What is the Profit First Method, and Why Does It Work?

The Profit First accounting method was developed by Mike Michalowicz in 2014 based on his experiences after launching two multi-million dollar companies that did not show a profit. Profit First is a cash management system that prioritizes profit by treating it as a non-negotiable expense rather than a leftover.  The system is centered on physically separating your revenue into five different bank accounts: Income, Profit, Owner’s Pay, Operating Expenses and Taxes. The Profit First method works because it is based on a behavioral principle called Parkinson’s Law. Originally applied to time management, the Law states that work expands to fill the time available to complete it. Let’s look at the principles of Profit First, then explore why it is so successful.

Determine Your Profit Allocation Percentage

The first step is to determine what percentage of revenue should be allocated to profit. The recommendation is to start with at least 1%. If you can’t carve out 1% right now, that’s a signal your expense structure needs attention. The percentage should increase as your business adjusts. A common Profit First target is 5% – 10% depending upon industry and overhead.

Open Five Separate Bank Accounts

You’ll need five core accounts. An income account where all revenue lands. Then, a profit account, an owner’s compensation account, an operating expenses account and a tax account. E-commerce sellers might add a sixth account for inventory. The number of accounts depends on how much of your revenue goes to direct costs before overhead.

Allocate Revenue to Each Account

After profit is set aside, determine target allocation percentages for each remaining account. Every time revenue hits your income account, transfer funds to the other four accounts based on your preset percentages. It is recommended that you do this twice each month, typically on the 10^th and 25^th, to align with common payment cycles. Modern banking platforms have made this step really easy. Set up the calculations and let the automated transfer rules do the rest. That way when revenue hits your account it will automatically be distributed as you have designated.

Pay Expenses from the Designated Account

Operating expenses are paid from the operating expenses account. Owner’s pay comes from the owner’s compensation account, etc. You do not touch the profit account except for quarterly distributions. If the operating expense account runs low before the next allocation, you do not pull from profit to cover it! You delay the expense, renegotiate a payment or find another way to stay within your budget. That constraint is what makes the system work.

Traditional accounting uses the formula: Sales – Expenses = Profit. The Profit First method flips it: Sales – Profit = Expenses. So why does Profit First work? It makes profit automatic. It helps you plan for irregular expenses. Your finances stay organized. And, it creates a structure your financial advisor can easily work with. If you’d like to learn more about the Profit First method, and whether your business is a good candidate to use it, contact Caja Holdings. We’ll work with you to make sure that your business is, indeed, profitable!