You’ve done all the planning and hard work to get your business off the ground. Perhaps you’ve even funding and outside investments. But suddenly you start to wonder – when am I getting my slice of the pie? Business owners need to be rewarded for their hard work and the financial risk they are prepared to take, and there are a number of ways in which to pay yourself. One of these is the Profit First method.
What is the Profit First Method?
This revolutionary method of thinking about profit and profitability was set out in Mike Michalowicz’s book, Profit First. The Profit First method is a system in which business owners take a percentage from each sale as profit, instead of thinking about profit as coming after expense and running costs.
What exactly do we mean by profits?
Profit can be seen as a straightforward way of gauging the health of your business. Put simply, the easiest profit formula is to calculate the amount left after subtracting your total expenses from your total revenue.
This simplest net profit formula is: profit = price – cost
This profit can then either be kept in the business and re-invested to finance future growth, or paid out as a share dividend to your shareholders.
Why is profit so important?
The importance of profit and a healthy cash-flow probably need no introduction to any business owner – but let’s remind ourselves again of the importance of profit. Earning a profit is crucial because profitability determines whether a company can secure financing from a bank, attract investors to fuel growth and cover salaries and running expenses. Companies cannot remain in business without turning a profit.
More about the profit first method
Normally, profit is calculated as an output of revenue minus expenses, and the number can change depending on sales. In a Profit First Method, profit is an input. In other words, the business gets paid a specific percentage no matter what. That means before expenses or other investments, profit is set aside. The Profit First Method looks more like this:
sales – profit = expenses
This means that you deduct profits from payments before expenses, instead of paying director salaries with what is left over after expenses have been deducted. With this method, you transfer set profit percentages of your incoming funds into different accounts or ‘buckets’ in order to cover profits, taxes, overhead costs and your own compensation.
How to use the profit first method:
A bucket refers to a collection of similar assets based on the core functions of your business:
- Profit Account (Savings Account)
- Tax Account (Savings Account)
- Owner’s Pay (Savings Account)
- Revenue (Transaction Account)
- Operating Expenses (Transaction Account)
First put all your income into your income account, then transfer the funds that are accumulating in your income account to your other accounts to pay what is needed. The key is to ensure that each account is only used for its designated purpose.
- Profit Account: In this account you place a small predetermined amount from every sale, to be used for debt reduction, emergencies, and for you to receive a bonus for all your hard work. The Profit First formula is about generating profit, so this account comes first!
- Owner’s Pay: This account is used to pay your after-tax salary or wage.
- Tax Account: This speaks for itself – use this to pay SARS.
- Operating Expenses: These are your running expenses like rent etc. As you have a limited budget for these expenses, the theory is that you will make sure to examine these carefully and cut unnecessary overheads. That is the magic of the Profit FIrst method.
Outsourced CFO Services
As Michalowicz says in his book, “Owner’s compensation is the money you get paid for working in your business; profit is the reward you get for owning it.” At OCFO we help founders figure out how to make their companies work for them – so that it is not only they who work for their companies.
If you leave profit up to the equation of revenue minus expenses, it’s likely that expenses will almost always end up eating all the profit. Our CFOs love helping founders put processes in place to make sure that profit is planned, set aside and paid out frequently in a predictable manner. Along with this, we make sure that founder salaries are market related and secured, and that the tax man is always planned for.
Explore pricing strategies, expansion strategies, supplier negotiations and cost cutting exercises with your outsourced CFO that all contribute to a healthier organization. Profit isn’t everything, achieving and maintaining profitability is the most sustainable way to grow the impact of your work. Sit down with our financial team and let’s work together on the future of your business.