Sales – Profit = Expenses can you spot the difference in this formula ? It is the same formula but the factors in different places.Isn’t it ? well this is called the Profit first formula. In this article you are going to learn about how to maximize your profit by following some simple steps.
If you are already aware about this concept, watch below video on how to implement in Xero
Mike Michalowicz introduced the Profit First concept by making a slight difference to the GAAP Profit formula and taking Parkinson’s law as a fundamental basis. Usually, profit is calculated after deducting all the relevant expenses, which need to make the revenue. BUT Profit First Concept prioritizes profit and deducts a predetermined percentage of profit from the revenue and uses the remainder to manage expenses.
Parkinson’s Law
Parkinson’s Law can be simply defined as the expansion of resources to fill the space available to complete a task.
E.g. If you were given two weeks to do an assignment, you will take two weeks to complete it. However, if you were given a week to complete the same assignment, you will complete it within a week. Likewise having less amount of money to spend on expenses will eventually lead to managing the expenses more efficiently.
Therefore, Profit First is subtracting a predetermined percentage of profit from the Sales revenue and figuring out a way to manage the expenses with the remaining portion of the money.
Profit First Implementation
Several requirements need to be fulfilled before adopting the Profit First Concept.
- Identification of Current Allocation Percentages (CAPs)
- Target Allocation Percentages (TAPs)
It is essential to complete the Profit Assessment Form (Figure 01) accurately as the first step of identifying CAPs and to move towards the TAPs recommended by Mike Michalowicz in his Profit First book or to create your unique TAPs, which are appropriate for your organization. The steps to be followed are outlined below
1. Actual Column
2. PF% Column – Choose the column that corresponds to your Real Revenue from Figure 02 and use percentages in it to fill the PF% Column. It is not necessary to follow the TAPs created by Mike Michalowicz. (Michalowicz, 2021) You can proceed with your percentages but always remember to keep small steps, as it will lead you to a long journey. E.g: If your real revenue is $200, use the percentages in column A from figure 02
3. PF$ Column – Multiply each PF% by the Real Revenue and put the result in the relevant cell.
4. Bleed Column – Subtract the PF$ number from the Actual number in each row and enter the outcomes in the corresponding cells in the bleed column.
5. Fix Column –
If the value in the bleed column is negative – put the increase
If the value in the bleed column is positive – put decrease
Bank Accounts & Put into Action
Setup four bank Accounts with your current bank apart from your Main Income Account
Transferring money and 10/25 Rhythm
As it is impractical and hard to disperse money in the income bank account daily to the other bank accounts, you can follow the 10/25 rhythm, which is mentioned in Mike Michalowicz’s Profit First Book, or else you can have a unique time pattern.
- On every 10th and 25th of the month transfer every single penny in the Income account to the previously created bank accounts based on the current allocation percentages.
- Transfer the entire amount in Profit and Tax Accounts to the externally created Tax and Profit Bank Accounts.
- Then you can write a cheque and disburse the salary for yourself by withdrawing money from the Owner’s Pay bank Account. However, remember to take only the previously allocated amount. This will be your biweekly salary but you can set up a date on how you want to be paid according to your preference.
- Finally, pay your staff and all the other expenses with the balance portion of money in the operating expense account.
Quarterly Distribution and Evaluation
Borrow 50% of the money from the externally created Profit Account, as a profit distribution for the owners and this should not be used as reinvestment to the business. Other 50% will remain as a reserve for the organization. It can be used in a time when there is an interruption or a decrease in regular income, which is essential for smooth functioning.
Further Mike Michalowicz explains that the purpose of the Profit Account is not limited to performing as a cash reserve but to being used as a measure of growth.
How is that POSSIBLE?
If there is an excess in the Profit Account after deducting the amount sufficient for 3 months cash reserve, that excess amount can be used as reinvestment to your business by making capital investments or by financially supporting any other decision that will benefit you in the long or short run. (Mike Michalowicz, 2021) You can also pay the quarterly estimated taxes with the money in the externally created Tax Account and get yourself a relief. Finally and most importantly, assess your CAPs in every quarter and try to move them towards TAPs.
Challenges & Issues
Minimum balance requirement, limitations in transactions, and charges related to bank accounts – There are some banks, which are good at offering flexible options to their clients when setting up multiple bank accounts.
- Increase in bookkeeping work related to reconciliation
- Remainder in Operating Expenses Account is not sufficient to cover the expenses.
- Analysis Paralysis – Rather than struggling to calculate the perfect allocation percentages, it is better to start with the numbers you have. Because learning can be definitely, obtain while practically doing it.
- Don’t bite off more than you can chew – Allocating a big percentage for profit in the initial stage will probably be a step of failure. Therefore, always remember “slowly and by small amounts”.
- Minimum balance requirement, limitations in transactions, and charges related to bank accounts – There are some banks, which are good at offering flexible options to their clients when setting up multiple bank accounts.
Mind Map
For more information about the this concept read the Profit First Book by Mike Michalowicz or visit to this websbite. If you are struggling with time Cloud AccBook can help you to implement this concept for your business . Feel free to contact us.