Last week, I told you how my young business lacked a plan and was held together by Band-Aids and Duct Tape. But then, this marvelous book Profit First came into my periphery.
This week, I want to share more about Profit First.
To recap, the standard GAAP (Generally Accepted Accounting Principles) equation for finances is:
Income – Expenses = Profit
Unfortunately, while mathematically sound, the GAAP profit equation doesn’t account for human behavior. Profit becomes merely leftovers after the beasts of expenses and taxes ravage your bank account. It’s something that is just a glimmer of hope that rarely appears as most businesses struggle on their check to check survival.
But Profit First says the way you look at your business should be:
Profit = Income – Expenses
Logically speaking, the math is the same, but the entrepreneur’s behavior is radically different. With Profit First, you take a predetermined percentage of profit from every sale first, and only the remainder is available for expenses. It’s the old adage, “Pay yourself first”, or as that great little book on finances – The Richest Man in Babylon put it, “Start thy purse to fattening.”
Why are you bringing up a law, Wendy? Here’s why: Author and historian C. Northcote Parkinson theorized that our demand for a resource increases to meet the supply of it. That is why when we are given two weeks to do a project it takes two weeks, and when we are given eight weeks to do the same project it takes eight weeks. That is why when given $1,000 to complete our work we get it done with $1,000 and when given $10,000 to complete the same work, it takes $10,000. Profit First makes Parkinson’s Law an asset. By taking your profit first, the money available for expenses lessens, and we are forced to be more creative about how we spend our money.
FINANCIAL GUMBO – A.K.A. Bank Balance Accounting
Most likely you have one business bank account, but really it’s a nebulous gumbo of the 5 key ingredients that make up your business’ finances:
- Operating Expenses
- Owners Pay
When all these ingredients are floating around in the same bank account, do you really have any idea just how much you can take in profit, or how much you have set aside to pay the IRS? Do you know how much your operating expenses should be for the month? No, you are flying blind. The old “Bank Balance Accounting” method where you log onto your bank account every day and check your balance is a poor way to make financial decisions, but it’s where most of us are stuck. If what we see in the account looks good, we tend to be a little looser with the check book. If the balance looks low, we panic and do whatever we can to make another sale.
Profit First teaches us that we should take those ingredients out and individually assess them, even going to the extent of setting up separate bank accounts for each of the key ingredients. Then, we work a plan to allocate pre-set percentages to each key area. When we follow the Profit First plan, we can continue with our old ways of Bank Balance Accounting, but we are truly only spending what is AVAILABLE to spend.
Next week, we will dive into how Profit First works, what in the world I’m talking about with multiple bank accounts, and a few ways to whittle down those nasty Operating Expenses.