Simplified: Implementing the Profit First Model for Entrepreneurs and Small Businesses
by Cory A. Wilson
I don’t usually fall in love so fast, but I can’t help it on this one. Mike Michalowicz’s profit-first approach is an amazing financial framework for small- and mid-sized businesses, entrepreneurs, and even families.
That’s why I’ve created a tool to get you going right now. Download this spreadsheet, and follow along.
Profit First for the rest of us
The profit-first approach challenges our standard assumptions about how businesses should operate. Normally, we think Revenue - Expenses = Profit. Because anything can be justified as an expense, many entrepreneurs will often overspend, with claims such as “it’s a write-off!” or “I’m reinvesting profit into my business so I can grow.” Spending “profit” on your business is an expense.
Mike Michalowicz challenges this logic with a simple re-statement of this formula: Revenue - Profit = Expenses. This approach changes the conversation to focus on goals and priorities. This approach considers what is possible and proportional, while removing any accounting wizardry.
When we start with revenue and profit, we are left with this question: Can my business run on what is left? If not, maybe we’re doing something wrong.
Define your buckets
To simplify our conversation for today, I’m going to refer to the various areas in which we slice and dice our spending as buckets. This approach will allow us to distinguish between these areas and our actual bank accounts, other types of financial products, and our budget or chart of accounts. Our buckets are the primary allocations of our revenue.
For everyone
Start with Profit, Taxes, Emergencies, and Operations. This assumes that your business is fairly straightforward and is most likely related to professional services or that you're just getting started.
Pro tip: Look at your last few years of taxes, and estimate your effective tax rate (revenue/taxes paid = effective tax rate). This rate is the percentage you should assign for taxes.
Pro tip: For emergencies, I recommend saving until you have at least 6-12 months of operating funds. You may want to start with a higher allocation to increase the rate of savings until you reach your milestones. After that, stick with a rate of 1% to continue to enhance that buffer.
For the solopreneur and small businesses
If you have payroll obligations, add a Payroll bucket. If you have contractors that you pay fairly regularly, add a Contractors bucket. If you have projects on longer timelines or with lots of related expenses and/or if you receive large deposits or retainers for work, add a Projects bucket. These additions are great for design firms, people running retreats or events, and even nonprofit organizations.
Pro tip: Money placed in the Projects bucket isn’t considered revenue yet because it’s for the future. When you draw from this account, count it as revenue for your allocations at that time.
For retail, online sales, and businesses with inventory or manufacturing
Create a Stock bucket for reinvesting the revenue percentage needed to repurchase or create stock. This bucket is also beneficial for retail, cafes, apparel, and more.
Setup your allocations
In setting up your initial allocations, be realistic about where you are today. This is accomplished by assigning a percentage for each bucket such that the total of all of your buckets adds up to 100%.
At a minimum, set your Profit to 1%, Taxes to 10%, and Emergencies to 1%. In this case, 88% remains for Operations and Pay/Owner draw. If you have investors, you’ll want to make sure that your Profit bucket is set to the minimum return expected by the investors.
Create new accounts
Create a bank account (or rename/repurpose existing accounts) for each of your buckets. If this feels overwhelming, start with your current accounts and add one account every few months.
Evolve your allocations over time
Starting small with only a few buckets is the perfect first step. I recommend trying to stick with this initial approach over the course of one or two quarters. From there, assess your profit/loss and balance sheets to determine how things are really going. Does reality match up with your original goals? Feel free to adjust accordingly. To avoid any system shocks, change the allocation percentages in small amounts (1% or 2% at a time, generally) to help avoid sudden financial cliffs.
Don’t cheat
Do not change the allocation percentage each month. Try to get the percentages right and stick with them for a few months to determine how things really are. The goal is to get your company operating within this framework in a way that leads to long-term stability, not to bend the framework around your business.
Allocate your cash
On the 7th day of each month — or whenever a bulk of your transactions consistently clear — add up your total revenue or income (minus any deposits), and use the spreadsheet and your allocations to determine the transfers you need to make. Then, make those transfers!
By doing this, you’re making sure that your capital is allocated well before you spend it elsewhere. If we have small plates, we eat less.
Automate where possible
There aren’t many (any?) banks that can automate transfers as a percentage of deposits; thus, a little management is needed here. If your revenue is fairly consistent, feel free to estimate the minimum amounts you’ll need to transfer each month and set them for the 7th day of the month. Check on your allocations every 3 to 6 months and update.
Let’s go
The profit-first methodology applies the concept of proportionality to everything you do. How much should I pay myself? It’s proportional to revenue. When should I hire new staff? When the Payroll account is consistently overfunded because my revenue exceeds my established minimums. When should I make upgrades to my website? When my operating account has an excess such that I’m not in danger of running out of cash later.
More importantly, this approach forces us to come to terms with the realities of our business. If your allocation for operations is not sufficient to run a given aspect of your business, then you have two options: find more revenue or reduce your overhead.
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