Whether you’re new to business accounting, or your business has been around for a while, you may have heard of Profit First accounting.
The very name, “Profit First”, lends promise to business owners who may be struggling to set aside revenue for profits.
But is Profit First all it’s cracked up to be?
Take a closer look at what it is, who should use it, and what challenges you can expect when implementing a Profit First accounting method.
What Is Profit First Accounting?
Profit First is a book and accounting method authored by Mike Michalowicz, which aims to help small business owners improve their cash flow and profitability.
The method involves setting aside a percentage of revenue as profit before paying expenses and then allocating the remaining money to cover expenses and taxes. The goal is to ensure that a business is consistently generating a profit, rather than just breaking even or operating at a loss.
The method also involves using separate bank accounts for different business expenses, such as taxes, operating expenses, and profit, to help better manage cash flow and budgeting.
How Does Profit First Accounting Work?
Profit First is an accounting method that emphasizes prioritizing profit in a business's financial strategy.
The basic principle is to set aside a percentage of revenue as profit before paying any other expenses. The business owner determines this percentage, but the system encourages setting aside at least 5-10% for profit.
The remaining revenue is then divided among expenses, taxes, and other obligations. By prioritizing profit in this way, the Profit First system aims to help businesses become financially stable and successful.
What Are Profit First Accounts?
Profit First accounts are different bank accounts that are set up to separate and manage the various types of income and expenses in a business.
The main accounts used in the Profit First method are:
- Income account: This is where all revenue is deposited.
- Profit account: A certain percentage of revenue is transferred to this as profit.
- Tax account: Another percentage of revenue is set aside in this account to cover taxes.
- Operating Expense account: The remaining revenue is allocated to cover operating costs.
- Owner’s Pay account: The owner’s salary is paid out of this account.
By separating the income and expenses into different accounts, the Profit First method makes it easier for business owners to track their financial performance and ensure they are consistently making a profit.
What Are Profit First Percentages?
The Profit First percentages are the percentage of revenue that is allocated to each of the above-mentioned accounts. The exact percentages may vary depending on the business and its goals.
The general allocation is as follows:
- Profit account: 5-10% of revenue is transferred to this account as profit.
- Tax account: 10-25% of revenue is set aside in this account to cover taxes.
- Operating Expense account: 50-80% of revenue is allocated to cover operating expenses.
- Owner’s Pay account: The remaining revenue is used to pay the owner’s salary or other owner’s draws.
It’s important to note that these percentages are not fixed and can be adjusted as the business evolves. The key is to have a clear understanding of the business’s financials and make adjustments as needed.
Current Allocation Percentages (CAPS)
Current Allocation Percentages (CAPS) is a variation of the Profit First Method. CAPS is an alternative method for determining the percentages for the different accounts in the Profit First system.
Instead of using fixed percentages for each account, CAPS uses a more dynamic approach. CAPS starts with creating a baseline allocation percentage for each account, then adjusts the percentages based on the current financial situation of the business.
The CAPS method uses the following steps:
- Establish a baseline allocation percentage for each account.
- Monitor the actual financial performance of the business and compare it to the baseline allocation percentages.
- Adjust the allocation percentages as needed to better reflect the current financial situation of the business.
- Repeat steps 2 and 3 regularly to ensure that the allocation percentages remain accurate and aligned with the business's financial goals.
The goal of CAPS is to help business owners make more informed decisions about allocating their revenue and managing their cash flow.
Target Allocation Percentages (TAPS)
Target Allocation Percentages (TAPS) is a variation of the Profit First method that involves setting target percentages for each of the accounts used in the Profit First system, based on the financial goals of the business.
TAPS helps business owners align their financial decisions with their desired financial outcomes by keeping the target allocation in mind while making decisions.
The main idea behind TAPS is that setting target percentages for each account helps business owners be aware of where their money should be going and make sure that the money is being allocated in a way that aligns with their goals.
TAPS involves the following steps:
- Identifying the financial goals of the business.
- Establishing target allocation percentages for each account, based on the financial goals of the business.
- Monitor the actual financial performance of the business and compare it to the target allocation percentages.
- Adjust the allocation percentages as needed to better align with the financial goals of the business.
- Repeat steps 3 and 4 regularly to ensure that the allocation percentages remain accurate and aligned with the financial goals of the business.
It's important to note that TAPS is built on the same principle of the Profit First method, which is to prioritize profitability and align financial decisions with the goals of the business. The difference is it adds an extra layer of targeting the allocation percentages.
