Profit First (2014) lays out the practical steps entrepreneurs can take to immediately see a positive difference in their bank accounts. These summaries explain how traditional accounting stands between businesses and the profits their owners dream of, and proposes a new approach that guarantees consistent profitability.
Entrepreneurship, International Accounting, Small Business, Economics, Finance, Currency, Money, Self Help, Personal Development
Introduction: Start making profits in your business today!
Getting a new business off the ground is no easy feat, and those who do should get the kudos they deserve. Unfortunately for them, the tough times don’t end when the business opens its doors.
From day one, entrepreneurs chase growth and sales, trying to get their businesses to eventually make more money than they spend. But an overwhelming number never even get close. In fact, 50 percent of businesses close down in the first five years, and those that survive do so paycheck to paycheck, often racking up debt along the way.
Needless to say, this is not the way to become profitable. There’s a better, more instinctive approach to earning and growing profits. These summaries explain how it works and how to implement it with immediate results.
In these summaries, you’ll learn
- why what you’ve been taught about profit is wrong;
- why five bank accounts are better than one; and
- how UPS truck drivers drove right into $6 million.
The traditional approach to profit rarely works because it goes against our natural instincts.
There are millions of businesses around the world, from corner stores to huge tech companies. And there’s one thing their owners all want – to make a profit. Luckily, there’s an age-old formula to do just that. Sell as much as you can, subtract your expenses, and the rest is yours.
A straightforward route to success, right? Not quite.
A survey conducted from 2013 to 2015 by the Global Entrepreneurship Monitor showed eight out of ten businesses folding, with a lack of profits being the main reason. How does this happen when there’s a formula? The problem is the formula itself.
The key message here is: The traditional approach to profit rarely works because it goes against our natural instincts.
The formula sets businesses up to fail in several ways. First, it triggers our natural tendency to use up whatever is available.
This was discovered in the 1950s when historian and author Cyril Northcote Parkinson came up with Parkinson’s Law, which states that the amount of work required to complete a task increases in proportion to the amount of time available. For example, if someone has to complete a report in two days, they’ll spend two days doing it. Give them a week for the same report and that’s how long they’ll take.
Swap time for money and the same thing happens in business. Entrepreneurs will find ways to spend whatever money is available and eat into their profits as a result.
There’s another way the formula keeps profits out of reach, and it’s through something called the Primacy Effect. This is people’s inclination to focus on whatever they see first and ignore the rest. If you’re shown a list of words, for example, you’re more likely to remember the words at the top. And since the formula starts with sales and ends with profit, entrepreneurs pump effort and resources into making more sales, believing this will automatically lead to profits.
But as you’ve just learned, profits are elusive. So, here’s the million-dollar question: how can entrepreneurs guarantee themselves a profit?
The trick is to rework the formula. Instead of subtracting expenses from sales, determine what your profits should be and then subtract them from your sales. So, if your goal is a 5 percent profit, subtract this before you’ve had a chance to spend it. No matter how much or how little money remains, your natural ability to work with what you have will kick in.
Rethinking the formula is a key step in making your business profitable, but it’s just that, a step. In the following summaries, we’ll delve into the rest of the strategy.
Working with smaller amounts of money makes managing your finances easier.
If you’ve ever tried to lose weight, you’ll be familiar with the idea of using smaller plates to consume fewer calories.
Because we’re compelled to pile as much as we can onto a plate, using smaller plates makes it easier to eat less food. When the author first heard this, he had a eureka moment. He was piling all his money into one big account and subsequently spending everything. So, to spend less, he needed smaller portions of money.
The key message here is: Working with smaller amounts of money makes managing your finances easier.
So, how do you divide your money into smaller piles? By setting up different bank accounts for different purposes. The author recommends five different accounts for your business. The main income account, one for your profits, one for the business owner’s salary, one for the taxes you’ll have to pay, and one for operating expenses.
Once you have your accounts, here’s how to manage them. Whenever the business earns revenue, it’s deposited into the income account. Then you transfer money to the other accounts, always starting with – you guessed it – the profit account. Once you’ve taken your predetermined profit, the remaining money is used to fund the rest of your accounts.
Each account should only be used for its specified purpose. For instance, any company bills must be paid from the operating expenses account, and when tax season comes around, you work with what’s in the tax account.
However, even the most disciplined people are tempted now and then. And so, just like some people try to avoid eating junk food and snacks by keeping them out of their homes, you can avoid dipping into two important accounts by keeping them out of sight.
These accounts are your profit and tax accounts.
