Traditional accounting is failing small businesses in three key ways:
- Too many small businesses are break even. A break even business typically means that these businesses are only two weeks of collections away from being insolvent. Approximately 23 million out of 28 million of small businesses are in this category – that means that 80% of small businesses are not profitable.
- Most small businesses only look at financial figures during tax season. The problem here is that they are failing to leverage their numbers to enhance their profitability and boost their growth the rest of the year.
- Business owners use their bank account balances to make decisions. The flaw here is that business owners don’t think about taxes, profitability and paying themselves. All the money tends to be spent, leaving most business owners short in profits and money to pay their tax obligations.
Each of these problems is caused by the traditional accounting mindset of ‘Sales – Expenses = Profits’. Profit becomes a leftover, instead of something that is focused on from the very beginning. A mindset shift, along with actionable steps, needs to take place to correct these issues.
What is The Alternative to Traditional Accounting?
Let’s redo the traditional accounting formula. Instead of ‘Sales – Expenses = Profits’, let’s shift it to “Sales – Profits = Expenses’. This called the Profit First method.
What’s the main difference? We plan for profit from the beginning. We set aside the profit in another bank account and learn to have the business expenses left over. This method will help you understand what you have left to allocate to operating expenses.
It cultivates scarcity in your business, which helps you cut costs, manage owner pay and plan for taxes.
Steps to Implement the Profit First Method
How do you go about implementing the Profit First method? You first must open five separate bank accounts. These bank accounts are:
- Revenue
- Profit
- Owner’s Pay
- Tax
- Operating Expenses
You may even wish to have more bank accounts, such as a payroll account, a sales tax account, or an inventory account as an example.
Every month, allocate your funds to each of these different bank accounts. You’ll be prepared to make educated decisions by seeing how much money you actually have available to spend on each category, pay yourself properly and be prepared for tax season.
The beautiful element of the Profit First method is that it plays into Parkinson’s Law. This law is a fundamental aspect of human behavior that dictates almost everything we do.
What is Parkinson’s Law?
Parkinson is someone who studied human behavior who determined that we tend to expand our use of a supply based on the amount available to us. For example, if we have four weeks to complete a project, it will take us four weeks.
How does this relate to accounting? If you have one bank account, you tend to look at that account and spend all of those available funds. When you have five different bank accounts, you will only view the operating expenses account when it’s time to spend money for the operations of your business. If you do not have enough money in this account, it is indicative of a problem with your cash flow management.
Think about when you buy a new roll of toothpaste. You use big strips of toothpaste when you first open the roll, but towards the end you are squeezing out every last drop. Everyone does it! Imagine if you could divide up a new roll of toothpaste into different rolls, allowing you to budget your toothpaste to last for the longest possible. That’s what the Profit First method accomplishes with your business.
To help control your urge to take money from other accounts, create your bank accounts at different banks. This makes it increasingly difficult to ‘rob’ your bank accounts if one of them comes up short.
Does Profit First Negate Traditional Accounting?
Absolutely not. It simply changes the core formula of the profit formula. Traditional accounting will still help you:
- Formulate a strategic plan
- Forecast profit and revenue
- Identify margin issues
- Review pricing issues
- And so much more
The Profit First method is simply another tool to have in your back pocket to help you manage your cash flow by playing upon the Parkinson’s Law to create scarcity in your business.
Final Thoughts
Your business depends on cash flow management to survive, yet alone thrive. Using the Profit First method will dramatically enhance your cash management techniques because it takes into account the psychology of spending money. You’ll be increasing your profits starting with your next deposit.
How many bank accounts do you use to run your business? Are you convinced of the need to open up a few new ones? Let us know in the comments!
