How to use the Profit First Method as a small business
The Profit First method is an increasingly popular money management system which helps businesses to grow by deducting their profit first. It was designed by American author and entrepreneur Mike Michalowitz with small businesses in mind. Solopreneurs can certainly benefit from the Profit First method too. However, since the U.S. Small Business Administration defines a small business as one with up to 1,500 employees, it’s safe to say that the system may require a little tweaking to work optimally for a sole trader. In this article, we’ve outlined how you can make the Profit First method work for you as a solopreneur.
How Does the Profit First Method Work?
Profit is typically defined as revenue minus expenses. The Profit First method flips the equation so that it looks more like this:
Revenue – profit = expenses.
Michalowitz argues that businesses should take profit first, rather than treating it as the leftover amount. This is based on Parkinson’s Law, the psychological principle that work expands to fill the time available. As a business owner, your costs will expand to fill your budget, so deducting profit first helps you reduce spending and boost your margins.
In order to use the Profit First method, business owners typically set up five separate bank accounts for the following purposes:
- Income – 100% of incoming cash flows into this account before being divided up amongst the following four.
- Profit – typically 5% of gross revenue
- Owners’ salary and wages – usually 50%
- Tax – traditionally 15%
- Operational expenses (including employee payroll) – 30%
Michalowitz advises that business owners transfer funds from the first ‘Income’ account twice per month, on the 10th and 25th.
Why Does the Profit First Method Work?
One of the biggest benefits of the Profit First system is that it helps business owners stay disciplined and avoid overspending. It also has huge benefits for your mindset: by putting this system into practice, you are setting a strong intention and being purposeful about profit. Finally, this method takes the guesswork out of profit, taxes and expenses, making it easy to stay organised.
How to Adapt the Profit First System as a Solopreneur
As a solopreneur, you may find that the above system works perfectly for you, but it’s likely you may need to tweak it a little.
For example, if you’re a remote worker with a very asset light business, your operational expenses may fall well below 30% of your gross income.
Depending on your income, you may not need to set as much as 15% of your aside for taxes, or in some cases you may need to allocate a larger percentage.
Furthermore, to replace your former “day job” salary, you might need to set aside more than 50% of your income for your salary and wages. If your overheads are low, it should be very easy for you to adjust this percentage.
As a sole trader, the key to making the Profit First system work for your business is knowing your numbers. In order to understand which percentages best suit for you, you must keep a careful track of your income and expenses using accounting software. Better still, review this data with your accountant or bookkeeper to devise a Profit First system that’s optimal for your business.
The Profit First method is an excellent way for sole traders to purposefully manage their money and stay on top of their bank accounts. If you’re serious about prioritising profit, talk to your accountant or bookkeeper about the ideal target percentages for your business and get started on the road towards better money management.