Sales – Expenses = Profits True of False?
It is true or false…
What?... How can that be?
According to the GAAP (Generally Accepted Accounting Principles) this is the equation that is used for the Profit & Loss or Income Statement so that is true.
It is false using the Profit First method and this is why…
Human behavior is to consume everything that we have available to us such as time, food, and money.
Take a minute and think about your personal life…
If you are given three days to complete a task, does it take you three days or do you wait until the last day to complete it?
Most people will take three days to complete or will wait until the last minute and they complete the task. We will take all the time given to complete the task even if we can get it done in less time.
If you have $1500 in your bank account, do you spend it all or put some aside for later?
A lot of people live paycheck to paycheck no matter what their level of income is because if it is in the bank account it must be used.
Businesses are no different. If there is money in the bank, then I have money to spend.
They see a net profit on the P&L Statement but they don’t know where the money is because it is not reflected in their bank accounts.
Profit First Philosophy
In order to understand the Profit First Philosophy, you must first
understand the basics concepts of revenue, profit, and cash flow.
If you have been following for the last couple of weeks, you have seen me post about questions about the GAAP equation of
Sales – Expenses = Profits.
This is timeless accounting formula that has been taught over and over to accountants and business owners for generations. I know, because this is what I was taught.
Profit First changes the equation to focus on profits first…Sales – Profits = Expenses.
When I first heard this, I thought, there is no way this will work. I am the kind of person that will do my best to prove something wrong so I implemented Profit First into my business. I was sure that I would prove it wrong…
The Profit First mission is to empower entrepreneurs with a simple cash flow blueprint that brings clarity and control over their business finances. It is designed to build your business in a sustainable way that sets you up for long term success.
Profit First uses dinner plates as a visual way of allocating revenue.
· The main plate is all the revenue that comes into the business.
· A plate for Profit
· A plate for Owner’s Pay
· A plate for Taxes
· A plate for Operating expenses.
The plates are used to allocate revenue based on a percentage that is done after an assessment of the business.
This philosophy is based on Parkinson’s Law – work expands to fill the time available to complete. If you have 3 days or 3 weeks to complete a project or task, it will take you the whole time but if you were given ONE day, you would also complete it.
The same is true with your revenue. If you focus on expenses, you will use all the revenue on expenses. In the equation of Sales-Expenses, the focus is on expenses.
Profit First focuses on taking the Profit first in order to force you to take a hard look at your expenses to analyze what expenses are necessary to generate revenue and what expenses are unnecessary.
It forces you to think smarter, be more resourceful and more innovative.
What Are The Main Benefits of Implementing Profit First?
Profit First is a behavioral framework…you won’t have to change your existing habits.
If you’re like me, one of the first things I check is my bank account.
Bank balance accounting is checking your bank balance to determine what expenses you can pay and what expenses you can put off until you generate more revenue to increase the bank balance.
Profit First allows you to view your bank balance but also uses the power of “out of sight, out of mind.”
As you generate revenue, you will take a percentage of that and move it to the profit account. You won’t have easy access to it so you won’t see it.
This is where the reverse engineering comes in…taking the profit first, ensures that you grow profitability and sustainably with the right size of business naturally.
It will give you the visibility over your progress to your goals which will keep you motivated to continue working towards your goals with cold hard cash in your bank account.
Don’t panic, an initial assessment will be done to determine the percentage of revenue to be put aside for profit.
This system is to help you grow a profitable and sustainable business so an assessment is necessary and then expenses will need to be analyzed.
How This Framework Can Help You Tackle Common Business Challenges?
Well, it does work and I have been using the system as well as some of my clients.
They see that is helps to tackle the following problems:
· Paying themselves while still making a profit
· Putting enough away to pay the tax man so they avoid the tax man payment plans
· Paying down or eliminating debt including their reliance on credit cards
· Gives them control and clarity about what expenses they can commit to in the future such as new employees or big asset purchases.
· Remove unnecessary expenses that are not helping to generate revenue
· Improving their sales margins
This helps us to help more small business be more successful, more profitable, and help them to beat the five-year hurdle.
So how do we do this?
We set up it based on the waterfall system where all the revenue income flows into your Income account which is then allocated to the different accounts on the 10th and 25th of every month.
The FIVE accounts:
1. INCOME: All revenue comes into this account. Picture this as the serving tray at a family dinner.
2. PROFIT: We start with a small percentage and build slowly towards your goal percentage
3. OWNER’S PAY: You pay yourself on the 10th and 25th of every month. How nice would that be?
4. TAX: Business and personal tax obligations. You know the tax man wants his cut whether you plan for it or not.
5. OPEX: This is the account used to pay all operating expenses on the 10th and 25th of every month.
The TWO Accounts (Out of sight out of mind): At a separate bank.
1. PROFIT HOLD: Holds profit allocations until it’s time for the quarterly distributions. How would you like to get a bonus every quarter?
2. TAX HOLD: holds the money owed to the government to make quarterly payments so there’s no stress when tax time comes because you have already paid the tax man.
These accounts should be set up so you can transfer funds to your primary bank but it should take a couple of days for the transfer.
This works and it will work for you.
3-Step Process For Implementing Profit First System.
1. Determine your allocation percentages.
· Current allocation – based on what you are currently spending in each of these areas. Profit, Owners Pay, Tax, and Operating Expenses. Be honest with yourself.
· Target allocations – compare your numbers with the target numbers.
Example: 0-250K allocations
Owner’s Pay: 50%
Operating Expenses: 30%
How did you measure up? What needs adjustments?
2. Calculate your revenue for the period in the income amount and transfer to the Profit, Owner’s pay, tax, and the operating expense accounts.
Make the allocations based on your current allocations, not the target allocations. Make sure to move the tax and profit to the hold accounts at the separate bank so they are out of sight and out of mind.
All allocations to accounts and payments are to be made on the 10th and 25th of each month.
3. Quarter Disbursals:
At the end of the quarter, take 50% of the PROFIT HOLD account and pay it to yourself as a bonus. The other half stays in the PROFIT HOLD account.
What do I do with this 50%? When was the last time you took your family on vacation? Save it and surprise your family.
Pay your quarterly tax payment to the IRS out of the TAX Hold Account based on your net income for the quarter.
Do YOU Want to KEEP More Of Your MONEY?
If you do, book a strategy call to see if we would be a good fit to work together.
See ya on the inside, Sarah