Why? Well, profit is exactly what you’re trying to have more of, so depleting that account wouldn’t make sense. And tax? Just think of the trouble you can get into when you can’t pay your taxes.
To keep this money safe, these two accounts should be with a different banks. This is where your profit and taxes will be kept in the long term. After you’ve divided the money between the accounts at your main bank, transfer the profits and taxes to the corresponding accounts at the new bank. Not seeing this money every time you look at your bank balances means you’re less likely to spend it.
Taking small steps towards a defined target is the way to grow your profits.
Now that you’ve got your different accounts, including one just for profits, you can start allocating the money as it hits your main income account. But do you immediately start taking as much profit as you think your business should be making?
Well, like many things, good profits don’t happen overnight. Slow and steady wins the race, and this is also how you should approach your profits.
The key message here is: Taking small steps towards a defined target is the way to grow your profits.
There is definitely an ideal percentage that should be going towards profit, and hitting this magic number is your goal. So, you need to define that target percentage.
One way of doing this is by looking at other companies in the same industry. Public companies have to share their financial reports, and by comparing their income to their total revenue, you can find out what their profit percentages are. Based on this, you’ll have a good idea of what your target should be. Include this in the name of your profit account so that you’re constantly aware of what your goal is.
Now that you know where you’re going, how do you get there?
By starting with one step or, more accurately, one percent. Start growing your profits by allocating just one percent of what your company makes to the profit account, and then reducing your operating expenses by one percent.
If you’re thinking that this isn’t much, remember this is a marathon to consistent profitability, not a sprint. Imagine overzealously taking twenty percent as profit, only to have your business struggle and be forced to use all those profits to rescue it. You’d be back at square one with zero profits, and probably a lot less enthusiasm for the process.
Also, you might start at just one percent, but you won’t stay there for long. At the end of every quarter, increase your profit allocation to bring it closer to your target, and reduce your operating expenses by the same amount. The author suggests going up by at least three percentage points each quarter. So, if you start with one percent going to profits, then you’ll move up to four percent in the next quarter. Over time, these small adjustments will pay off in a big way.
Your profits are there to reward you and to serve as a safety net for the business.
Imagine that you’re baking a cake for yourself. You find the perfect recipe, gather the ingredients, and once it’s done, you cover it in icing and step back to admire your creation.
But admire is all you do. You don’t have a single piece or even a lick of icing.
Now picture doing the same with your business, working hard on it and watching your profits grow, but never get to enjoy a cent. This is no way to treat your profits.
The key message is: Your profits are there to reward you and to serve as a safety net for the business.
This, however, doesn’t mean that you can reach into your profit account whenever you feel like splurging on something. Instead, only take your profits at the end of every quarter, as the shareholders of large public companies do. This way, you’ll look forward to your profits and not misuse them or rely on them to support you.
And just as you wouldn’t – or at least shouldn’t – eat your entire cake in one go, don’t take everything that’s in the profits account at the end of each quarter and reinvest it in the company. Take 50 percent of your profits and enjoy it by spending it on yourself or your family, not the business. Remember, this is your reward! The remaining 50 percent should stay in the account as an emergency fund for the business and this is where you’ll keep depositing your profits.
After a while of putting money into your profit account and increasing your profit percentage, something great will happen. You’ll take your 50 percent at the end of the quarter, and realize that what’s left is enough to cover your business costs for more than three months!
This is the only time you’re allowed to take funds from the profit account and reinvest them in the business. Take the excess money, make sure to leave three months’ worth of funds, and decide how you can best use it to help grow your business.
At this point, you should give yourself a pat on the back! You’ve got a business that’s consistently making a profit and you’ve got money in your pocket to prove it. But this isn’t the end of the road. You can free up more funds in your business and further increase your profits. More on this in the following chapter.
Learning how to do more with less will give your profits a boost.
Do you know that feeling of unexpectedly finding money in your coat pocket, or under the couch? It’s great, isn’t it?
Guess what? You can get that same feeling from your business. You just need to know where to look and what to do.
The key message here is: Learning how to do more with less will give your profits a boost.
The first place to look is at how efficient your business is. Is there anything you’re spending more money on than necessary? Are there tasks that could be done faster? Even seemingly small changes can have a big impact on your profits.
Just ask the people at United Parcel Service, also known as UPS. In 2006, they decided to increase their efficiency and made some interesting and effective changes. For example, they realized that drivers spent more time waiting at traffic lights, and used more fuel when they took left turns. By instructing the drivers to avoid left-turn lanes as much as possible, UPS saved time and fuel to the tune of $6 million per year.
