The Old Business Profit Equation Is Broken, Take Profit First
When you start a business, you dream of a one that lets you live the life you want to live. You joke and say it’s sitting on the beach drinking adult beverages, but that’s not what most people are striving for. Knowing that you can pay your bills, live comfortable and take the vacations you want is enough.
Why then are so many entrepreneurs so far from that ideal? Many of my clients only come to me when the dream is seeming to fall through their grasp. They’ve run a successful business, but it’s not quite what they wanted. There’s not enough money left over and they don’t know why. Worse yet, they have increased revenue and there is less money available.
Oh sure their accountant says they made a profit, but as Profit First says:
Accountants define profit differently than entrepreneurs. They point to a fictitious number at the bottom of an accounting report. Our definition of profit is simple: cash in the bank. Cold. Hard, Cash. For us.
I’ve been there. The accountant says I’ve made a decent 5 figure profit but it’s felt like the hardest year on record. When I ask where the money is I’m told I spent it…somewhere.
That’s not the business I want to run and that’s where Profit First comes in. Instead of sticking with the GAAP (Generally Accepted Accounting Principles) which only make sense to accountants, it teaches us how to deal with money in a way that makes sense emotionally to the rest of us.
Relying on traditional accounting methods to grow profitability is the equivalent of telling you to jump off a cliff and flap the living crap out of your arms.
In fact, I was talking to an accountant friend on the weekend. He knows the GAAP’s and yet, as we talked what made sense to him was the methods in Profit First.
Profit First by Mike Michalowicz, flips the regular equation for profit on its head. No more Sales — Expenses = Profit because that leaves so many businesses with no profit. They’re barely keeping their head above water.
Oh, they may mask it through a tough time by putting in lots of extra hours. Sure their social media profiles look amazing. But they’re failing and don’t know how to get out of it.
Money is the foundation. Without enough money, we cannot take our message, our products, or our unique services to the world. Without enough money, we are slaves to the business we launched.
If you’re not going to stick with the old broken formula, what do you do with your money?
The Profit First Method
To start Michalowicz gets us to set up his ‘5 Foundational Accounts’ which are.
- Owner’s Comp
- OPEX (operating expenses)
All your money goes into the income account. Every time you get paid you deposit the money and leave it there. It’s not for you to spend, yet.
On the 10th and 25th of the month, it’s time to tap into the income account and the first thing you do is…pull out your profit.
Then you divide up your income into the other accounts by percentages, we’ll get into how to decide on those in a minute. If you look at your expenses and don’t have the money to pay everything Michalowicz has one thing to say to you:
and if there isn’t enough money left for expenses? This does not mean you need to pull money from the other accounts. What it _does_mean is that your business is telling you that you that you can’t afford those expenses and need to get rid of them.
You don’t pull the money out of other accounts because:
A big note here: there is a possibility that you will not have enough money in your accounts to pay bills or pay yourself what you need to make. This should be a major wake-up call. When you don’t have enough money to pay your bills, it is your business screaming at the top of its lungs, warning you that you can’t afford the bills you are incurring. Or if there isn’t enough money to pay your salary adequately, it is your business shouting out that you can’t run your business the way you have been running it; otherwise, you will continually compromise yourself.
That’s a hard thing to think about, isn’t it? You’re used to your Starbucks daily or getting a new computer yearly. The truth is, that the only way you’ve afforded those things is by stealing from your salary and your profit.
What then do you do when there isn’t enough money for the things you had wanted to purchase?
When less money is available to run your business, you will find ways to get the same or better results with less. By taking your profit first, you will be forced to think smarter and innovate more.
Yup, you get creative. You make that laptop stretch a bit longer. You drop your editor and start using an online service that delivers 80% of the value for 20% of the cost. Most of us were creative with our finances at the beginning. because there was no income to speak of in our fledgeling business. It’s only moderate success that caused us to increase what we thought we deserved to an unsustainable level.
If you’ve opened the foundation accounts and understand that you need to allocate your money by percentages, you still need to figure out what those percentages are, and we start that by figuring out where our business is at.
Figure out where you’re at and set your Profit First percentages
Denial is a wonderful thing; it lets you ignore reality until reality punches you in the face.
Have you avoided looking at your finances? Avoided talking about them with your spouse?
