The book Profit First by Mike Michalowicz was published in 2014. Pitched for businesses surviving from “check to check,” the book reveals a revolutionary formula to help you make more money. This formula stems from Michalowicz’s theory that the GAAP accounting method is setting up businesses for failure.
GAAP Accounting – What Most Businesses Use
For those who don’t know, the GAAP accounting method is an accrual-based accounting method. This means that revenue and expenses are accrued instead of recording them when cash is incoming and outgoing. So, while the GAAP accounting method may give you a true representation of your monthly revenue and expenses as they’re incurred, it can leave you with a cashflow headache. For example, you may earn revenue from an order placed in May, but you don’t get paid until June. And it’s not just delayed payments that defy logic with GAAP; it’s also the fact that the GAAP formula goes against human nature. Here’s the formula:
Sales – Expenses = Profit
Under the GAAP formula, profit becomes a leftover resource. If it’s there, you can take it, and if it’s not, there’s no profit. Similarly, this relates to Cyril Northcote Parkinson’s theory, “the demand upon a resource tends to expand to match the supply of the resource.” Applied to the GAAP formula, this means you may see revenue come into your business and, by nature, may see that all of this money is available for expenses. Basically, the expenses expand to the amount of money available in your account. As a result, businesses have less profit under the GAAP formula.
Introducing Profit First
To turn around the way business owners think about profit, Michalowicz introduced this formula:
Sales – Profit = Expenses
Under this formula, profit is prioritised. In practice, you could set aside a predetermined percentage of your sales for profit. This amount is automatically transferred to a separate bank account and the remaining money covers your businesses expenses. While this may be a difficult shift to make at first, it forces you to work with the money you have to cover expenses. This could mean your business postpones a large asset purchase, delays a new hire, or thinks of new and inventive ways to cover expenses and grow the business.
Implementing the Profit First Formula
To implement the book’s principles in your business, there is some administration you need to complete. First, you need to decide on the percentage of revenue you’ll allocate to profit. As a general rule of thumb, Michalowicz suggests 15%. This number could be more depending on your business structure and industry. After you’ve decided on the percentage of sales you’ll allocate to profit, set up dedicated bank accounts to reflect the formula. These accounts will include profit, owner’s pay, tax and an everyday account for revenue and expenses.
How to allocate Profit under the Profit First Formula
Once you’ve decided on your profit percentage allocation and set up your bank accounts, you need to determine if you should be allocating profit based on total income or real revenue. If you run a business where operational expenses are more than 20% of the total income such as materials and subcontractors, you should allocate profit from ‘real revenue.’
The book introduces the term real revenue. It means that total income in a resource-intensive business doesn’t truly reflect the size of the business. For example, a home painting business may have $1 million in revenue each year, but it requires $700,000 worth of materials and subcontractors to complete the work. This means the business is actually a $300,000 business, and this is the real revenue. In this case, the business owner would allocate profit based on $300,000 real revenue, not total income.
For services based businesses that don’t have large operating expenses, profit can be allocated from total income. This is suitable for online businesses who don’t need to pay employees or have other large overheads.
The profit first formula is a new way to think about how your business makes a profit. While it takes time to adjust, it’s a transformative way to approach your finances in your business. Remember, the content in this article is for general information purposes. You should speak with your accountant before you make any big changes to your bookkeeping and accounting processes to make sure it’s right for you.
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