How to use the profit first method to increase your business’s profitability

It’s easy to feel sidelined with business expenses and other obligations that stifle growth and eat into your company’s revenues, and unfortunately for small business owners, nearly 4 out of 5 small businesses fail in large part due to poor cash flow management. That’s where the Profit First approach to accounting can come in. This relatively new approach for modern entrepreneurs can provide a budgeting solution that promotes financial security and growth, and helps business owners take a smarter approach to managing their money.

As the name suggests, the Profit First business model can help increase profit, which can help your organization flourish in today’s competitive climate. Here, we’ll help you understand how the profit first method works and how it can contribute to the financial health of your small business.

What is the Profit First Method?

Mike Michalowicz, a successful serial entrepreneur and former small business columnist for the Wall Street Journal, launched three multi-million dollar companies before he turned 35. He later set out to pass on what he learned to other entrepreneurs through a series of best-selling books that outline a new way for business owners to think about revenue and profits. 

In his book Profit First, he lays out a strategy to “transform any business from a cash-eating monster to a money-making machine.” The book’s radically simple central idea came out of Michalowitz’s own struggles with maintaining cash flow with one of his earlier business ventures.

Rather than chasing the next big sale or expansion, Michalowitz decided to flip the typical accounting process on its head and set aside his “profits first.” He would take a percentage from each sale as profit, and then he focused on scaling expenses around that benchmark.

In a relatively short time, this method has earned acclaim from accountants and other financial professionals for introducing an innovative, effective budgeting strategy for business owners. It may sound counterintuitive at first, but if you focus your business around profit, everything else follows—including more profit.

How does the Profit First Method work?

To understand the Profit First business model, it’s important to review how profits typically work for small businesses. 

Traditionally, most business owners structure their budgets as follows: 

Income – Expenses = Profit 

In other words, you simply take your income and subtract your expenses, and whatever is left—which, for many business owners starting out, may not be that much—gets chalked up as profit. 

The Profit First business model shakes things up a bit, changing the formula to: 

Income – Profit = Expenses 

In other words, instead of immediately trying to account for your business expenses, you set aside a designated amount of cash to serve as profit. 

For example, you might commit to setting aside 10% of revenue and designating it as profit, before your expenses have a chance to take a bite out of their earnings. This method may take a little getting used to, but over time, it starts to change how you think about the money coming into your business. Specifically, it encourages you as a business owner to prioritize your own pay (something which often gets overlooked) and being more thoughtful about the expenses you’re accounting for. 

And even if you’re not managing the books or are relying on the help of an accountant to keep things in order, Profit First encourages you to maintain a closer relationship with your business finances, which is critical when it comes time to scale. 

How can you optimize your banking practices for Profit First? 

Using the Profit First Method requires having strong control over your cash flow and being able to adequately separate out money based on different buckets. The best way to achieve that is to distribute your funds into your main account and five separate sub-accounts:

• Income: Your main business checking account holds the revenue that your business earns. You can optimize for Profit First by allocating a set percentage from your revenue earned to count toward your business’s profitability.
• Payroll: This sub-account is where your team’s salaries and wages would go.
• Tax savings: This sub-account is where you’ll set aside a fixed amount to go toward taxes. 
• Operating expenses: This account holds cash meant to go toward salaries, rent, office supplies, business travel, and other bills etc.
• Marketing expenses: This sub-account would be where you’d keep your marketing budget.
• Emergency: You would use this sub-account to save money for unexpected expenses and emergencies.

Because separate accounts are so central to the Profit First strategy, it’s important to look for a bank or banking platform that supports easy account management, like the ability to open a series of sub-accounts under your main account. You can start small by simply designating accounts for ‘Operating expenses’ and ‘Tax savings,’ then work toward adding the others as your business grows.

Some of the best business checking accounts even give you the power to set up automatic transfer rules between your main account and sub-accounts, so you can automatically transfer a percentage of your balance to an ‘Income’ sub-account or your main account if that’s where you decide to keep profits.

Did you know?

With Bluevine Business Checking, you can create sub-accounts to separate budgets for expenses, emergencies, taxes, payroll, and more. You can also easily set up automatic transfer rules to use the Profit First strategy by creating a ‘maximum balance’ rule and setting the maximum balance to $0.

Learn more

How much should go into each separate account? 

Figuring out how much of your cash should flow into each of the aforementioned accounts starts with first understanding two types of goals: current allocation percentages (CAPs) and target allocation percentages (TAPs). 

Your CAPs reveal how your money is being spent right now, based on your current income and expenses. Your TAPs, on the other hand, reveal your desired budget and show what your business would look like if it were operating at peak performance and efficiency. 

Michalowitz helps break down allocations based on TAPs, with examples of adjusted percentages based on your business’s yearly income: 

Notice that, as your business grows, it will impact the amount of money that you should be allocating to different buckets. For example, as your business grows and starts bringing in more revenue, the more money you’ll be putting toward operating expenses (and the less you’ll be adding to the owner’s comp bucket). 

Michalowitz recommends that business owners make a habit of allocating money into ‘Income,’ ‘Taxes’, ‘Operating expenses,’ and ‘Payroll’ accounts or sub-accounts on the 10^th and 25^th of every month. However, the specific days aren’t as important as making sure that you have a system in place that works for you.

For this method to be effective, you need to ensure you use each account to pay the bills designated in each category. At the end of every business quarter, you can go back and review your budget and make any adjustments as necessary.

Did you know?

As a good rule of thumb, if there is money left over in your main account or ‘Income’ sub-account at the end of a quarter, you as a business owner can claim 50% of that as a bonus but should put the other half in your ‘Emergency’ sub-account to build a capital reserve for your business.

Every business is different, and sometimes it takes a little testing to figure out the right approach to managing your business finances. Profit First is a method that, when implemented correctly, can help support sustainable long-term growth. And while it may take some getting used to and can stall immediate growth, this approach to financial planning for your business is designed to set you up for ongoing success in the long run.