Profit First Method: Increase Profit With This Formula

Many small business owners struggle to pay themselves consistently while keeping their businesses afloat. The Profit First method offers a new approach to cash flow management, helping entrepreneurs prioritize profit and ensure they’re compensated. While this may sound intuitive, it’s often difficult to balance personal pay with business expenses. Profit First not only secures owner pay but also encourages a creative, disciplined approach to managing every expense.

Mike Michalowicz first introduced the idea in his book, Profit First. Since then, the method has won praise from accountants, entrepreneurs, and advocates for financial independence. But switching to a Profit First mindset can be a challenge. Keep reading to learn how to set up your accounting to put Profit First and learn how North One can make the process easy.

What is the Profit First Method?

Traditionally, profit is calculated by deducting expenses from total sales, leaving whatever remains as the profit.

Traditional Profit Formula:
Sales – Expenses = Profit

The Profit First formula takes a different approach, flipping the standard profit calculation on its head. Instead of seeing profit as what’s left over, the Profit First formula allocates revenue to profit and then uses what’s left over to pay for expenses.

Profit First Formula:
Sales – Profit = Expenses

Switching to this method may feel uncomfortable at first because it goes against common advice given to business owners: maximize growth at all costs. However, focusing on growing sales without prioritizing profit from the start can quickly drain a business’s cash reserves, putting it at serious risk of failure. 

Putting profit first makes business owners more careful about spending. It also helps them make business decisions that match their financial health and work-life balance. This mindset shift can be transformative, especially for those unaccustomed to paying for themselves.

What About Other Costs?

It might seem unrealistic to “put profit first” when a business has critical expenses to cover. So how does the Profit First method make this work?

After allocating money to profit, business owners divide the remaining funds to cover essential expenses such as taxes, operating costs, and the owner’s salary. The amounts to set aside for each category are determined by Target Allocation Percentages (TAPs), which are recommended guidelines based on your business’s revenue and financial needs.

Current Allocation Percentages (CAPs), on the other hand, reflect how your money is actually being allocated right now—essentially, how you’re currently spending your income. By comparing your CAPs to the TAPs, you can see where your business is spending too much or not enough money. This helps you make changes that are needed.

By setting aside money for each category, business owners can see their financial health better and avoid the common problem of spending too much.

How Does the Profit First Method Work?

It may seem like a big ask to flip the traditional way of accounting for profit on its head. Luckily, the Profit First method is simple and easy to set up. Follow these four steps to get started:

1. Determine Your Profit Margin

The first step in the Profit First system is deciding what percentage of your revenue you want to allocate to profit. A common recommendation is to aim for a profit margin of at least 5%, but this can vary depending on your business’s size, goals, and financial needs. If you’re currently unable to allocate any profit, you may need to re-evaluate your business budget and spending habits. This step ensures that profit is built into your business from the beginning, even if it means starting small.

2. Set Up the Five Profit First Accounts

Next, you’ll need to open five separate ‌accounts for your business to divide your income and expenses efficiently. These accounts should include:

• Profit Account: For setting aside your profit, which you can take as a distribution or reinvest.
• Owner’s Salary Account: To allocate funds for the business owner’s salary or compensation.
• Operating Expenses (OpEx) Account: For business expenses like rent, utilities, and materials.
• Taxes Account: To set aside money for taxes, ensuring you’re prepared when tax time comes.
• Emergency Savings Account (Optional): To create a buffer for unexpected business expenses.

By having separate accounts, you make sure money is set aside for each purpose. This makes it less likely to use money that is set aside for unnecessary expenses.

It’s important to work with a bank that knows the Profit First method. Some traditional banks can make it hard to open and manage many sub-accounts. Many banks limit the number of accounts you can open or charge fees for each one, making it harder to save money for specific things. 

However, there are banks that focus on providing easy-to-manage accounts, like North One. Their Envelopes feature makes it easy to open and automatically fund the five Profit First accounts.

3. Allocate Revenue to Each Account

After you’ve set up your accounts, it’s time to allocate your incoming revenue based on Target Allocation Percentages (TAPs). These percentages are the amount of money you’ll allocate to each account each time you make a deposit. For example:

• Profit: 10% of revenue
• Owner’s Pay: 40% of revenue
• Operating Expenses: 30% of revenue
• Taxes: 20% of revenue

The goal is to allocate profit first, followed by taxes, owner’s compensation, and operating expenses. As your business grows, you may find the need to tweak these percentages to better suit your financial situation.

The percentages above are just examples. You can optimize your TAPs and CAPs with Profit First Percentages. These percentages serve as a roadmap for how your business allocates its income based on annual revenue. Check out the chart below to see how percentages change as revenue grows:

4. Use Designated Accounts to Pay Expenses

Now that you’ve made your allocations, you’ll use the money in your Operating Expenses Account to pay for business costs like rent, salaries, and utilities. You’ll use the money you set aside for taxes to pay your business taxes, and the funds in the Owner’s Pay Account will cover your salary or compensation.

By ensuring that each expense is paid from the appropriate account, you prevent overspending and ensure that your profit remains untouched.

Pros and Cons of the Profit First Method

The Profit First method offers a fresh approach to managing business finances, with a focus on profitability from the start. However, like any system, it has its advantages and challenges. Here’s a breakdown of the upside and downside:

Advantages:

• Guaranteed Profit: By prioritizing profit first, you ensure your business is always profitable, even in lean months. Setting aside profit before covering other expenses helps safeguard your financial health.
• Better Cash Flow Management: The system encourages careful allocation of income, which prevents overspending and improves cash flow. By designating specific accounts for taxes, owner’s pay, and operating expenses, you’re less likely to miss essential payments.
• Clearer Financial Picture: With separate accounts for each category, you gain a clear view of your finances, making it easier to track where money is going and identify areas for improvement.
• Simplifies Budgeting: Profit First helps simplify budgeting by automating the process of allocating percentages to different accounts. This takes the guesswork out of financial planning, helping you stay on track with your business goals.

Disadvantages:

• Requires Discipline: The Profit First method demands a higher level of discipline. Business owners must consistently allocate funds to the appropriate accounts and avoid dipping into funds meant for other purposes.
• Not Ideal for Every Business: Some businesses, especially those with fluctuating revenue or high overhead costs, may find the Profit First method difficult to implement. The fixed percentages may need constant adjustment, which can be cumbersome for some owners.
• Bank Fees: Traditional banks may charge fees for maintaining multiple accounts, which can add up over time. It’s essential to find a bank that offers easy account management without excessive charges, like North One.

While the Profit First method can offer significant benefits in terms of profitability, cash flow, and financial clarity, it also requires discipline and careful setup. Consider whether this approach aligns with your business’s needs and if you’re ready to commit to the system for long-term financial success.

How to Open Profit First Accounts With North One

North One Business Banking account lets you create free Envelopes to segment your money. You can create envelopes in a few quick clicks and automate what percentage of each payment goes where. Folks following along with Profit First have already noticed how useful this feature is for their new journey.

North One enables Profit First entrepreneurs to open envelopes for Income, Owners Compensation, Operating Expenses (OpEx), Profit, and Tax accounts in just a few clicks. North One also has no minimum balance for these accounts so you don’t have to worry about low-balance fees.

Open up a North One account here to get started on your Profit First journey. Making big changes in your business accounting — and making real steps forward — doesn’t have to be complicated. North One is happy to help you get started.