How to Prioritize & Increase Profits With the Profit First Method
The tax season is often a time when business owners review their finances from the prior year. And while this may seem like an arduous task, it’s also a great opportunity to set your business up for success for the years ahead.
Most business owners start a business with the goal of earning a great profit. Yet just a few months or years into it, they unintentionally lose sight of this goal as they get busy with day-to-day operations. But profit is not merely what's left over after expenses - it's the intentional allocation of funds to ensure business sustainability.
So today, we want to show you a method you can use to maximize profits in your business so you know where to direct your focus to keep your company profitable and ensure you’re well compensated for your business efforts.
By prioritizing profit from the start with the Profit First method, you’ll set your business on a path towards financial stability and growth.
What is the Profit First method? And why should you use it?
Profit First is a method designed to help business owners manage their business finances effectively in order to maximize profits on an ongoing basis. Developed by Mike Michalowicz, this approach differs from traditional business planning methods in that it doesn’t just focus on increasing revenues. It also ensures that those revenues are wisely allocated to make room for greater profits and reward the business owner for their efforts.
The foundational premise of the Profit First method is to set aside a portion of revenue as profit before covering expenses. Some of the benefits you can gain from using this method in your business include:
Financial stability for your business
Profits serve as a buffer against unforeseen expenses, economic downturns, or business challenges. They provide financial stability and allow your business to weather periods of low revenue or unexpected costs without having to resort to borrowing or other forms of financing.
More money to reinvest into growing your business
Reinvesting profits can fuel growth and innovation, enhancing the long-term viability and competitiveness of the business. These funds can be used to upgrade equipment, expand operations, hire more staff, invest in research and development, or launch new products and services.
Greater opportunities to expand and diversify
Profitable businesses have the flexibility to explore new markets, expand into new geographical areas, or diversify their product and service offerings. This diversification can help you reduce reliance on any single source of revenue or client.
So how do you actually implement the Profit First method to boost the profitability of your business?
4 steps to using the Profit First method in your business
Here are four steps that you can use to get started implementing the Profit First approach in your business:
1 - Establish separate bank accounts
You'll want to set up five separate bank accounts for your income, profit, owner's pay, taxes, and operating expenses. While this may seem like a headache at first, it will help you keep track of your money and simplify things in the long-term. We’ll explain more about these five separate accounts in the next section of this article.
2 - Allocate your revenues
Determine what percentage of your real revenue (or sometimes gross profit) you want to allocate to each account. In the Profit First methodology, these allocations are known as Target Allocation Percentages (TAPS). These percentages will vary based on the size and nature of your business.
3 - Set up automated transfers
Set up automated transfers between accounts using predetermined formulas and schedules. This will help you save time and avoid human error. For example, doing your allocations in a rhythm, like the 15th and 30th of the month, will allow you to know exactly when money is being moved.
4 - Review and adjust frequently
Regularly review your real revenue allocations and adjust them if necessary. As your business evolves, your financial needs and goals may change, so it’s important to stay flexible and make adjustments accordingly.
Now let’s take a closer look at the important step of setting up separate foundational accounts for your business and how to allocate funds to each.
Setting up your foundational accounts
When starting with the Profit First approach, there are five foundational accounts that you'll need to set up, each with a specific purpose:
1 - Income
This is where all of your revenue goes. By separating your income from your expenses, you can better track your cash flow and make informed financial decisions.
2 - Profit
Here, you'll set aside funds for your profit. By making profit a priority, you'll be more motivated to grow your business and increase revenues.
3 - Owner’s Compensation
This is where you'll allocate funds for your salary or draw to reward yourself for your hard work. As a business owner, it's essential to pay yourself a regular salary to cover your living expenses.
4 - Taxes
By setting aside a portion of your revenue for taxes, you’ll be able to avoid any surprises when it's time to file your taxes. When it comes to taxes, it's important to keep in mind that they apply to the net profit of your business.
5 - OpEx (Operating Expenses)
After you’ve allocated funds to all other accounts, the amount that’s left can be used to cover operating expenses that are essential for the day-to-day functioning of a business. These include items like employee salaries, rent, utilities, office supplies, insurance, advertising, maintenance, professional services, travel, depreciation, or software licenses.