Once you’ve scoured your business for opportunities to reduce time-wasting and cut costs, it’s time to take a look at your customers and refine how you serve them.
If all your customers have very different needs, then you spend time and money catering to the specific needs of each one. But if all your customers want the same thing, you can focus on how to do that one thing quickly, perfectly, and at a lower cost, until you’re serving more clients with fewer resources. That’s efficiency!
So, figure out what your company does best, and then get even better at it. Then, market yourself to the clients that need these services. The money you save will have you moving towards your profit target even faster.
Paying off your debt doesn’t have to get in the way of making your business profitable.
You’ve heard the saying “it takes money to make money”, right? And as a business owner, you’re probably aware of just how true this is. Building a company requires a lot of cash, and sometimes you just don’t have it.
Whether it’s by borrowing money from friends and family, taking out a loan, or even maxing out a credit card or two, many entrepreneurs find themselves in debt. And when this happens, becoming debt-free can easily take precedence over everything else, including making a profit.
But this doesn’t have to be the case.
The key message here is: Paying off your debt doesn’t have to get in the way of making your business profitable.
No matter how bad your debt is, you should continue putting a percentage of your company’s income into your profits account. Doing this while paying off what you owe will build your cash reserves and eventually ensure that you have enough to cover any expenses in the future.
If you’re wondering where the money to clear the debt will come from, just look in your bank account.
Remember the profits that you’re pocketing every quarter? You’ll have to sacrifice some of them, 99 percent to be exact. Put 99 percent of your profit share towards debt payments, and keep the remaining one percent for yourself. Losing such a big chunk of money might sting, but this will get you debt-free much faster.
Now, having the money to pay off debts is not enough, you also have to be strategic with it. Here’s how.
Start by listing your debts from the smallest amount to the largest. If you have different debts of the same amounts, put the one with the higher interest rate first. Then, make the minimum payments on all the debts except the smallest one at the top of your list. Now, put the rest of your money towards this debt. Once you’ve paid it off completely, add the money you’ve freed up to payments for the next debt on your list.
Before you know it, there’ll be nothing left to pay off and you’ll have more of your profits to enjoy.
Applying the profit-first system to your personal life can help you gain financial freedom.
How great would it be to never have to worry about money again? Picture living in your dream home, and booking holidays whenever you feel like it. Or simply having the comfort of knowing that you can cover any expenses that life throws at you.
However you imagine a life free of financial stress, you can make it happen with the same profit-boosting tactics you’ve just learned.
The key message in this chapter is: Applying the profit first system to your personal life can help you gain financial freedom.
Just as your business has different accounts for different purposes, you should split your personal finances across a few accounts. Have an income account where your salary is deposited, and then create accounts for your day-to-day expenses, recurring payments like rent or insurance, retirement funds, and any emergencies that might come up.
Every time you get paid, immediately transfer a percentage into your retirement account. You’ll eventually have to live off this money, and so the account gets first dibs and the other accounts are filled after it.
If the debt is keeping you up at night, do exactly as you would in your business. Use 99 percent of the money allocated to your retirement for debt payments and keep the remaining one percent in the retirement fund. Do this until your debt is paid off and then turn your focus back on growing that nest egg.
As you watch it grow, you might be tempted to start living a bit larger. After all, the money’s in the bank so why not? But this is exactly the opposite of what you should do.
To eventually become financially free, you need to consistently save as much money as you can. So, no matter how much money you see in your account, your lifestyle should remain the same. The author recommends maintaining it for five years. Keep your costs low by doing your research before buying anything. Find out if there are cheaper or free options, learn how to negotiate, and give yourself time to think about making big purchases.
But if you’re thinking, “Wait a minute, there’s no fun in being this frugal,” don’t worry, you can enjoy a bit of your money and still save. Whenever your income increases through a raise or a tax refund, for example, invest only half of that money in your lifestyle and put the rest where it needs to be, in your retirement fund.
After enough years of adding to this fund, it will start earning enough interest to fully support any lifestyle you choose, making you completely financially free.
Insights from Profit First by Mike Michalowicz
You can grow your business and be profitable from day one. The key is to tweak the universal business formula from Sales ‐ Expenses = Profit to Sales – Profit = Expenses.
Instead of using income to pay for expenses and seeing what profit is left over, take a portion of each sale as profit (no matter what), and use what’s left over to pay expenses. It doesn’t seem like a big change but taking “profit first” can completely change the way you do business and convert your business from a cash‐eating monster to a money‐making machine.
