How to use the Profit First method to boost your startup’s profits
What if you could make your startup profitable simply by changing the way you manage cash flow? This is the premise of the Profit First method of accounting — a technique for managing startup finances popularized by Michael Michalowicz’s 2014 book, “Profit First.”
In a world where a majority of startups never achieve profitability, the Profit First accounting method serves as something of a paradigm shift in how a startup can operate. Read on to learn more about the Profit First accounting method for founders: what it is, how it works, and how you can use it to manage your business.
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 is in stark contrast to 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 founders scrutinize their spend to ensure they’re focusing on factors that drive profitability for the business. Michalowicz reasons that, if 10% of your sales each month 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 around that, rather than leaving profit to the whims of adjustable expenses. Think of it like reverse engineering profitable growth.
The Profit First method also ensures founders are paying themselves for their hard work — something founders 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 profit out of your cash deposits before paying expenses. To perform the Profit First method responsibly, Michalowicz recommends founders 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 that holds the predetermined percentage of revenue your business takes off the top as profit.
- Owner’s pay: The account that holds the percentage of income used for founder(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 that holds remaining business revenue not allocated for profit, owner’s pay, or taxes that’ll go towards 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 goal of the Profit First method is to make your CAPs align with your TAPs by optimizing spend. To help founders accomplish this, Michalowicz provides guidance on how to best organize TAPs based on a company’s annual income:
How much money should you put into each account?
Michalowicz recommends founders allocate revenue from the income account to the other accounts in accordance with 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 make sure to pay their bills out of the appropriate account. It’s also advisable to revisit your TAPs periodically and make adjustments as the business scales.
Is the Profit First method right for every startup?
Keep in mind that while Profit First accounting can unlock new potential for your growing company, it isn’t always the best natural fit for every startup team. For example, the Profit First method is all about enabling a steady and controlled growth, and is rooted in a longer-term vision. For a lot of VC-backed startups that are in hyper growth stages or looking to scale quickly, profitability is seen more as a long-term goal, not a short-term reality. As such, it can be tough to implement Profit First accounting while remaining aligned with investor expectations.
That said, it’s important to consider the unique position of your company and team to ensure that Profit First aligns with your collective goals and roadmap.
For decades, businesses have derived profit from what’s leftover after expenses are covered. The Profit First method offers a new way for founders to think about cash flow that can help them operate more efficiently and grow profitably over time.
If you’re ready to try the Profit First method for your business, Mercury can help. When you open an account with Mercury, we make it easy to manage your Profit First method with percentage-based transfers between accounts. Simply set the percentages you wish to allocate to each account, and when funds hit the account, Mercury automates your transfers at the predetermined time(s) of your choosing. Get started by applying for an account today.