After you've set up each of these five accounts, you’ll want to analyze your company’s financial data to see how money flows and decide how to allocate your real revenue to each account based on the Target Allocation Percentages. These percentages should be based on your gross profit - the difference between your total revenue and your cost of goods sold.
For example, you can put 5% of your real revenue (gross profit) into the tax account, 10% into the profit account, and so on, depending on the specific needs of your business. You can then adjust these allocations over time as needed. If you’re not sure where to start with these allocation percentages, you can also consult a Profit First professional to help you.
How to review & track your Profit First strategy
Creating a Profit First strategy for your business is a great step towards financial success. However, without consistently reviewing and refining that strategy, it’s easy to just let things go and get back into old habits that might not be moving your business forward.
After establishing your strategy, build time into your schedule - perhaps once a week - to look at your business finances. Here are 7 key metrics in your business we suggest reviewing at least once a month to help you stay on track towards greater profitability:
Revenue: Keep track of how much money is coming in and out of your business and look for any patterns you can use to help you manage your cash flow.
Cost of Goods Sold (COGS): How much is it costing you to provide a product or service? Use these numbers to reduce unnecessary expenses to ensure that you're making a profit in your business.
Gross Margin: Calculate your gross margin to see how much you're making off of each product and figure out the best pricing strategies.
Operating Expenses: Keep an eye on your operating expenses to see where you can cut costs and optimize your spending.
Net Profit: Once you subtract your operating expenses from your gross profit, you’ll arrive at your net profit - the ultimate number you want to maximize in your business.
Net Profit Margin: This is simply the percentage of revenues that result in profits. Through the Profit First approach, you can directly control the net profit margin ahead of time, rather than waiting to see what happens. It’s a proactive, instead of a reactive approach.
As you review these numbers on a consistent basis, you’ll get a better feel for how to adjust your Target Allocation Percentages as needed. To avoid overwhelming yourself when making changes to these allocations, start by making 1-2% changes until you build up to the amounts that would be ideal in your business. You can then set your business goals and Key Performance Indicators (KPIs) based on your desired revenue and profit numbers.
Want to avoid the nuisance of dealing with complicated spreadsheets and disorganized financial information as you review the numbers? Try Metrique to simplify your business finances. You’ll finally have a clear picture of your most important numbers, making it easier than ever to understand and analyze the health of your business. Plus you’ll be able to model hypothetical scenarios to see how allocation your revenues or adjusting your expenses will shift your bottom line so you can always stay focused on maximizing profits.
What if you have little or no profit in your business?
Whether your business is new or not generating much profit yet, using the Profit First method can actually help turn things around to start seeing more profits quicker.
The first step is to adopt a profitability-oriented mindset early on. This means examining your beliefs and actions around money, letting go of any disempowering ones, and making a conscious choice to prioritize the profitability of your business.
When developing profit-saving habits, it helps to start small. Allocate a percentage of your gross profit towards company profit - even just 1% initially. Over time, you can increase this amount as your business grows. This is easier to do when you have a plan for what you want to do with the profits you’ll be making - perhaps an exciting new business project you want to get started on once you accumulate a certain amount in profits.
If you don’t have a lot of profits to work with but want to invest into the growth of your business, you can also use debt, if managed carefully. While excessive debt can hurt your finances, being strategic about using debt can give you the leverage to grow and expand your operations enough to boost your profits in the long-run.
Plus, getting into the habit of creating a budget and regularly tracking your financial performance with tools like Metrique will help you make informed decisions that align with your business goals, values, and steer you toward greater profitability.
Integrate Profit First into your business seamlessly
Following the core principles of Profit First, including separating bank accounts, percentage-based allocations, automated transfers, and regular reviews, will help you achieve greater financial stability and growth in your business. And while the Profit First approach is simple, implementing it can feel overwhelming and time-consuming at first.
If you’d like the help and guidance of a certified Profit First professional, we’re happy to provide a full analysis of your business financials along with recommendations for ways to improve your profitability. To get started, learn about our CFO2GO program where you’ll gain the expertise and support of Metrique’s founder and certified Profit First expert to save you time in deciphering complex numbers and optimizing your business strategy.
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