Business Profitability: Profit First Accounting Tips

Last week, we discussed the basics of Mike Michalowicz’s Profit First method. It is a way to rethink how you manage business income and expenses. When done right, it can help you ensure a certain amount of profitability and better manage your cash flow from sales and other revenue sources. Read the full article here.

Today, we want to dive a little deeper into the Profit First method and look at how to approach the accounting itself. Previously, we’ve established that you should set up five separate business accounts:

1. Income—The primary revenue that the business earns (before allocation).
2. Profit—An allocated percentage of revenue to cover unexpected expenses, or count toward additional profitability once all expenses are covered.
3. Tax—A fixed amount going toward business taxes.
4. Operating Expenses—Cash to cover all operating expenses—rent, supplies, salaries, travel, marketing, utilities, etc.
5. Owner Compensation—Your fixed salary or set percentage as the business owner.

How Much Cash Should I Put in Each Account?

By having these accounts set up, you can effectively manage your cash flow and make sure that a predetermined amount of each sale is allocated properly. So, how much of your money should flow into each of these accounts?

Let’s start by identifying two key goals:

1. Current Allocation Percentages (CAPs)—How your cash is being spent right now in relation to current expenses and revenue.
2. Target Allocation Percentages (TAPs)—Your ideal allocation of cash if your business was operating at peak efficiency.

Basically, you will be setting a range using your CAPs and TAPs. You have to start the Profit First method based on what you are earning right now. At the same time, you should be projecting for your target revenue growth goals. As your business income goes up, your allocation percentages might change. Michalowicz illustrates a sliding scale in his book.

Adjusting TAPs Based on Business Income

For example, he shows a company making less than $250,000 a year. Here’s how he recommends allocating the cash into each of the accounts. Of course, the income account will always be 100% of the revenue coming in, and then it needs to be appropriately disbursed into the other accounts from there.

• Profit – 5%
• Tax – 15%
• Operating Expenses – 30%
• Owner’s Compensation – 50%

As you can see, half of the revenue is going toward the owner’s compensation. You are making sure to pay yourself as a primary operating expense when the business is less profitable. As revenues and profits go up, the scale slides and the money is allocated differently. Let’s compare the allocation breakdown based on a target annual revenue of $5-10 million:

• Profit – 15%
• Tax – 15%
• Operating Expenses – 65%
• Owner’s Compensation – 5%

Naturally, the tax allocation stays basically the same while the other allocations change quite a bit. More money is being distributed toward operating expenses. Costs generally increase as your business gets larger and more successful. You have more employees, higher fixed costs and more expenses overall. This is why the operating expenses account receives a much higher allocation. Meanwhile, the owner’s compensation allocation goes down significantly. Why? Because the relative revenue is much higher. 50% of $250,000 revenue is $125,000. 5% of $5 million revenue is $250,000. The business owner’s personal income has doubled despite a much lower allocation percentage. Plus, there is more going into the general profit account, so that is potentially additional income for the owner at the end of the year.

Michalowicz’s model actually shows an owner’s compensation allocation of 0% once the company exceeds $10 million in revenue. More cash is allocated to the profit account (20%), which is where the owner ultimately makes the most income within a highly successful and profitable business.

Is Profit First Right for You?

The main point of Profit First is to make sure your own income and business profitability is covered as if it were a fixed operating expense. Higher operating costs often lead to more sales motivation to bring in enough revenue. This leads to more business growth. As the business grows and reaches its target income goals, the cash allocations can be adjusted in order to allow for continued growth—all while profitability and a steady income are ensured.

Next week, we will explore some of the advantages and disadvantages of the Profit First method.

If you are an entrepreneur in need of need business planning, tax planning and personal financial planning guidance, contact Illumination Wealth today for an introductory consultation.