The GAAP (Generally Accepted Accounting Principles) formula for determining a business's profit is Sales – Expenses = Profit. It is simple, logical and clear. Unfortunately, it's a lie. The formula, while logically accurate, does not account for human behavior. In the GAAP formula profit is a left over, a final consideration, something that is hopefully a nice surprise at the end of the year. Alas, the profit is rarely there and the business continues on its check to check survival.
With Profit First, the formula is flipped to Sales – Profit = Expenses. Logically the math is the same, but from the standpoint of the entrepreneur's behavior it 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.
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 profit first the money available for expenses lessens, and we are forced to find ways to get the same things done for less money.
Most entrepreneurs use their bank account to determine the financial health of their company, when they should be using the Income Statement, Balance Sheet and Cash Flow Statement. The issue is that they do not know how to interpret those statements so, they end up looking at their bank accounts. Bank balance accounting means that you use your bank account balance to make financial decisions. If the balance is low, they try to sell more stuff and collect on overdue accounts. If the balance is high they will spend money, an example would be purchasing new equipment or expanding their office. The problem is that the individual does not see the true financial health of the organization and might not have enough money left over to pay themselves, taxes or produce a profit.
Profit First uses the “bank balance” idea by creating separate accounts for everything. Twice a month a percentage of the revenue that is deposited in the operating account will be distributed to the other accounts, that are not touched. This will help the entrepreneur ensure that they have enough money for taxes, to pay themselves and produce a profit. The individual then has to control their expenses to ensure that the company will survive on the “left overs” in the operating account.
Many entrepreneurs try to force themselves to become better at accounting and to become more disciplined in their fiscal management by pure willpower. But just like a muscle, willpower can be drained. And in a moment of financial stress or bigger than expected expenses the entrepreneur will break their own fiscal rules and spend the money they have.
The Profit First principle does not try to change your habits (that is nearly impossible to do), Profit First 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 fiscally strong and you will benefit from regular profit distributions.