I know I have and not some time in the far past, but in the last 3 months. I was trying to deny the reality that business felt tight. Then tax season came and I looked at my revenue, it was a punch in the face.
While having what felt like a tight year, it was the highest revenue year to date by more than $15k.
The instant assessment takes about 20 minutes, a bit longer if you need to dig around and find last year’s taxes. It has you find:
- Top Line Revenue
- Materials (like if you’re retail and need to buy all your supplies)
- Real Revenue (Top Line — Materials)
- Profit (the real $ you have in the bank or have given to owners but not salary. This is not what an accountant says you should have)
- Owner’s Comp (what you paid yourself and any other owners)
- What tax did the company pay for you
- Expenses (your total expenses for the year in question)
If that didn’t quite make sense, you can download an explanation and the spreadsheet I’m talking about, for free.
With that information, you figure out what your real percentages for each of your foundational accounts. Then Michalowicz gives you what the percentages should be at in a healthy business. Then it finishes by helping you decide if you need to increase or decrease your percentages.
Some of you will not like the numbers you see at all. I was higher on expenses than I had hoped but also had just given up my office and one of the regular contractors I used. That cut almost all the expenses I’d need to if I wanted to hit the ideal percentages in Profit First.
You’ll see in the PDF above the percentages Michalowicz thinks you should have given your income. For many web professionals, the expense number can go lower, maybe to 25% since many of us work from home and aren’t paying for our lights. Other than that the numbers line up well with what my business has done most years till I got an office.
Once you have your percentages and where you want to start working the plan.
Stick to the plan
The path to financial freedom is paved with simple, small habit changes that become systematised and apply to both your business and personal finances.
Looking at my first quarter running on Profit First, it seemed crazy to see my expense amount building so fast. I mean, a few thousand a month in expenses felt crazy, but only because I never thought about it before.
If I purchase a new laptop every few years and pay my bookkeeper and then my yearly software renewals come up, the extra that sits for months looks like it will cover what my real expenses are.
It’s easy when you get started to see the numbers and think they’re crazy, but leave them for at least a quarter. Work the plan.
A great quarter can trick you into believing your business is on a permanent upswing and you start spending like this is the new normal. But drought periods come quickly and unexpectedly, causing a major gap in cash flow and cutting back on expenses is nearly impossible because or business (and personal) lifestyle is locked in at our new level.
As you realize that you’ve got too much in your expense field, drop it by 1% — 2% and allocate that to the other fields as needed. Not pay to start. Maybe even add another account where you’re collecting to pay off debts (we’ll talk about the Profit First thoughts on business debt shortly).
By working the plan you can help stop the feast/famine pay cycle common to so many small business owners. You won’t be overpaying yourself in good quarters only to not pay yourself in lean quarters. You’ll let the pay build up and even everything out.
Here’s the deal, my friend: Profit is not an event. Profit is not something that happens at year-end or at the end of your five-year plan or someday. Profit isn’t even something that waits until tomorrow. Profit must happen now and always. Profit must be baked into your business. Every day, every transaction, every moment. Profit is not an event. Profit is a habit.
For years now we’ve been a debt-free house. I’ve been running a debt-free business even, well except when I made Mistake #6 and raided the tax account. That left me with money owed to the government, which sucks.
Profit First, sits where Dave Ramsey took our family a few years ago. Cut up the credit cards and stop all automatic payments. Let them default and then only start up the ones you can’t live without.
Even better than getting a new Credit Card, get a Visa Debit and don’t allow overdraft. Then if you don’t have the money to pay for it, you can’t.
Well-dressed poverty is still poverty. Just because your business is making lots of money doesn’t mean you’re hanging on to it.
When Michalowicz looks at debt, he makes is first modification to the standard Profit First system. With your debt take 99% of your quarterly profit allotment and put it towards the debt. Use that 1% to party because you deserve the reward.
Once your debt is gone, you can go back to using the 50% of the profit account as your owner’s reward quarterly.
The new definition of success is not about the most revenue, employees, and office space but the most profit, generated through the fewest employees and with the least expensive office space.
Increasing your Profitability
With the system in place, it’s time to increase your profitability. There are two main points Michalowicz gets across when in comes to increasing your profitability.
To grow the biggest and the fastest, you need to be the best at something, you need to first determine what you are best at and do it a whole lot better. To get there, you take profits first and the answers to being the best at something will reveal themselves.
