Business

A Budgeting Approach That Guarantees Profitability

November 2020 issue

A Budgeting Approach That Guarantees Profitability

For nine years, Arica Dorff, Cr.Photog., ran a successful pet photography studio in Las Vegas. At least she thought it was successful. Her revenue looked good, but at the end of every year she wondered where all the money had gone.

Photographer Arica Dorff
© Donna Halvorson
Photographer Arica Dorff

After selling the studio and moving to the state of Washington, Dorff renovated her business into a more mobile, flexible operation. She adopted a new approach to budgeting and pricing that helped her guarantee profitability regardless of how the economy was performing. Yes, guaranteed profits. In fact, using this system, Dorff has doubled her take-home pay while photographing a quarter of the sessions she used to do at her studio.

PROFIT FIRST

Profit first is an accounting method pioneered by entrepreneur and business author Mike Michalowicz. The system is based on the concept of allocating business revenue into different buckets to pay for all a business’s vital expenses. At its most basic level, profit first works like a digital version of the envelope system, that age-old budgeting method where you cash your paycheck and divide the money into a series of envelopes for all your different expenses (mortgage, groceries, gas, supplies, etc.). You spend only what’s available in each envelope on each category of expenses.

Translating this approach to your business, you create a central revenue account for deposits, then maintain different accounts for each type of business expense. At regular intervals, you transfer money from the revenue account into the expense accounts based on predetermined percentages. Then you pay your bills from those accounts using only what’s available in the accounts. The intent is to run your business based on what you can afford, not on what you think you need.

The percentages are the key, and they’re based on your total gross revenues. No matter how much money is coming in, you maintain the same percentages for each category. The total sums going into each account will vary from month to month, but that’s OK. The percentages should give you what you need to pay your expenses and to budget appropriately. At the end of the year, you can evaluate and adjust your percentages if necessary.

Revenue: 100% of gross business revenue goes into this account, which Dorff empties every two weeks into four expense accounts with these allocations:Dorff uses five accounts. Revenue is deposited into one, and that money is distributed into four expense accounts.

Owner pay and retirement: 50%

Taxes: 15%

Profit: 5%, which can also be used as a rainy day fund

Business expenses: 30%

The budgeting aspect of the profit first system is nice, but the system’s proponents say that the real value is the underlying philosophy. The traditional way of thinking is to pay off expenses first, and whatever is leftover is profit. Essentially:

Sales - Expenses = Profit

Profit first flips that equation. The system’s No. 1 priority is profit and owner pay, and everything that’s left goes to expenses:

Sales - Profit = Expenses

It’s a simple but revolutionary concept based on three priorities: set aside profit, save for income tax, and pay yourself.

If you pay those things first, then everything else is what you have to run your business. “People wonder, What if there’s not enough money left to pay all my expenses,” says Dorff. “Well, that tells you that you can’t afford those things. You can’t afford the new camera or more employees or the expensive studio rent. The business isn’t functioning effectively if you’re covering all those expenses but can’t afford to pay yourself.”

PRICE FOR PROFIT

“So many photographers charge based on what other people charge, or they just pull numbers out of the air based on what feels good,” says Dorff. “But how do you figure out what is really profitable? No one really knows.”

Until they do the math. Go back to Dorff’s percentages for subdividing the accounts, which call for allocating 30% of gross revenue to business expenses. Within that business expense category, you can get more specific to account for the two primary types of business expenses: cost of goods and general expenses (also known as operating expenses).

Cost of goods covers all expenses related to creating and delivering products to clients, including everything from the session to lab fees to packaging and shipping costs.

General expenses are everything else, such as studio rent, utilities, employee salaries, and marketing.  

To set your prices for profit, consider how you’ll allocate the percentages for these two types of business expenses. Let’s say you break up that 30% business expense category into 20% for cost of goods and 10% for general expenses. That 20% cost of goods percentage is the key percentage for determining profitable pricing.

Here’s the simple equation: Divide 100% by the percentage you’re allocating to cost of goods. In this example: 100 / 20 = 5. You should mark up products by a minimum factor of 5 (and more for items that are labor intensive). That means if your cost of goods for an item is $10, you multiply $10 by 5 for a product price of $50.

WATCH SPENDING

The success of this approach relies on careful monitoring of your spending. Think back to the envelope system. Each envelope is a finite resource. You have to be disciplined about spending only what’s in each envelope and also creative in wringing maximum benefit from that limited amount of money. Applying the same concept to your business, you have to make sure you don’t spend more than what’s in the virtual envelope for each section of the business.

“If you don’t force yourself to do that, then you just buy things based on what you think you need, and that’s how you end up overspending,” says Dorff.

To get all your expenses to fit within the percentages you’ve allocated for them, you need to look at your numbers and sync them with how you want to run your business. For example, if you want a high-end retail studio and multiple employees, you may need to increase the general expenses portion and decrease the cost of goods percentage. By contrast, if you have a home studio and no employees, you can keep your general expenses lower and allocate a higher percentage of your revenue elsewhere. The goal should always be to keep your general expenses as low as possible.

UNCERTAIN TIMES

It’s easy to set goals and allocate strict budgeting practices when money is coming in. But what about when it’s not? How does this approach work when times are tough—say, during a global pandemic?

Stick to the plan, says Dorff. You shouldn’t change the percentages you’re saving even if you’re bringing in less revenue. That’s the beauty of budgeting by percentage; those percentages adjust the amount of money you need automatically. For example, if your gross revenue goes down, so does the amount you owe the government. As long as you’re allocating the right percentage, you have the right amount of money. Let’s say you were grossing $200,000 and you put aside 15% for taxes. You’d have $30,000 for taxes. However, if the economy tanks and your gross revenue drops to $100,000 but you still save 15% for taxes, then your tax savings fund will have only $15,000 in it, but that’s all you need. As revenue goes down by a percentage, so do many of your expenses.

As long as you’re keeping general expenses as low as possible, you’ll remain profitable regardless of your gross revenue. Plus, your profit account also serves as your rainy day fund. If you regularly contribute the allotted percentage to that account, then you have a built-in safety net that can help with cash flow during slow times.

“Resist the temptation to dip into your owner’s pay to cover expenses,” says Dorff. “You’re literally taking money out of your pocket.”

In addition, the answer isn’t discounting your products. Unless you’re reducing your cost of goods by the same percentage as the discount, offering a discount throws off your saving percentages. That jeopardizes your profitability, and you could end up working at a loss when you need money the most.

“This doesn’t have to be complicated,” says Dorff. “It can be a simple way to budget, and you’re guaranteeing that you run a profitable business. It doesn’t matter if you’re bringing in $10,000 or $200,000, you’re still profitable.”  

Jeff Kent is editor-at-large of Professional Photographer. 

Tags: bridging the gapbusiness operationsgap

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