Series 3 Episode 7 – Why You Should Use the Profit First Model in Your Small Business
In today’s episode I really want to tackle an area that I keep seeing coming up again and again, both in my membership The Money Circle, and also with my one-to-one clients – the subject of profits and how to set up your business accounts when you’re running your own business.
Why do you Need to Put Profit First in Small Business?
It sounds obvious right? But many of us don’t put our profits first; we may think that we do but we actually don’t. Sometimes that can be because of mindset. It could be perhaps that you don’t feel worthy of charging enough for your services for example, and that can be made up of a lot of behavioural biases, many of which we’ve already uncovered and discussed on this podcast. Sometimes we can even get in our own way of success because of lack of confidence or imposter syndrome. But more often than not it’s actually because we follow the traditional accounting model which is;
Sales – Expenses = Profit
It makes sense, right? It’s completely logical; we take our sales, minus the costs that it takes to run our businesses and whatever is left is ours to take as profit and income. But the trouble is that we’re often driven by emotions and habits and so this model puts us into the habit of putting sales first and profits last. And often more sales can mean more expenses, so if we focus on growing too quickly and attracting more clients, or selling more products for example, then this usually means increasing our expenses. What I’ve seen from coaching a few people recently is actually if we don’t have our basic financial foundation set, if we don’t have an emergency fund and then something crops up that rocks that boat, then it means that we can put ourselves into quite a stressful financial situation.
Why I Love the Profit First Model
I think it’s particularly important for you to understand this model when you’re starting out in business. Many of you will know that I am a huge lover of Starling Bank – I wrote a blog about my experience of switching to them in January – I moved to them because I was about to fly out to Australia to see my twin brother and I wanted a fee free account when I was going abroad. But actually what happened is I completely fell in love with this very clever little bank, and as many readers will already know, I’m not a natural planner (ironically as a financial planner!) My relationship with money was driven by my natural tendencies to be spontaneous with money, and not just within money but in life. I have to really focus hard on planning my finances and other areas of my life, otherwise I get completely carried away with the doing and not with the planning. This obviously has some positive connotations and some positive behaviours, and if you resonate with this you may be nodding your head right now. Being spontaneous has got some really fantastic benefits, as it enables you to take bigger risks than perhaps somebody who has a strong dominance in planning, for example.
When I first opened a Starling bank account, I loved how it helped me to get insight into my spending habits. Within the app itself you can see where you’re spending and who you’re spending with. I was able to be very very conscious about my spending, and then I created some little gold pots and started planning my spending. Actually giving every pound a job, and allocating money out for specific purposes; being much more proactive rather than reactive with money. It literally revolutionised my life, and in that same year I read a book called Profit First and in fact I reread it again this summer to really embed and implement the model.
To me Profit First is the business version of mental accounting, that focuses your business on profit being a habit, not a situation that just occurs in your business. Mental accounting is known as the two pocket theory; it’s a behavioural bias that occurs when people put their money into separate pots, mentally separating their money for different purposes. Each account is for a different purpose – so maybe one account is for bills and another one of the accounts that you have is for treats. Mental accounting is a concept that was developed by an economist called Richard Thaler and he explained that mental accounting often leads people to make irrational investment decisions and behave in financially counterproductive ways, such as carrying a large credit card balance whilst also investing. One of the most common irrational decisions that I see for entrepreneurs, particularly in their early days of business, is when they take the common traditional accountants view of managing money in business;
Sales – Expenses = Profit
This kind of makes sense, right? But, I don’t know about you but I created my business because I wanted to support my passion to help more women to become financially independent, and also for me to create financial freedom and security for my life and for my family. I suspect you created your business for a similar reason. You built your business essentially to support your family, and to help build a life that is in line with your values and passions. So what profit first tells us is that there’s a big difference between making money (income) and making money (profit). Money is the foundation of our businesses; without money you cannot serve your clients, and you cannot realise your true potential because you get stuck in a cycle of just existing.
We talked about the impact of not charging enough in last week’s episode, and you can’t serve your clients unless you too are making profit. Not making money, not making sales, not making income, but making profit. And profit is not an event either – profit is a habit. In his book, Mike explains how we get caught up in this survival trap, and he suggests that part of the problem is that we look at the balance in our bank account as one part, and then we make decisions on how to manage the business without really looking at other issues such as tax or how much salary we’re drawing, never mind the actual profit.
Tax is one of those areas that you either do or you don’t save for. Particularly when you’re setting up in business it’s really important to make sure that from day one of your business any sales that you’re generating in your business, you need to be shimmying off around about 20% depending on whether you’re a sole trader or a limited company. Putting around 20 percent into a tax pot means that you don’t get that awful surprise when that letter hits your doorstep to say that your first year’s worth of tax is due. If you’re a sole trader in your first year you’ve also got to pay 50% ahead of next year, and that often hits new business owners in the face so don’t fall into that trap.
So if we take the traditional model of sales – expenses = profit – this is also known as what we call the primary effect – so we focus on what comes first, i.e. sales, we become blind to see what comes last i.e. profit. The traditional model makes us blind to profit, so rather than trying to change our habits with our business finances, what Mike talks about in this book is how the answer is to use a system that works with your existing habits.
Many entrepreneurs try and force themselves to become better at accounting and become more disciplined. I don’t know about you; I do find accounting interesting, but it’s certainly not something I want to be focusing on in my business. That’s something that I like to outsource. The Profit First principle doesn’t try and change those habits, it works with your existing habits. By first allocating money to different accounts and then removing the temptation to borrow from yourself, your business will become stronger and you will benefit from regular profit distribution. Genius, right?
How Does Profit First work in Small Business?
