Profit First: Money Management for the IEC
Readers on my mailing list heard the story of my epic $30k tax bill of 2016. Fortunately, I am have always been financially conservative (even when I was financially ignorant!) and I had the money to pay the bill, but it was a wake-up call that I had to get a much better hold on my finances.
(I was being sarcastic about Trump!)
I wish that I could say that I transitioned to the Profit First method right away. If I had, it would have saved a whole lot of hassle. Even though I was back in good graces from the accounting perspective, I was always confused about how much I was actually taking home at the end of the day. I didn’t know how to effectively plan ahead, either.
I think that I had actually gone from one extreme to another - I would always wonder about who I could hire, what I could afford, what was coming ahead. I had a lot of anxiety and it was really hard for me to plan effectively.
Enter Profit First.
If any of these challenges resonate with you, you really need to pick up a copy of the book.
You struggle with making decisions about big expenses, like office space or hiring an employee, because you don’t know what you can actually afford.
You feel guilty for spending money on “extras” like tools and other small behind-the-scenes expenses that can add up.
You worry about whether you are allocating too much or too little for taxes.
You make a lot of money but don’t really see as much in your pocket as you “should” at the end of the day because it all just disappears somehow!
I recommend getting a hardcover version so that you can refer back to it as needed, take notes, etc. Once you start this system, you will be shocked to learn that So. Many. Other. Small. Business. Owners. use it. It’s like a club I didn’t know existed!
What is it?
It’s basically Dave Ramsey-style budgeting with a nod to the concept of Parkinson’s law.
Mike Michalowicz was a super-successful entrepreneur who was also flat broke. The more he earned, the more he spent. Each year his accountant would tell him that he made a profit, but he never actually saw it! Where was this mythical profit going?
Revenue - Profit = Expenses
Instead of calculating his profit by subracting the expenses from revenue, Michalowicz decided to look at the equation backwards- instead, he’d take his profit FIRST! By taking this money out, his operating expenses would be naturally restricted, forcing him to make do with what he had instead of spending money on excess - that’s the Parkinson’s law component.
How Does it Work?
There are many different ways to implement Profit First, but the general idea is that all incoming revenue should be put into a holding account. Twice per month, the owner should divide the money in the holding account into various other accounts dictated by pre-set percentiles. The first, of course is profit! Michalowicz recommend putting profit into a separate account that CANNOT BE TOUCHED, ideally in a separate bank entirely. I’m pretty good with financial self-control so I just put it in a separate savings account within my bank, but I don’t touch it.
It can start to get a little complicated after that, with some busines owners choosing to divide their money up into tons of different accounts for different purposes. There are lots of calculations involved.
Keep it Simple, Stupid
I do not do well with overly complicated processes and definitely not overly complicated calculations! So, I keep my allocations really simple and divide the money up like this:
25% profit
25% owner pay
40% operating expenses
10% taxes**
**The reason that my allocation for taxes is so low is because I have an LLC taxed as an S Corp, so I pay taxes on the owner pay with each paycheck. The employer portion of the taxes (both for my employees and me) comes out of operating expenses and of course the rest comes out of the paycheck itself, and goes to Uncle Sam before it gets to me. Even still, I’d be looking at more like a 15% allocation except that I take my retirement contribution out of my profit at the end of the year (I max out a SEPP plan with 25% of my base salary, and this is tax-deductible).
Answers to Everything
So how does this solve all of my burning questions about expenses? Well, I’ve already decided how much I can spend on everything so I have no questions (or guilt!) about spending it.
Do I want to upgrade to a larger or nicer office space? Do I want to hire a new employee? How about the new iPhone, a conference, or any of the other gazillion expenses that come up?
I know exactly how much I have and exactly how much I WILL have coming in. If I make $500,000 and allocate 40% to operating expenses, that means I have $200,000 to play with. That has to cover the costs of all of my employees, all of my rent, you name it - down to the last granola bar I give my clients! There’s no temptation to spend extra, because the money is in a separate account that’s not to be touched.
No More Lean Months
Last year, I made exactly $12k during the fourth quarter of the year. I actually had the best year I ever had and made a TON of money, but hardly any of it came between October and December. I take in a lot of cash each year during the third quarter because of the way I bill clients, but such a lean fourth quarter was unusual. Even my husband was confused (he does my bookkeeping). I think it was mostly a fluke, but quarters like this are not a concern with Profit First because all of the money is allocated properly from the get-go. I have already figured out what I can afford to pay my employees and already have the money set aside. There’s no concern that I can’t cover payroll because I’m not frittering away money with the expectation that I’ll earn more later to cover expenses.
Not Rocket Science
Like I said in the beginning - it’s not anything overly complicated and is essentially just a fancy way of budgeting, but it’s been pretty awesome nonetheless. Buy the book! You won’t regret it.
Disclaimer
I have absolutely no affiliation with Mike Michalowicz or Profit First. I just really like the concept and want to share what has worked for me with others :)