Introduction
In the fast-paced world of e-commerce and retail, managing finances can be challenging. Ensuring profitability while juggling inventory, operational expenses, and taxes requires a robust financial strategy. Enter Profit First, a cash management system that prioritizes profitability and provides a clear framework for financial health. In this blog, we'll explore how to implement Profit First, create a business budget, and use open-to-buy (OTB) to maintain a healthy inventory level.
What is Profit First?
Profit First is a cash management system designed by Mike Michalowicz. It flips the traditional accounting formula of Sales - Expenses = Profit to Sales - Profit = Expenses. By prioritizing profit, this method ensures that your business remains financially stable. This approach is particularly beneficial for e-commerce and retail businesses, which often struggle with managing cash flow and profitability.
Why Use Profit First?
Implementing Profit First helps you maintain a healthy cash flow, reduce financial stress, and build a sustainable business. For e-commerce and retail businesses, this method can address common challenges like unpredictable sales cycles, inventory management, and operational expenses. By allocating funds to profit first, you ensure your business is always working towards financial stability.
Setting Up Your Profit First Accounts
To get started with Profit First, you'll need to set up multiple bank accounts:
1. Income Account: All revenue is deposited here.
2. Profit Account: A percentage of income is transferred here.
3. Owner's Pay Account: A percentage is allocated for the owner's compensation.
4. Tax Account: Set aside a portion for taxes.
5. Operating Expenses Account: The remaining funds are used for business expenses.
6. Inventory Account: Funds allocated for purchasing inventory.
This system ensures that each dollar is accounted for and allocated towards your business's financial health.
Allocating Percentages
The key to Profit First is allocating the right percentages to each account. Based on a 60% gross profit margin, here are the suggested percentages:
A | B | C | D | E | F | |
Annual Income Level | $416,667 | $833,333 | $1,666,667 | $8,333,333 | $16,666,667 | $83,333,333 |
Inventory | 40% | 40% | 40% | 40% | 40% | 40% |
Profit | 3% | 6% | 9% | 6% | 9% | 10% |
Owner’s Comp | 30% | 21% | 12% | 6% | 3% | 2% |
Tax | 9% | 9% | 9% | 9% | 9% | 9% |
Operating Expenses | 18% | 24% | 30% | 39% | 39% | 39% |
These percentages should be adjusted based on your business's needs and financial goals. For e-commerce and retail businesses, consider factors like seasonal sales fluctuations and inventory costs.
Creating a Business Budget
A business budget is a financial plan that outlines expected income and expenses over a specific period. To create a budget, follow these steps:
1. Estimate Revenue: Project your sales based on historical data and market trends.
2. Determine Fixed Costs: List expenses that remain constant, such as rent and salaries.
3. Estimate Variable Costs: Include expenses that fluctuate with sales, like shipping and inventory costs.
4. Plan for Profit: Use your Profit First allocations to ensure profitability.
5. Review and Adjust: Regularly compare actual results to your budget and make necessary adjustments.
What is Open-to-Buy (OTB)?
Open-to-Buy (OTB) is a budgeting tool used in retail to manage inventory purchases. It helps businesses plan how much inventory to buy each month to meet sales goals without overstocking or understocking. OTB ensures that you have the right amount of products available to meet customer demand while keeping inventory costs under control.
How to Calculate OTB
To calculate OTB, use the following formula:
OTB = Planned Sales + Planned End-of-Month Inventory - Planned Beginning-of-Month Inventory - On Order Inventory
This formula helps you determine how much you can spend on new inventory each month. Adjust your OTB based on sales trends and inventory turnover rates.
Example:
Let's go through an example of calculating OTB for an e-commerce business, "Online Store Co."
Scenario:
- Planned Sales for August: $40,000
- Planned End-of-Month Inventory for August: $25,000
- Planned Beginning-of-Month Inventory for August: $20,000
- On Order Inventory for August: $5,000
OTB Calculation:
OTB = $40,000 + $25,000 - $20,000 - $5,000 = $40,000
So, "Online Store Co." can spend $40,000 on new inventory for August. This ensures they have enough products to meet sales targets while maintaining a healthy inventory level.
Integrating Profit First, Budgeting, and OTB
Integrating Profit First, budgeting, and OTB creates a comprehensive financial management system. Here's how they work together:
- Profit First: Ensures profitability by prioritizing profit and controlling expenses.
- Business Budget: Provides a financial roadmap, outlining expected income and expenses.
- OTB: Manages inventory purchases to align with sales goals and prevent overstocking.
By using these tools together, you can maintain financial health, optimize inventory levels, and ensure your business remains profitable.
Example: E-commerce Business
Let's look at an example of an e-commerce business, "Online Store Co." In June, they made $50,000 in revenue. Using the Profit First method, their allocations might look like this:
- Income: $50,000
- Profit (3%): $1,500
- Owner's Pay (30%): $15,000
- Tax (9%): $4,500
- Operating Expenses (18%): $9,000
- Inventory (40%): $20,000
They create a budget based on these allocations and calculate their OTB to ensure they have the right amount of inventory to meet customer demand without overstocking.
Example: Retail Business
Now, let's consider a retail business, "Brick & Mortar Inc." They made $80,000 in revenue in July. Their Profit First allocations might be:
- Income: $80,000
- Profit (3%): $2,400
- Owner's Pay (30%): $24,000
- Tax (9%): $7,200
- Operating Expenses (18%): $14,400
- Inventory (40%): $32,000
By creating a budget and using OTB, they ensure they have enough inventory to meet sales goals while keeping expenses under control.
Monitoring and Adjusting
It's crucial to regularly monitor and adjust your allocations, budget, and OTB. Review your financial statements monthly and adjust percentages as needed. For e-commerce and retail businesses, this could mean increasing your operating expenses allocation during high sales periods or adjusting your tax allocation based on quarterly tax estimates.
Common Challenges and Solutions
Implementing Profit First, budgeting, and OTB can come with challenges, such as cash flow variability and high operational costs. Solutions include:
- Cash Flow Management: Use historical data to predict cash flow patterns and adjust allocations accordingly.
- Expense Reduction: Regularly review expenses and identify areas for cost savings.
- Inventory Management: Implement just-in-time inventory practices to reduce holding costs.
Case Study: Successful Implementation
"SewCelebrate," an e-commerce business, implemented Profit First, created a detailed budget, and used OTB to manage inventory. Within six months, they saw a 20% increase in profitability. By prioritizing profit and controlling expenses, they were able to reinvest in their business and achieve sustainable growth.
Next Steps
If you're ready to implement Profit First, start by setting up your bank accounts and determining your initial allocations. Create a detailed business budget and calculate your OTB to manage inventory purchases. Consider working with a Profit First Professional for personalized guidance. Remember, the goal is to create a financially healthy and sustainable business.
If you have any questions or need assistance managing your company's finances, schedule a call with Jacob by going to https://www.jacobcurtiscpa.com/5-strategies-calendar. We're here to help you piece together financial freedom.
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