What does the profit first setup actually look like in in practice? The profit first system is set up using four key principles and it’s referred to using the analogy of eating healthily.
- Having small plates. So the idea here is to work with the idea that you need to finish everything on your plate. The Profit First model talks about how the solution is to reduce the size of the plates, therefore reducing the size of your portion. When money comes into your business, immediately send portions of it out to the following accounts; profit, tax, salary, and operating expenses. I’m going to come on to the practicalities of how those four pots work in a second but those are the portions that we need to separate money out as soon as it comes into our business.
- Serving sequentially. When you’re eating smaller portions, start with your veggies first; they fill you up with all the good stuff. Relating that to business, when you’re dispersing the money that comes into your business, of those four accounts you’re paying profit first.
- Removing temptation. You know about this one, right?! Get rid of all the chocolate, all the wine, all the junk food. Get rid of any temptation that’s in the kitchen that will take you off track from healthy eating; in your business it’s about getting that profit account out of easy reach. So moving it into a different pot, moving it into a different bank maybe, automating those deposits. Don’t look at it, and just make it hard to steal it away from yourself.
- Enforce a rhythm. This kind of goes back to see the concept of not shopping when you’re hungry; the idea is to have a few calories every couple of hours, and the same holds true for your business. Don’t pay bills only when you’ve got money, pay them on a regular basis. Enforce that habit, and force that rhythm.
One of the most interesting early chapters of the Profit First book for me is when Mike talks about how this is based on the theory of Parkinson’s law. For those of you are not familiar with Parkinson’s law, this was a theory that was developed in 1955 by a modern philosopher called C Northcote Parkinson, and he explained that it triggers two main behaviours and Mike uses these behaviours in an analogy in the book with a tube of toothpaste.
When you’re brushing your teeth you need to intentionally make less toothpaste available to brush your teeth. He talks about the idea that intentionally making less toothpaste (ie money) available to brush your teeth is how you operate your business. When there’s less toothpaste available in that tube, you automatically run your business more frugally and run it more profitably. When you have a full tube of toothpaste, you’re not really that fussed about how hard you squeeze because there’s tons in it, but you know when you get to that last little bit in the tube you’re going to really try to squeeze everything out to make it spread further. And that’s the same principle; if you make less available in the first place you just automatically run it more frugally.
The second principle around that is when less money is available to run your business (ie in the toothpaste analogy) when it’s less available, particularly if you’ve moved that money out of sight, you’ll always find ways to get the same results or better results with less. So in other words by taking your profit first you’ll be forced to really think smarter. If you implement profit first you’ll start to use the powerful human behaviour; Out of Sight, Out of Mind. As you generate profit you’ll move this from your immediate accessibility, set aside money for tax and then whatever’s left is what you have to manage your expenses. So the old formula becomes the new formula;
Sales – Profits = Expenses
Your focus is not so much on the sales but it’s on making profit, and whatever is left is what you have to run your business on. Mike suggests that you have several accounts for your business in order to operate under the profit first model;
- An income account. This is where your sales come in.
- A profit account. This is where you regularly allocate a certain percentage for yourself as profits
- An owner’s comp. This is essentially your salary accounts. Obviously if it’s just you and your business that salary account may be the same as your profit account. But if you employ a couple of staff members, that would maybe your salary pot.
- A tax account. So that’s the percentage that’s owed to the taxman.
- An OPEX account. This is essentially operating expenses for your business.
Mike talks in quite some detail and gives some templates in the book itself as to how much you need to allocate those percentages depending on whether you’re just starting out in business or whether you’re an existing business. But he also in addition to those accounts recommends that you have two other out of reach accounts; one which he labels up profit hold and the other is tax hold.
When I was implementing this in my business I used the Starling business account to set up my five pots. So I have my main account as my income account when the money comes in, and then I set up pots two three four and five in the goal section area of Starling Bank, and then what I did is I set up profit hold and tax hold with another organization. So those were completely out of reach; out of sight out of mind. You can read more about how this works in the book but I think that Starling Bank business accounts, particularly for UK business owners, offers the perfect solution to creating these pots without having to open up lots and lots of different bank accounts with different organisations, which let’s face it could end up maybe you could end up racking up a little bit of bank fees and over complicating things.
Why Does the Profit First Model Work?
In reality for me it’s about the simplicity of it and the visual nature of everything. I think Mike’s system really combines both the human behaviours relating to finance – how we know how we feel about money, the habits that we’re generating around money, and then a real easy to implement system.
How Do You Implement the Profit First Model in Your Small Business?
Read the book, and I would definitely recommend that you buy the book rather than actually downloading it as an audio.
Identify those money leaks; what are your money leaks in your business that you need to draw out as much profit as you can from your business to then look at what’s left to run as it as expenses? And this is something that will really transform your business; cutting expenses is normally so much easier than trying to conjure up new sales. So perhaps challenge yourself to look at your expenses and maybe cut out five to ten percent of your monthly expenses in your business right now.
Implement the profit first model into your business. There are some profit first approved accountants in the UK that you can find online – I’m currently working with one of them and we also actually have her coming into The Money Circle membership very shortly to do some training specifically on how to implement the profit first model into your business.
It would also be remiss of me not to mention that we are about to kick-off our next free Facebook five day challenge which is incidentally called Plug Your Money Leaks, so if this is an area that you really want to focus on now the kids are back to school, and you want to get business or personal finances in a really good position ready for the next quarter for the rest of 2019 then you can join here. We tackle those taboo subjects of money in a really relaxed and fun way, so grab your glass of wine, cup of tea, your pyjamas, and I really look forward to seeing you there!
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Profit First – Mike Michalowicz
Starling Bank Business Account