account will accumulate and be there when you need it.
Owner’s pay account: Place 30% of a deposit here. This is the account from which you pay yourself.
Taxes account: Move 15% or more (if you know you have a higher tax rate) into this account. This money is for taxes; nothing else.
Operating expenses account: What’s left of the deposit goes here.
Using this method, Michalowicz predicts that you’ll end up taking more than 45% of the revenue right off the top from the very beginning. This means you have less money left over with which to run your business. But now you can determine what you can actually afford to spend based on what remains, which is significantly less than the initial deposit.
An Example of Profit First
Let’s look at what the Profit First system asks you to do.
- Imagine you have received a deposit. Let’s say it's $5,000.
- Immediately, you will transfer 2% ($100) of this to your profit account.
- 30% ($1,500) will go to the owner’s pay account.
- 15% ($750) goes to the account for taxes.
- You have $2,650 left.
Reality check - What are you left with? If you can’t cover expenses with what remains, you may need to cut expenses.
This will likely force you to be creative, find ways to innovate and avoid the trap of using all of your profit to pay for expenses.
In the book, Michalowicz addresses the question he’s often asked: How can I grow if I don’t reinvest all of my profits back into my business?
His answer is that by using the Profit First system, you are going to prioritize profits, which will tell you if you can afford to grow the way you want to.
If not, you’ll know what you need to change first, in order to grow.
Michalowicz suggests specializing in order to get good at what you do. Because by focusing on profits and implementing the core principles, you’ll review what is making you money and what isn’t.
If you want healthy, sustainable growth—which, not so surprisingly, will spawn more healthy growth—Michalowicz encourages business owners to reverse engineer the profit.
What’s needed to make this work?
Profit first is supposed to be a simple method to help you keep more of the money you earn.
Discipline in implementing, committing to, and sticking with this strategy is necessary. And yet, it’s a flexible plan. You can adjust the percentages to better fit your business.
Are all the different bank accounts necessary?
Well, you’ll have to be the judge of that. The purpose of the Profit First system is to make sure that business owners have cash. And since the system recognizes that human nature doesn’t always opt for the most disciplined or smartest choice first, the different bank accounts can facilitate this strategy.
If you struggle with discipline, then setting up five different bank accounts might be the path for you. But remember that setting up different accounts means you have a few things to take into consideration, such as whether they require minimum account balances, charge for transfers, or come with other fees.
Explore Profit First Budgeting
While this is a brief overview of the Profit First method, you may want to read Michalowicz’s book for the most comprehensive breakdown of his system.
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