Make a profit every year with the Profit First Formula

Many small business owners struggle to understand their cash flow (the money moving into and out of their business), and sometimes aren’t sure if they’ve actually made any money until the end of the year. Even worse, sometimes they haven’t made any money—but by the time they realize that, it’s too late to fix.

When a small business fails it's because of poor cash flow management or poor understanding of cash flow 82% of the time. That’s a stressful place to be and it doesn’t need to be that way.

One tool that can help is the book Profit First by Mike Michalowicz, which teaches business owners how to “transform any business from a cash-eating monster to a money-making machine.”

In this article, we’ll provide a summary of Profit First—including the Profit First method and the Profit First formula. Our aim is to help you:

• Better understand your business finances
• Set up a cash flow management system
• Make a profit and get paid, no matter how small your income might be

Putting profit first

So, what is profit? Check any business textbook and you’ll find that your profit is whatever’s left over after you subtract your expenses from your revenue.

Sales – Expenses = Profit

While it makes sense to cover your expenses first, there’s no guarantee that you’ll make a profit with this formula.

What is the Profit First formula?

The Profit First formula flips the equation, giving profit the focus it deserves.

Sales – Profit = Expenses

You might wonder what difference this really makes—isn’t it just semantics? Kind of. But what Michalowicz is trying to highlight is more psychological than anything: you have to approach your business thinking profit first, not profit last.

What is the Profit First method?

The goal of the Profit First method is to develop a system for building your business in a sustainable way that creates long term success. To get started you must first account for your profit, taxes, and your own pay. What’s left over is what the company has to spend on everything else.

We usually think of expenses (e.g., cost of material, rent, salaries, utilities) as unavoidable, when they can often be eliminated, avoided, or delayed. When you discipline yourself to set aside a percentage of revenue for profit and only spend what’s left to cover your expenses, you’re forcing yourself to spend more wisely.

Starting the Profit First method can be uncomfortable. It might mean you have to delay some of your spending on growth in the short term, even when you want to keep pushing forward.

But the Profit First method also means that when you do encounter a great opportunity to grow your revenue and profits, you’ll have the retained earnings available to invest in it without endangering your business. If you put every spare dollar back into your business, you might think you’re planting seeds for growth—but you’re actually putting yourself at risk for a future crisis.

How to implement the Profit First formula

1. Create smaller spending buckets

The first step is break down how you allocate your income by creating smaller spending “buckets.” A bucket refers to a collection of similar assets. In this case, your buckets are five bank accounts based on the core functions of your business:

1. Profit Account(Savings Account)
2. Tax Account (Savings Account)
3. Owner’s Pay (Savings Account)
4. Revenue (Transaction Account)
5. Operating Expenses (Transaction Account)

Imagine that each bank account is a bucket and your cash is the water. We’ll go over how to determine how much money to allocate into each account together. In addition, you might need a few other accounts depending on your business and the goals you want to achieve.

Most businesses can get started with these five accounts and build out from there. But if you’re feeling overwhelmed, it is okay to start off with only one or two accounts, like Profit or Profit and Tax.

Now, let’s go over determining how much money goes into each account.

2. Determine your Profit First percentages: CAPS and TAPS

There are two types of percentages we need to determine what your current finances look like and set your Profit First goals: the Current Allocation Percentages (CAPS) and the Target Allocation Percentages (TAPS).

You’ll use these Profit First percentages to determine how much money you distribute into your bank accounts.

Your CAPS show where your Real Revenue is being spent right now—what your business is buying day-to-day in its current format. You can figure out your current allocation percentages using the Preparing for Profit First calculator and worksheet.

Real Revenue is your Total Income minus the cost of materials and subcontractors. You should only take this into account if a large portion of your operations (more than 20%) requires materials and subcontractors.

The TAPS detail where we want your Real Revenue to go once the business is running at efficiency and profitability; these are the ideal percentages you’re working towards hitting.

The goal is to gradually move from your CAPS to your TAPS. You won’t hit these percentages overnight (or even this year in many cases) but you can’t work towards them until you know what they are.

It’s important to note that depending on the size and nature of your business, some of these numbers might deviate significantly from those outlined in the book.

Below is a chart outlining various revenue-dependent scenarios. We can see that higher revenue often increases profitability and operating expenses while decreasing the owner’s pay, for some businesses. These should be used as an example and may be different for your industry or business type.

3. Transfer your Cash

You should first put all your income into your income account. Establish a rhythm for transferring the funds that are accumulating in your income account to your other accounts.

How often should that happen? It’s completely up to you. The book recommends you allocate your money into the Profit, Taxes, Owner’s pay, and Expense accounts on the 10th and 25th of each month.

Many business owners start out thinking they need to follow the 10/25 rhythm exactly, but this isn’t necessary. Some business owners do it every two weeks, while others do it weekly. Whatever rhythm you establish, you need to stick to it!

4. Make Payments

Use your Profit First accounts to pay your bills. The key is to ensure that each account is only used for its designated purpose.

• Profit Account: This account accumulates a very small amount ‘off the top’ that can be used for debt reduction, emergencies, and for you to receive a bonus for all your hard work. The Profit First formula is about generating profit, so this account comes first!
• Owner’s Pay: This account is used to pay your after-tax salary or wage. Fight the temptation to ‘re-invest’ this into your business because it’s your salary. You need to get paid!
• Tax Account: Use this account to meet all your tax and superannuation obligations.
• Operating Expenses: This is all the money your business has available for operating expenses like office supplies, marketing, meals or business travel. Get creative and spend it wisely, because all the other accounts are spoken for. If you don’t have enough money to meet your operating expenses, then that’s a problem you’ll need to address.

As Michalowicz says in his book, “Owner’s compensation is the money you get paid for working in your business; profit is the reward you get for owning it.”

5. Review

At the end of each quarter, your unique Profit First system should be reviewed and adjusted.

The Profit First mindset shift will challenge you to re-evaluate every element of your business model, including your accounting methods and your personal financial situation. As your situation changes, so too will your need for cash, so your account transfers should reflect these changes.