Emacsen's Blog

I use Profit First, the Theory of Constraints, and Plain Text Accounting to help my small business

Being a geek means being driven understand processes and improve them. That's been the case with my accounting system and running a small side business. I want to share some of the insight I've gained in the last year about accounting in my small business.

Specifically, I want to share how I use Profit First, the Theory of Contraints, and Plain Text accounting. These are three systems that fit together extremely well.

What is Profit First

Traditional accounting states that Revenue - Expenses = Profit. We take the money that we bring in, we substract what we spend, and we're left with our profit. While this is standard accounting practice, Mike Michalowicz, in his book Profit First, notes that this often leads small business owners astray. A business owner will spend money on things they think they'll need, and then will chase down profit to cover their expenses.

Worse still, many small business owners tighten their own belts by not tranfering any company profits to themselves, leading to reductions in lifestyle or even leading them to go into personal debt in order to cover the cost of their business.

Michalowicz addresses this in two ways. The first thing he suggests is to use discreet accounts to capture your money as it flows through your company.This technique, traditionally known as Envelope Budgeting and used for household budgets, is modernized and adapted by Michalowicz for the modern small business.

The other change Michalowicz suggests is to flip the standard accounting model on its head and say that Revenue - Profit = Expenses. What this means in practice is that we treat some parts of the business, such as taxes and owner compensation as essential and they should come out of revenue before we then look at operating expenses. The Profit First model forces us to strictly manage the business budget.

The combination of different accounts and a different outlook keep us from falling into the trap of letting the expenses drive the business. By prioritizing our costs first, we will be incentivized to spend only what we have, which forces us to either increase revenue or decrease spending to fit the business.

Profit First recommends allocating specific portions of our business income to crucial areas such as taxes, emergency savings, and owner compensation. These allocations are proportionally fixed and happen before looking at operating expenses, which helps us stay disciplined and avoid making excuses to spend that money elsewhere. Only after the keys areas are taken care of, do we review the business's operating expenses.

For example, by setting aside money for the business's income tax before anything else, we ensure that we don't need to worry about tax fees, an expensive legal dispute with the tax authorities, or the possibility of prison.

Similarly, by setting aside a rainy day fund, we protect ourselves from the regular turbulence of a small business, where some periods are less profitable than others.

Once those and other key areas are accounted for, then the business can examine whether the money it spends running the business- its Operating Expenses- are balanced. If the remaining money in revenue does not cover the Operating Expenses, the Profit First model says that we need to cut the Operating Expenses before we think about increasing revenue, since presumably we're already doing our best to bring in money.

Increasing revenue is a topic on its own, but when examining how to cut expenses, we can use the Theory of Constraints to help streamline the process.

The Theory of Constraints

The Theory of Constraints (ToC) is a framework that explains how to analyze a system, identify its limiting factors, and effectively address these factors to achieve the goal. The Theory of Constraints can be used to address almost all aspects of our business, including revenue and expenses.

In brief, ToC has five stages, outlined below in plain language:

1.  Identify the thing holding you back, the constraint
2.  Make small changes to either fix the constraint or to make it less
    of a problem
3.  Treat the constraint as a fixed point in your process
4.  Prioritize and fully address the constraint
5.  Do it all over again

This process is fairly generic but works surprisingly well. For example, I found that there were two costs that stuck out in my budget, an email service that costs a lot of money, and my hosting provider bills.

I realized in both cases that we had overprovisioned because I hadn't realized how little I would need to run my service. It was the equivalent of renting a huge warehouse and then only needing a few shelves. We could save money by downsizing, and I'm in the middle of that process now.

Using the traditional profit analysis, we'd only be allocating for the tax and owner's payment after operating expenses, so while we might look at operating expenses eventually, Profit First provides a 'moral framework' for how to approach budgeting, and the Theory of Constraints offers a roadmap to address them. Plain Text Accounting will help us find the income or expense pain points.

Plain Text Accounting

Plain Text Accounting is a term for a set of bookkeeping software programs that reads data from plain text files and use double entry bookkeeping principles to differentiate accounts.

In Plain Text Accounting, you have various accounts that correspond to both actual bank accounts Assets:FirstBank:Checking and to various expenses, Expenses:Hosting:MyCloudProvider. This makes it easy to identify exactly how money flows in your business.

Since the income and expense account names are somewhat arbitrary, you can use Plain Text Accounting to get as general or as granular as you like. You could have general categories like Income:Bakery or go with categories like Income:Bakery:Cookies:ChocolateChip, and the same goes for your expenses, such as Expenses:Hosting:DomainRegistration:GoParent. Plain Text accounting software makes it easy to create these hierarchies and even to create aliases, so you can make queries and reports with one line commands, making it easy to find patterns such as changes in a revenue stream, or expenses that have creeped up over time.

Profit First categories differ from Plain Text Accounting's accounts, and this is where I diverge slightly from the Profit First model. Profit First recommends setting up multiple bank accounts for each of its categories. I use virtual accounts to accomplish the same, but without needing to use multiple accounts. My approach requires more fiscal discipline but is easier to manage. If you prefer the physical accounts that Profit First recommends, you could those accounts to your Plain Text Accounting system without needing to use virtual accounts.

Where to go from here

These three frameworks, Profit First, Theory of Constraints, and Plain Text Accounting all work together to help your small business operate better. If you want to get started using one or any of these techniques for yourself, here's where I recommend you begin.

For Profit First, I recommend reading "Profit First" as well as either "The Toiler Paper Enterpreneur", both by Mike Michalowicz.

For the Theory of Constraints, I highly recommend "The Goal". It's not only informative about the ToC framework, but also an engaging read.

For Plain Text Accounting, there's a wonderful website plaintextaccounting.org.

All in all, these systems have worked well for me, and maybe they'll work for you too.