This goes back to so much of what every business owner hears. Don’t be a generalist, be an in-demand specialist. When you are a specialist, you say no to lots of prospects in favour of the few that allow you to provide the most value, and earn the most money.
How do you get two times the results with half the effort?
The second point is about systems and efficiency. For a developer, it’s sticking with one framework. Reusing as much as you can while still delivering a quality product to your customers.
Efficiency increases your profit margins or the amount of money you earn as profit on each product or service you offer. Increased profit margins will boost your company’s profit without the need for increased sales.
By sticking to your niche, you can get more efficient and increase your profitability.
Some modifications to Profit First
If I see money to spend, I can spend it. Michalowicz knows that many business owners are like this but he has a plan. Move your Profit and Tax accounts somewhere that is hard to get at.
Put them at a different bank and get them to turn off all the convenience features like online banking or phone banking. You want it so that you have to go in and physically visit and sign something to get at the money.
When it’s hard to touch it, you won’t.
In our business, this means that my wife (a partner in the business) opened an account for the profit and taxes. On the 10th and 25th, I send money to those accounts. I can’t see them and she is a nerd and won’t touch them.
Quarterly we sit down and deal with the accounts sending the money where we need to.
Michalowicz has other modifications to the basic system, like an account for new capital purchases. It’s easy to want to jump right into those advanced techniques but that would be falling into Mistake #2, taking on too much too soon.
Stick with the basics for a few quarters and then you can start getting advanced.
The biggest mistakes people make with Profit First
Michalowicz finishes his excellent book with the biggest mistakes he sees when trying to implement Profit First.
Mistake #1: Go it alone
Don’t go it alone, you will fall back into your former habits and it won’t end well with your finances.
Get a mentor or a mastermind group and have them keep you accountable. Show up with your finances and show the numbers to them.
Being transparent, even when it’s hard is what will help you stick to the plan.
Mistake #2: Too much too soon
You may want to make 30% profit, but it’s not going to happen out of the gate. You may want to jump to the advanced techniques, but that’s a recipe for failure.
Instead, stick with the basics. Even 1% profit to start is likely more than you’ve had in the past.
Adjust your percentages every quarter and stick to the plan.
Mistake #3 Grow First (and Profit Later)
The healthiest companies figure out how to consistently be profitable first and then they do everything they can to grow it.
This is a rampant thought today and yet we see that Twitter is still not profitable. Blue Apron may never be profitable.
You can’t afford this. Find a profitable idea and then grow it.
Mistake #4: Cutting the wrong costs
It’s easy to get used to a new lifestyle and never want to give it up. You love the fancy car you own, so you hang on to it payments and all while things flounder.
I hung on to my remote office while I enjoyed it less and couldn’t afford it.
Get comfortable with cutting back on lifestyle.
Mistake #5: ‘Plowing Back’ & ‘Reinvesting’
When you don’t have enough money in your OPEX (operating expense) account to cover expenses, it is a big red flag that your expenses are too high and you need to find a way to fix them fast.
Your profit is for you, not to stick back in your business. If you want a profit, take it first and keep it as profit.
The key is this: the profit distribution can never go back to the company. You can’t use fancy terms like reinvest, plowback, or profit retention. No term you use will cover up the fact that you are stealing from Peter to pay Paul.
Mistake 6: Raiding the tax account
I’ve done this, and it’s never a good idea. It’s helped me not cut expenses I should have.
Don’t spend your extra tax savings at the end of a quarter or a year either. Once you have your assessment, then you have some more profit.
Mistake #7: Adding Complexity
Stick to the simple plan. Forget about fancy accounting terms like depreciation. It doesn’t matter as you manage your day to day cash flow.
Keep It Simple Stupid, cash is cash and deal in cash.
Mistake #8: Skipping the bank accounts
Don’t have one big ‘holding’ account and then write down what goes where. That will only muddle the numbers when you do your quick bank check as you log in.
Muddled numbers will mean you don’t deal with your money well.
Should you get Profit First…YES! I rarely rate a book as a 5-star book, but this is one of them. One of the big problems that business owners face is that they are terrible at dealing with their finances.
Profit First is an easy read with a simple plan that anyone can follow. By following it, you’ll start on the path to building the business you dreamed you’d be building. Only it won’t be a pipe dream anymore. It may take time to get everything where you want, but it will happen if you keep working the plan.
photo by: clement127