A Guide to the Profit First Strategy for Small Businesses

In a typical business, sales are generated, expenses are paid, and whatever is left over is profit. One limitation of this common arrangement is that a profit is never guaranteed. Sales must exceed expenses for that to happen. However, the Profit First strategy offers an opportunity to prioritize profit from Day One.

What is the Profit First Strategy?

You’re in good company if you haven’t heard of Profit First. It’s a strategy created by Mike Michalowicz and the subject of his book, Profit-First: Transforming Your Business from a Cash-Eating Monster to a Money-Making Machine. The book was first published in 2014, meaning the strategy has only existed for a decade.

Profit First is an accounting method that places profit at the beginning of the revenue cycle rather than relegating it to the “whatever is left over” category. It can be thought of as the pay-yourself-first strategy applied to running a business.

The basic approach starts by establishing a desired profit from the beginning. A business anticipates a certain level of revenue within a specific accounting period. Based on that sales level, the business determines how much it will pay in expenses. Profit is established based on the anticipated revenue, and expenses are paid out of whatever is left over.

This is the opposite of traditional accounting systems, in which expenses are prioritized and profit is never certain. It’s unorthodox, to say the least, which is why it’s a strategy employed by small businesses rather than large, publicly traded companies.

How Does the Profit First Strategy Work?

Traditional accounting views a company’s profit as what’s left over after all expenses have been paid: Sales – Expenses = Profits.

Profit First flips that script to put the focus on profits: Sales – Profit = Expenses.

Profit

The strategy begins with establishing the desired profit margin. For example, you might decide from the beginning of your business or accounting cycle to target a profit margin of 5%, 7%, or 10%. However, the system isn’t so rigid for a business startup. For example, you can forgo setting a profit during the first business cycle or two, or at least until the business generates a credible cash flow.

Bank Accounts

The system recommends setting up five foundational bank accounts :

Income: Where all revenue is initially deposited
Profit: For storing predetermined profit percentages
Owner’s Pay: For founder/owner salaries
Taxes: For setting aside money for tax obligations
Operating Expenses (OpEx): To cover business expenses

Similar to the envelope budgeting strategy, you’ll set up separate accounts for each category. Rather than using physical envelopes or bookkeeping accounts, you’ll set up a dedicated bank account for each envelope.

Some banks specifically work with the Profit First strategy, enabling you to set up multiple accounts with lower fees. Two examples are North One (Business Banking Account) and Relay, which bills itself as the official banking platform for Profit First.

Naturally, the first account you will set up will be a profit account. The designated profit percentage will be deposited into this account as revenues are received. That ensures that profit takes top priority. Other accounts can be set up for major categories, such as owner’s salary, taxes, inventory, and general operating expenses. There’s much flexibility here, based on your business type.

As revenue is earned, it’s allocated into each account – starting with profit. This way, you will prioritize profit from the beginning of the cycle. Other expenses, like taxes and operating expenses, are paid from their respective accounts.

Because Profit First is essentially a business budgeting system, you have greater control over expense allocations. This will be necessary to ensure that the desired profit allocation is reached, which may force you to evaluate expenses carefully before they are incurred. And using a business credit card to track your expenses can help keep tabs on your company’s costs.

What are the Advantages of the Profit First Strategy?

If you’re a small business owner, there are solid advantages to the Profit First strategy:

You’ll prioritize profit from the beginning of the business or accounting cycle rather than waiting for it to happen.
Because expenses are determined in advance, you can exercise greater control over how much is spent in each category.
The emphasis on profit can enforce greater control over operating expenses, even forcing the business owner to be more innovative, i.e., do more with less or seek less costly alternatives.
The emphasis on profit as a primary objective will give your business a steady stream of capital for future expansion.
Profit First can prevent you from waiting months or years before your business becomes profitable.
The strategy can be implemented with existing businesses, even if you have used different accounting strategies.

What are the Disadvantages of the Profit First Strategy?

As you should rightly expect, Profit First is hardly a perfect strategy that is not right for everyone.

Disadvantages include the following:

Not all businesses can use the strategy. Businesses with long sales cycles, which require large expenditures upfront, may be unable to prioritize profit.
The system requires setting up multiple bank accounts to maintain discipline. This can be complicated from a bookkeeping standpoint and results in fees for multiple accounts.
Profit First may require more than five bank accounts, complicating bookkeeping issues.
A dedicated employee may need to maintain percentage allocations for each revenue payment received.
The strategy will be unreliable in a business with unpredictable revenue streams.
The strategy can collapse in a business with high fixed expenses, like high rent and debt payments.
It will not work for a business that has little or no revenue.

Frequently Asked Questions (FAQ)

What is Profit First for a small business?

Profit First is a unique accounting strategy that moves profit generation from the end of the business cycle to the very beginning. It does this by directing the first dollars a business earns into profit, with operating expenses, rents, taxes, and debt payments coming out of the remainder. In a real way, it completely reverses the normal accounting cycle of expenses first and profits out of whatever is left.

What is the Profit First Rule?

As the name implies, profit comes first in the Profit First strategy. It is determined at the beginning of the accounting cycle based on a preselected profit percentage. Much like the pay-yourself-first philosophy in personal budgeting, Profit First allocates the first dollars of revenue to profit for the business.

Is Profit First a good method?

That depends on the business and the owner’s dedication to making Profit First work. In a real way, Profit First requires more discipline than more traditional accounting systems. That’s because it requires intentionality from the very beginning. Not only must you establish your expected profit percentage from the very beginning of each cycle, but you must also set up and maintain separate bank accounts for each major category.

Why is it important for small businesses to focus on Profit First?

Profit First forces the business owner to focus on creating the desired result from the very beginning. Not only is the profit percentage established at the beginning of the accounting cycle, but a dedicated profit account is put in place to receive those funds. Seeing the funds accumulate in the profit account is an effective way to make the pursuit of profit real.

Should You Use the Profit First Strategy?

The decision to use Profit First should rely on the answers to two questions:

Is Profit First a strategy you can be comfortable with on a personal level?
Is your business suitable for implementing such a non-traditional strategy?

If the answer to both questions is yes, you can implement Profit First on a trial basis. Try it for at least one year. You will need to commit a certain amount of time to the strategy since it differs from the usual method of expenses first, followed by profit. You may need time to acclimate to a different way of running your business and thinking.

Once implemented, you can evaluate the benefits Profit First provides. For example, if you are comfortable determining your profit percentage from the beginning—of providing yourself with something of a business lighthouse to follow—you may find this strategy to have many advantages.

However, if your business depends heavily on generating a certain minimum level of revenue, profit may not be a priority until that revenue level is achieved. But once the income target is achieved, you can still use Profit First.

Every business needs to reach profitability to survive. Profit First can establish that priority for either a new or existing business that is already generating a healthy cash flow.