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or decades, businesses have followed the same formula when managing their books: sales minus expenses equals profit. While this method has become standard practice, it's not the only way to manage your business finances. The Profit First method has become an increasingly popular alternative to traditional business accounting.
Profit First accounting is revolutionary because it involves entrepreneurs paying themselves before addressing any expenses. For decades, small business owners have accepted less compensation than they deserve because they pay themselves last, after spending most of their money on their business expenses. Profit First flips this idea on its head and provides a more desirable way to conduct business for the modern entrepreneur.
Here's a closer look at Profit First accounting, the method that is helping small businesses become profitable much faster.
What is Profit First accounting?
Profit First is a concept introduced by entrepreneur and author Mike Michalowicz in his book "Profit First." Published in 2014, the book revolutionized the concept of modern accounting, essentially proposing to reverse the order in which funds are allocated. The general idea behind Profit First accounting is that businesses should pay themselves first and let what remains to dictate how much they can spend on operating expenses.
- Traditional accounting: Sales – Expenses = Profit
- Profit First accounting: Sales – Profit = Expenses
When making a sale, business owners should take a percentage of the revenue generated as profit. In doing so, you can immediately become more profitable and reduce expenses to what's necessary to run your business. The Profit First method is based on Parkinson's Law which states that work expands to fill the time available for completion. If you apply this concept to running a business, this means that as a business owner, your business expenses often grow to fill your budget. By subtracting profits first, you reduce how much you can spend on operating expenses, thus more easily safeguarding against underpaying yourself.
Business expenses are typically treated as if they are unavoidable. However, creativity and discipline make it possible to shrink your operating costs. Whether it's payroll, rent, equipment, utilities, supplies, or other costs, there are ways to eliminate or decrease your costs when necessary. By setting aside a percentage of your revenue as profits from the beginning, you force yourself to be more disciplined with company spending.
How does Profit First accounting work?
Traditional bookkeeping targets profits as what's left over after you pay everything else. As the name suggests, the Profit First accounting method prioritizes profits before dealing with operating expenses. Small business owners take profits out of the cash deposits from sales. The system relies on having predetermined percentages, called Target Allocation Percentages (TAPS), assigned to profits, owner's pay, taxes, and operating expenses.
Profit: 5% to 20%
Owner's Pay: 0% to 50%
Operating Expenses: 30% to 65%
The percentages will vary depending on the business, your total business revenue, and how you currently spend your revenue. The more your company makes, the higher the percentage you'll set aside for profits and business expenses, while the percentage for the owner's pay will likely decrease.
How can Profit First accounting help your small business?
We tend to stretch our time, or in this case, our spending, to fit whatever is allocated to us. While traditional accounting and bookkeeping strategies don't account for this tendency, the profit-first method does. By allocating funds for profits at the beginning, you guarantee that your business will be profitable, even as a startup.
Using the Profit First method also teaches you to become more disciplined. That doesn't mean you must be frugal and pinch every penny to run your business. It means that you have to be more intentional about which resources and expenses have the greatest positive impact on your business. In other words, invest your resources in what moves the needle most: Is it having specific equipment to improve efficiency and productivity? Is it a marketing plan? Is it hiring more employees? Limiting expenses only to what you’ve allocated forces you to think strategically about where to put your money to work.
How to set up Profit First accounting with Novo
Novo Business Checking is ideal for business owners who want to implement the Profit First method. With free, built-in features that enable business owners to organize and set aside funds to match the Profit First accounting method, you can do Profit First accounting with Novo rather than chasing your funds across multiple checking accounts.
Here's how you can do Profit First accounting for your business with Novo.
1. Set up Novo Reserves
While the Profit First method advises setting up five separate bank accounts, Novo’s Reserves feature enables you to set up different ‘buckets,’ all within the same business checking account. With Novo Reserves, you avoid the headache and additional time spent trying to keep track of your business funds across five separate platforms.
Not only that, but Novo’s new Profit First package enables you to set up Profit First accounting with your business in just a few clicks. And while you can use our free Profit First calculator to determine the ideal percentage of cash inflow to each category, the Profit First package built into your Novo account comes with pre-set percentages for each Reserve category that match the Profit First methodology.
- Income: Your business revenue
- Profit: The percentage of revenue allocated from revenue for profit
- Owner's Pay: The percentage of revenue allocated for your salary
- Tax: The percentage allocated to pay business taxes
- Operating Expenses: The percentage allocated for payroll, rent, office supplies, equipment, marketing, utilities, and other business expenses
2. Allocate funds twice a month
The Profit First method ordinarily recommends allocating your funds twice per month, on the 10th and 25th. This is because your funds ordinarily will not distribute automatically with a typical setup of multiple bank accounts.
However, with Novo, you have the option to set up automatic percentage allocations of your cash inflow into each Reserve. This eliminates the need to remember (or make the calculations for) this step. As an added benefit, you’ll have a better understanding of your allocation amounts in real-time, as soon as you receive money into your account.
3. Distribute funds quarterly
The Profit First Method also recommends distributing your funds quarterly. Each business quarter, take 50% of the funds from your Profit Reserves as profit distribution. In other words, these funds do not get invested back into your business.
And when the time comes for quarterly business taxes, you'll make those payments directly from your Tax Reserves.
Make the Profit First method part of your business plan
Having a business plan is one of the keys to creating a clear vision and path to success for your business. Revise your business plan to incorporate the Profit First method as necessary. At the minimum, it should be a significant focus of your company's immediate and long-term planning. With the shift in how you approach allocating your funds, Profit First accounting will also affect how you address financial projections and your overall business structure.
Profit First accounting can help you become more intentional in how you run your small business while offering the flexibility of increasing your personal revenue sustainably. And you don’t have to be an accounting expert to set up a financial strategy that benefits both you and your business long-term: Novo Reserves enables you to automate your cash inflow for smarter, simpler banking.
This page is for informational purposes only and is not intended to be relied upon as legal, financial, or accounting advice. Please consult your own professional if you have any questions.