This concept is much easier to understand with an example. For this example we’re going to start with revenue for the last 12 months – even if last month was really great, you need to look at your historical average so you account for ups and downs, and don’t base your plan on your high income months only.
Ralph’s Landscaping brought in $120,000 in sales in total for the last 12 months. Target allocations for the whole year are:
- 50% owner comp = $60,000
- 15% taxes = $18,000
- 5% profit = $6,000
- 30% expenses = $36,000
Ralph decides to pay himself twice per month. For owner comp, Ralph is going to set his annual salary at $60,000 based on his allocations, which equates to $2,500 per bimonthly pay period.
At Ralph’s next money meeting, he reviews his deposits and finds that he made $6,000 in sales. He then allocates his money to four buckets:
- 50% owner comp = $3,000
- 15% taxes = $900
- 5% profit = $300
- 30% expenses = $1,800
Since Ralph has $3,000 in his owner comp bucket, he has more than enough to pay himself his $2,500 bimonthly salary. Yay! He leaves the remaining $500 in the account. That way, if he has a dip in sales prior to his next money meeting, he has some cushion and can continue paying himself a regular salary.
He also has $300 in his profit account, so at the end of the quarter, he gives himself $150, or half, as a profit distribution. He leaves the rest in the account to use if crap hits the fan.
The next quarter, Ralph runs his new 12 month numbers, and updates his allocations based on his latest average revenue. If revenue is up, he gives himself a raise!