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In our family’s monthly budget reports, I share details about the way I use Mike Michalowicz’s Profit First accounting method in my solopreneur business. I share my current business revenue, expenses, and the salary I set aside for myself. In this post, I’d like to explain more about the Profit First system itself so that you can decide if it is right for you.
Before jumping into the explanation, though, let me come right out and say this:
Implementing Profit First has been the single best thing I have done to really understand my business finances and the health of my business.
It’s also one of the best things I have done to improve our family’s finances, since it finally allowed us to have a consistent “income” despite wide fluctuations in my business from month to month.
The need for a system
I’m a strong believer in budgets. I create monthly budgets for our family, which we use so that we can make the most progress towards our financial goals each year. Being intentional with our money has a clear impact: we don’t spend (as much) on the things we don’t really care about, and we direct more of our money toward the things that matter to us.
Our business finances need the same care and attention, even if we are a micro-business or a business of one.
Without a system for understanding business finances, it can be difficult to determine whether your business is actually healthy or not. I remember that when I first started my tutoring business, I was bringing in more money than I had been in my previous W-2 job.
But what I didn’t realize was that because my students were scattered throughout the greater Seattle area, the amount I was spending on transportation was cutting into my profits significantly. And then there are taxes, which for self-employed individuals can be much higher than expected.
In my own thinking, though, I tended to gloss over these expenses, and I was never entirely clear on how much I could take from the business as my pay.
The amount of clarity I gained from implementing Profit First was priceless. I can now confidently say what revenue targets I need to hit in order to know that my business can afford to pay me the salary I need.
Profit First explained
Profit First is both a big picture idea and a concrete method for business accounting.
The underlying idea of Profit First is essentially a mental shift towards treating profit with more intention (the same way I argue we should be intentional about our money goals in our personal finances).
In his book, Mike Michalowicz suggests a revision of our traditional conceptualization of profit as what is left over after you subtract your expenses from your revenue:
Sales – Expenses = Profit
He performs a bit of algebra, and proposes a slightly different version of this formula:
Sales – Profit = Expenses
Yes, it’s just algebra, but it encapsulates a mindset shift.
In the traditional equation, profit is a leftover. Subtract out your expenses, and hope that there’s some profit left over.
In the second equation, profit is set aside first, and the business has to make do with the leftovers. Essentially, this mathematical sleight of hand forces us to run a leaner business, preventing expenses from growing out of control.
It’s the same logic you might be using in your personal finances if you automatically transfer part of each paycheck to savings or to a retirement account before you even get the chance to spend the money on random stuff.
Implementation of Profit First
For a clear and detailed explanation of how to implement Profit First in your business, I highly recommend reading the book. But here’s a basic overview:
First, you’ll set up a few different bank accounts for your business so that you can set aside money ear-marked for a particular purpose into the bank account specifically designated for that purpose.
In the book, Mike Michalowicz recommends five accounts:
- Income – for capturing all revenue
- Owner’s Compensation
- Taxes – either business taxes or your own income taxes as the business owner
- Operating Expenses
The book contains recommendations for what to look for when choosing bank accounts, but basically you just want to make sure the accounts have no fees and no low-balance penalties.
Then, twice a month, you’ll take any revenue that has come in, and you’ll dole it out to those other bank accounts according to percentages you have decided in advance. (The book walks you through an exercise to help you determine what your starting percentages should be, and then recommends adjusting every quarter to get closer to where you’d like them to be.)
Once you have the system set up, the goal is to run your business based only on the money you have in your expenses account. You’ll pay yourself from your owner’s compensation account, and you’ll pay your taxes from the taxes account.
And the fun part – once a quarter, you’ll also give yourself a bonus from the profit account.
How I use Profit First in my business
I first implemented Profit First in my tutoring business by setting up multiple accounts at my local credit union. While I started out with the five accounts recommended in the book, I soon added a sixth account for professional development business expenses, which I decided to budget for separately.
I shifted around my allocation percentages from time to time throughout my first year using the profit first method. Partly, it was a learning process to determine what was sustainable for my business. But sometimes I adjusted the percentages to reflect new goals I set for my business.
In case you’re curious, my current allocation is as follows:
- Profit: 2%
- Taxes: 18%
- Owner’s Compensation: 63%
- Operating Expenses: 8.5%
- Professional Development: 8.5%
I’m also currently experimenting with using a single high-yield checking account instead of the six different accounts at my credit union. I love getting 1.1% APY through my American Express Business Checking account – and I’m also earning a $300 bonus for setting up the account. It’s a little more cumbersome, though, since I have to keep track of how much money is in each Profit First “bucket” through a spreadsheet. If that doesn’t sound fun to you, then follow the book’s advice to create multiple bank accounts.
As I said previously, implementing Profit First has been one of the best business decisions I have ever made. I value so much the clarity it has given me as a business owner. It has given me a way to be intentional with my business finances the same way I try to be with our family’s personal finances.
I do know, though that intellectually knowing the broad-stroke steps for Profit First is different from actually knowing how to move forward in your own particular case. If you’d like support, please know that I offer pitch-free complimentary coaching sessions. I’d be happy to help.