Last editedJan 20232 min read
The way that your business approaches the concept of profit, from an accounting perspective, can have a serious impact on cash flow. Taking a ‘profit first’ approach forces you to be smarter, more resourceful, and more innovative with your company’s finances, enabling you to become fiscally strong while eliminating unnecessary expenses. Learn everything you need to know about the profit first formula with our helpful guide.
Profit first formula explained
According to GAAP (the Generally Accepted Accounting Principles), the formula for calculating a business’s profit is as follows:
Sales – Expenses = Profit
However, according to adherents of “profit first” accounting, there’s another way.
Within the framework of a traditional profit formula, such as the one endorsed by GAAP (above), profit is essentially the final consideration, a leftover.
The profit first formula encourages businesses to flip the script. So, what is the profit first formula? Simple, it’s just a slightly rearranged version of the traditional profit formula:
Sales – Profit = Expenses
Although the math hasn’t changed, adjusting the formula in this way represents a radically different approach to how businesses think about profit. Essentially, you’re going to take profit from your company’s cash deposits before expenses. Having already taken profit, your company will use the remaining cash to pay for rent, payroll, utilities, and so on.
In a nutshell, it’s all about ensuring that your business gets paid first.
How does the profit first formula work?
In the profit first system, you’ll transfer predetermined percentages of cash deposits into various different bank accounts in order to cover your business’s profit, taxes, revenue, operating costs, owner’s payments, and so on.
There are two types of percentages you need to think about. Current Allocation Percentages (CAPS) refers to how your financials are currently allocated, while Target Allocation Percentages (TAPS) is where you want your business’s financials to be allocated in order to improve cash flow, business growth, and profitability.
So, where do these percentages get sent to? Well, there are five different ‘profit first’ accounts: income, owner’s compensation, tax, profit, and operating expenses. These accounts will help you to keep track of where your money is going and what it’s being spent on, enabling you to track your TAPS and distribute funds effectively.
Once you have a handle on all this, you should be able to effectively use profit first to guide your business’s finances.
Benefits of the profit first formula
There are a number of benefits associated with the profit first formula:
It’s easy to implement, and you don’t need to be a “numbers person” or have an accounting background to understand the system or the profit first formula.
You’ll see results in the profit column of your company’s P&L statement straightaway.
You can gain a greater degree of control and clarity over which expenses your business can commit to while maintaining a profit.
It's a great way to motivate yourself to rethink whether certain expenses are worthwhile, or whether they’re unnecessary and can be eliminated with limited impact on your business processes.
Challenges of the profit first formula
Of course, the profit first formula isn’t without challenges, and there are a number of points that businesses considering switching to a profit first approach should conspire:
If you get your CAPS wrong, then your TAPS will be wrong as well.
Profit first can encourage business owners to eliminate too many expenses, which can cause the company’s performance to suffer. It’s important to strike a balance.
Some business owners aren’t comfortable with an approach that prioritizes profit above everything else, while employees may struggle to adapt to profit-based decision-making, especially if they haven’t received the appropriate training.
It can be challenging to manage inventory, payroll, and large asset payments without running out of cash in your accounts.
So, is profit first right for you? Well, that’s down to your business’s individual preference, but it’s certainly a viable option for anyone who’s interested in rethinking their approach to the concept of profit.
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