The profit-first system relies on four principles ‐ the same four principles that millions of people around the world use to lose weight:
Use a smaller plate
Just as constraining the size of your dinner plate will automatically lead to less calorie consumption and help you shed excess weight over time, constraining the size of your operating expenses budget will help you shed excess expenses over time.
When you allocate more money to profit and force yourself to spend less on expenses, you’re forced to find efficiencies and cut unnecessary expenses. For example, you may find a piece of software that streamlines a process and allows you to rely on fewer contractors. Or maybe you discover that having office space isn’t necessary and allow all your employees to work remotely. One entrepreneur in the book likes to challenge his team by asking: “How can we keep doing what we’re doing for a third of the cost?”
If your first course of a meal is a leafy green salad, rich in nutrients, you’ll tend to not overeat when consuming future courses. Profit is like nutrient-rich food. When you begin allocating real sales revenue to profit first, you’ll increase your satisfaction and naturally want to spend less on expenses because:
- Profit makes business rewarding because at the end of each quarter (January 1st, April 1st, July 1st, and October 1st), you distribute profit to you and your partners and can spend that money on whatever you want. Essentially, profit money is play money (or party money!).
- Profit creates a cash reserve for emergencies, which provides peace of mind when running a stressful business.
- Profit is the best metric to measure the health of your business.
If you move your profits to a separate bank, one that makes it difficult to withdraw funds (withdrawal fee + delay), you’ll be less tempted (and less likely) to use your profits to pay for expenses.
Enforce a rhythm
If you have significant time gaps between financial assessments, you’ll tend to think your finances are much better than they are and purchase more expenses than you can afford. When you use the profit first system, you transfer money from the INCOME account to the operating expense account (OPEX), owner’s compensation account (COMP), tax account (TAX), and profit account (PROFIT) on the 1st and 15th of every month, which allows you to frequently assess the health of your business.
Getting started with the Profit First system:
Step 1: Create five checking accounts at your bank. Nickname the accounts: INCOME, OPEX (operating expenses), COMP (owner’s compensation), TAX, and PROFIT.
Step 2: Determine the % of real sales revenue (money you have after paying for materials and subcontractors) in INCOME you allocate to OPEX, COMP, TAX, and PROFIT. Put your current allocation percentages at the end of each nickname (Ex: COMP 8%). If you are not allocating any money to PROFIT, start by allocating 1% to PROFIT and subtracting 1% from OPEX.
Step 3: Determine your target allocation percentage for each account. Author Mike Michalowicz has assessed thousands of small businesses and collected the average allocations that all healthy businesses abide by:
- 0‐250K in revenue: PROFIT 5%, COMP 50%, TAX 15%, OPEX 30%.
- 250K‐500K in revenue: PROFIT 10%, COMP 35%, TAX 15%, OPEX 40%.
Step 4: On the 1st and 15th of every month, transfer all the money in INCOME to the other four accounts according to your current allocation percentages (see step 2). Allocate to PROFIT first.
Step 5: At the end of every quarter, increase the allocation percentages on your PROFIT, COMP, and TAX accounts by 1% and reduce your OPEX allocation percentage by 3% until you reach your target allocation percentages (see step 3).
Step 6: In a separate bank, create PROFIT and TAX savings accounts. At the end of every quarter, transfer the money from your main PROFIT and TAX bank accounts to these external PROFIT and TAX accounts so the money is out of sight and out of mind.
If you follow this profit-first system, you’ll be forced to cut more and more non‐essential expenses and find creative ways to grow your business without mindlessly increasing expenses. After a year of following the profit-first system, your business will gradually transform from a cash‐eating monster to a well‐oiled profit‐making machine because you’ve made profitability a habit, not an event someday in the future.
The key message in these summaries:
The best way to make sure your company makes a profit is to simply take it. By immediately allocating a percentage of every bit of income to profits, you get into the habit of running your business on less money. This will encourage you to take a closer look at your operations and become more innovative and efficient wherever possible, putting even more money in your pocket.
Get into a regular habit of managing your money.
Rather than waiting for the end of the month to distribute your money between accounts and make any necessary payments, start doing this every two weeks. Facing your finances this often allows you to keep close tabs on how your savings are faring and where your money is being spent, making you aware of exactly where you stand financially at any given point.
About the author
Mike Michalowicz launched and sold two multimillion-dollar companies and currently operates his third, Obsidian Launch, a consulting firm that ignites explosive growth in companies that have plateaued. He is the author of The Pumpkin Plan, also published by Gildan Media, and is a small business columnist for The Wall Street Journal.