What if you could make your business profitable simply by changing how you manage cash flow? This is the premise of the Profit First method of accounting — a technique for managing business finances popularized by Michael Michalowicz's 2014 book, "Profit First."
In a world where most new businesses never achieve profitability, the Profit First accounting method is a paradigm shift in how a startup can operate.
What is the Profit First method?
The Profit First method in accounting calls for directing a percentage of all sales directly to profit before taking out expenses. This starkly contrasts traditional accounting methods, which classify profit as income remaining after expenses have been paid.
Traditional accounting: Sales - Expenses = Profit
Profit first: Sales - Profit = Expenses
By taking profits off the top, the Profit First method aims to help entrepreneurs scrutinize their spending to ensure they're focusing on factors that drive profitability for the business. Michalowicz reasons that if 10% of your monthly sales go directly to profit, you'll be forced to figure out how to manage your resources more efficiently. In other words, it encourages you to prioritize a healthy profit margin and build a more conscious budget rather than leaving profit to the whims of adjustable expenses. Think of it like reverse engineering profitable growth.
The Profit First method also ensures entrepreneurs pay themselves for their hard work — something small business owners are often hesitant to do in the early days of the business.
How does the Profit First method work?
The Profit First method is relatively simple: take the profit out of your cash deposits before paying expenses. To perform the Profit First method responsibly, Michalowicz recommends that entrepreneurs utilize multiple business checking accounts to distribute percentages of the business's cash deposits.
The five foundational accounts used in the Profit First accounting are:
Income: A general-purpose account where all business revenue is deposited.
Profit: The account holding the predetermined revenue percentage your business takes off the top as profit.
Owner's pay: The account that holds the percentage of income used for the owner(s) to pay themselves a salary.
Tax: The account that holds the portion of business revenue allocated to pay taxes.
Operational expenses (OpEx): The account holds remaining business revenue not allocated for profit, owner's pay, or taxes covering business expenses.
How much money should you put into each account?
The trickiest aspect of the Profit First method is determining how much revenue you should allocate to profit vs. expenses. In his book, Michalowicz describes the amount you're currently allocating to each account as your Current Allocation Percentages (CAPs) and the amount you want to allocate to each account as your Target Allocation Percentages (TAPs).
The Profit First method aims to align your CAPs with your TAPs by optimizing spend. To help entrepreneurs accomplish this, Michalowicz guides how to best organize TAPs based on a company's annual income:
Michalowicz recommends that small businesses allocate revenue from the income account to the other accounts per their TAPs twice per month on the 10th and 25th (though you can adjust the specific dates in a way that makes the most sense for your business).
To use the Profit First method effectively, founders must pay their bills from the appropriate account. Revisiting your TAPs periodically and adjusting as the business scales are also advisable.
Is the Profit First method right for every small business?
Remember that while Profit First accounting can unlock new potential for your growing company, it isn't always the best fit for every business. For example, the Profit First method enables steady and controlled growth and is rooted in a longer-term vision. For many VC-backed startups in hyper-growth stages or looking to scale quickly, profitability is seen as a long-term goal rather than a short-term reality. As such, it can be tough to implement Profit First accounting while remaining aligned with venture-scale expectations.
That said, it's essential to consider your company's and team's unique position to ensure that Profit First aligns with your collective goals and roadmap.