Who Should Use Profit First Accounting?
Profit First accounting is particularly well-suited for businesses that tend to overspend, who are new to managing finances, or who struggle with managing their finances.
The Profit First method can be used by any business, but it’s particularly useful for businesses that:
- Have a hard time setting money aside for taxes, profit, or other expenses.
- Have a history of overspending.
- Are struggling to make a profit, or want to increase their profitability.
- Want to better understand their finances and make more informed decisions about their money.
Profit First provides a simple and straightforward system for managing cash flow and increasing profitability.
The Profit First method is a cash management system and is not meant to replace traditional bookkeeping or accounting, but rather to be used alongside it.
Who Shouldn’t Use Profit First Accounting?
Profit First is not suitable for all businesses, it depends on the needs and financial situation of each business.
The Profit First accounting method may not be beneficial to businesses that:
- Are already highly profitable and have a strong cash flow.
- Have a very low profit margin.
- Are in a start-up phase and do not have enough revenue to support the additional accounts required by the Profit First method.
- Have a very high revenue and the Profit First method might not be able to provide the granularity needed to track the performance of the different parts of the business.
- Are not comfortable with opening multiple accounts or are not able to open multiple accounts due to banking regulations.
The Profit First method is a good way to manage cash flow, but it’s not the only way. Business owners are encouraged to explore different methods and find the one that works best for their business.
What Are Some Challenges To Implementing Profit First Accounting?
Implementing the Profit First accounting method can be a valuable tool for small business owners. However, there can be some implementation challenges, including:
- Changing financial habits: Changing how a business handles its finances can be difficult, especially if the business owner has been doing it a certain way for a long time. It can take time to adjust to the new system and to consistently follow the Profit First method.
- Setting aside money for profit: One of the key principles of Profit First accounting is to set aside a percentage of revenue for profit. This can be difficult for business owners who are used to spending all of their revenue on expenses.
- Opening multiple bank accounts: The Profit First method required the use of multiple bank accounts to separate different types of income and expenses. Opening multiple bank accounts can be time-consuming and may require additional fees.
- Keeping track of multiple accounts: With multiple bank accounts, it can be challenging to keep track of all the transactions and balances for each. It’s important to have a good system in place for monitoring and reconciling the accounts regularly.
- Maintaining the system: Profit First accounting requires regular monitoring and adjustments to ensure that the allocation percentages are accurate and aligned with the business's financial goals. It can be challenging to maintain the system over time, but with the help of a financial professional or accounting software, the task will become much easier.
- It’s not a magic solution: Profit First accounting is a cash management system. It’s important to have realistic expectations and understand that it may take time to see results.
Overall, implementing Profit First accounting requires a commitment to changing financial habits, remaining consistent, and staying patient with the process.
Will Profit First Accounting Help Your Business Succeed?
The Profit First accounting method is not a guaranteed solution for business success. It’s a tool that can help the financial health of a business, but it’s not a magic solution to all financial problems.
The success of the Profit First method will depend on the business owner’s ability to consistently follow the system and make adjustments as needed.
Business owners should weigh the pros and cons of the method to determine if it’s a good fit for their business and financial goals.
5 Alternatives To Profit First Accounting
There are alternative methods to the Profit First accounting system, CAPS, and TAPs. These include:
- Zero-Based Budgeting: This method involves creating a budget from scratch each month. Starting with zero dollars, every dollar is allocated to specific expenses and savings. This approach helps the business owner to understand where their money is going and make sure that all the expenses are necessary.
- The 50/30/20 Rule: This method involves dividing your income into three categories: 50% for necessities, 30% for discretionary spending, and 20% for savings and debt repayment.
- The 80/20 Rule: This method focuses on identifying the 20% of activities that are responsible for 80% of results, and then allocating resources accordingly.
- Cash Flow Forecasting: This method involves projecting future cash inflows and outflows to anticipate potential cash flow problems and take action to prevent them.
- Accrual Accounting: This method records financial transactions when they happen, regardless of when the money is received or paid. It gives a more accurate picture of a company’s financial health by tracking revenues and expenses as they occur, rather than when cash changes hands.
These alternatives are not mutually exclusive. You can pick and choose the elements that work for you and incorporate them into your accounting system.
No single method is the best for every business. Know your business’s unique needs and financial goals and then choose the method that supports those goals.