Profit First: How to Grow Your Small Business Sustainably

Profit First is a revolutionary concept introduced by Mike Michalowicz in his book, “Profit First: Transform Your Business from a Cash-Eating Monster to a Money-Making Machine.”

This book cuts through the noise and gives an actionable plan for financial success in business or personal life.

It’s not your typical finance guide filled with confusing terminology and complex concepts. Instead, it offers a refreshing approach to cash management that is simple, effective, and based on human psychology. The Profit First concept is a game-changer for busy entrepreneurs who are short on time, overwhelmed, and not seeing the financial results they desire.

In this article, we will explore the concept of Profit First and how small business owners can apply it to grow their business

What is Profit First?

Profit First is a cash management system that prioritizes profit over everything else. It flips the traditional view of accounting which is not effective for small businesses because it does not take into account the realities of cash flow.

Traditionally, here’s how you would calculate profit:

SALES – EXPENSES = PROFIT

The Profit First system flips this formula making profit the top priority, based on the following formula:

SALES – PROFIT = EXPENSES

This seemingly simple change alters how you manage your finances.

How does Profit First help you manage your finances?

The Profit First System encourages business owners to change their behaviour around money in order to effectively manage their finances.

Here’s an overview of how it achieves that objective:

Profit First adds the human component to conventional accounting

A key difference between Profit First and conventional accounting is that Profit First takes into account natural human psychological and behavioural tendencies; whereas conventional accounting is more about rational tracking and reporting of financial information.

Profit First doesn’t present any new accounting concepts.

Instead, the Profit First approach recognizes that business owners are not always rational when it comes to money. They may be prone to certain biases or tendencies that can impact their financial decisions. In fact, various studies show that some behavioural tendencies/ biases can harm your financial health, even if you have the best accounting knowledge.

Therefore, Profit First gives a set of strategies to implement sound financial management while also curbing typical human biases.

Profit First “guarantees” profit and limits expenses

The amount of money you have available tends to dictate your spending habits. When you have more money you tend to spend more, and when you have less you tend to spend less.

Research data shows that lower-income earners tend to spend more when they get more money compared to high-income earners. Moreover, recent ABS data shows that almost half of Australian businesses are experiencing increased operating expenses.

You may have plenty of revenue coming into your business, but if your expenses are high, you may end up with very little profit to show for it. This is where Profit First comes in.

With Profit First, you take your profit first, rather than waiting to see what is left over at the end of the day. You’ll set aside a certain percentage of revenue for profit beforehand, and only spend what is left over on expenses. Doing that forces you to be more mindful of your spending and helps ensure that there is always a profit at the end of the day.

Ultimately, limiting your expenses also forces you to seek creative ways to cut costs.

How to manage your business finances using Profit First

What makes Profit First particularly useful is it presents a set of practical actions to manage business finances efficiently.

Here’s an overview of the practical recommendations.

Four principles of money management

The Profit First System utilizes four main principles to support better money management by leveraging on natural human tendencies.

Here’s how the four principles can help you implement Profit First:

1. Small Plates – Allocating funds in small “plates” limits spending and encourages frugality.

2. Serve Sequentially – Prioritizing profit before everything else ensures that you don’t overlook this crucial aspect of the business when dealing with multiple issues in running a business.

3. Remove Temptation – Transfer profits to a separate, out-of-sight account to avoid spending it on expenses.

4. Enforce a Rhythm – Avoid reactive/ impulsive spending by establishing a consistent rhythm of allocating funds to specific accounts on specific days of each month.

Five main bank accounts

To implement this system in your business, you’ll first set up five main bank accounts. (The specific number of bank accounts will depend on the business type, business structure, cost of having multiple accounts, and other factors.)

The five accounts are:

• Income - For revenue coming into the business

• Profit – Pays down debt and the business owner. Should not be used to reinvest in the business. Instead, set up a separate account for business reinvestment

• Owner's Pay – Pays your salary.

• Tax – Pays business taxes

• Expenses – Pays overheads and operating expenses.

Next, determine the Target Allocation Percentages (TAPs) of your revenue to allocate to each account based on your business structure, type of business, and current financial situation.

For example:

• Owner's Pay – 45%

• Expenses – 30%

• Tax – 20%

• Profit – 5%

Finally, twice a month you’ll transfer the allocated funds from the “Income” account to their corresponding accounts. Some banks provide an automated system that automatically transfers allocated funds based on your predetermined percentages.

With those separate accounts, you’ll conveniently restrict the use of funds only for their specific purpose.

How much profit to set aside with Profit First

The key is to set aside a realistic percentage of revenue for profit, as well as other business costs.

This will vary depending on your specific business and industry. But generally, you’ll start with a small percentage and gradually increase it over time.

As a useful benchmark, here are the average profit margins in various industries in Australia (2020-21):

Limitations of Profit First

Although effective, the Profit First system can have downsides that business owners should be aware of.

• One potential problem is that short-term profits may reduce future payoffs. If you take too much profit, you may not have enough to invest in the business for long-term growth. That may lead to slow growth.

• Another downside is the challenge of ensuring that Target Allocation Percentages (TAPs) are reasonable and achievable.

Ultimately, you’ll need to find the right balance between maximum profit now and less profit for future growth.

How Cleverly Accounting can help you implement Profit First

Our team of professional accountants at Cleverly Accounting can help you implement the Profit First system effectively.

We understand the challenges small business owners face and recognize the importance of having a system in place that can provide financial stability and growth. Therefore, we always take a comprehensive approach by:

• Making an in-depth assessment of your financial situation. This includes a review of your cash flow, income, expenses, and debt.

• Creating a customized plan with the most realistic business budget percentage breakdown/ allocation for the different Profit First accounts.

• Providing ongoing support and guidance to help you monitor and adjust the Profit First system based on business growth and other factors.

To learn more about how we can help, call us at (08) 6186 1998 or book an obligation-free 15-minute discovery call.