Profit First by Mike Michalowicz (207 pages)
Profit First has been on the shortlist of many entrepreneurs’ “must-reads”. I’m a podcast junkie, and over the course of a few months Michalowicz came up at least a half dozen times. So it was time to give the book a try.
The crux of the message for business owners is: change your fundamental accounting method. The traditional formula looks like this:
Sales – Expenses = Profits
Michalowicz explains how this can undermine any business. Most entrepreneurs plow the money they make back into the business in order to grow. Sounds reasonable. Most people want to scale.
However, this can become a downward spiral toward bankruptcy. Entrepreneurs who continually scale face a crisis if there is a setback. Take the supply chain problems of 2020 as an example. If you didn’t have profits in the bank to fall back on you no longer had a business.
The analogy that Michalowicz uses is that your business is like a chubby person; it needs a diet. The formula that Michalowicz suggests is:
Sales – Profits = Expenses
He goes on to explain the 4 core principles of Profit Frist accounting.
1. Use Small Plates
Dieting is directly transferable to business. If you want to lose weight start by eating from a smaller plate. You will eat smaller portions. You will take in fewer calories. You will become thinner.
The same is true in business. If you pay yourself first, deposit the profit in an account directly from sales you have a “smaller plate” for expenses. Your expenses will be leaner. Your company will be more productive.
2. Serve Sequentially
Keeping with the idea of a good diet, you should serve yourself vegetables first. This will start satisfying your hunger. When the mashed potatoes come by you’ll eat less of them. By eating your vegetables first you will naturally become healthier.
Profit is your business’ vegetables.
3. Remove Temptation
Humans are innately lazy. It’s in our DNA from our caveman days to reserve physical and mental energy. If you put the potato chips in the cabinet over the fridge, the one you need a step stool to get to, you’ll be less inclined to eat them. Better yet, don’t buy them at all. You’ll have to go all the way to the store when a chip urge hits.
Taking the profit out of your bank account keeps you from spending it.
4. Enforce a Rhythm
Don’t wait until you’re hungry to eat. This will cause you to binge and make bad decisions. Instead, eat 3 meals a day at prescribed times whenever possible. You will eat less overall.
Choose 2 days each month to pay yourself profits. And do it each and every month on those 2 predetermined days.
All four of these principles are based on behavioral science. When you know what makes humans act in a certain way you can use it to your advantage.
Michalowicz devotes the rest of the book to walking you through how to implement these ideas in your business. He gives a concrete step-by-step plan. There are plenty of charts and examples to make his process clear and easy to understand.
SHOULD I READ IT?
Profit First is a best seller on Amazon with over 5,400 five-stars ratings. I have come to appreciate the power of human psychology as it relates to business. The ideas proposed in this book are built on human behavioral theories.
Paying yourself first, especially for a new business, is counterintuitive from a purely accounting standpoint. The urge is to reinvest in the endeavor and make it grow. However, when evaluating more closely you can see how this could lead to financial insolvency.
The subtitle of Profit First is “Transform your Business from a Cash-Eating Monster to a Money-Making Machine”. I think Michalowicz gives a compelling argument for paying yourself first. He also instructs you on how to accomplish the goal.
Chapter 1 Your Business is an Out-of-Control Cash-Eating Monster
Money management skills is a talent too few people have. It’s often not learned in school. And this holds true for many business owners as well. They can grow a business and often have awesome sales skills. Being able to make sales and grow a company is enviable. But without understanding the financial management leg of a firm it can easily fail.
And fail they do. You’ve probably read the statistic that 50% of businesses don’t last 5 years.
There are so many stories of scrappy entrepreneurs sleeping in their cars or offices, working 18 hour days to grow their dream into a functioning company. The problem arises when the business starts to grow. The bills grow along with it.
Maybe you rent a larger office, procure new software, hire a few people. Once you scale your expenses it’s not easy to undo the growth. You signed a lease. Laying off an employee whose family counts on their paycheck is tough.
So many entrepreneurs are of the mindset: I just have to keep investing to grow the business and the profits will come tenfold next year — or the year after that.
This is a house of cards. If there is a setback of any kind you don’t have a backup. Your business has become a cashing-eating monster that’s out of control.
Chapter 2: The Core Principles of Profit First
Micalowicz fell into the trap of the cash-eating monster. After successfully selling 2 companies he went on the burn through all of the money on other endeavors and wound up in debt.
It was then, while he was drowning his sorrows in beer and watching infomercials he heard a bodybuilder talk about the small plates theory of dieting. This was his light bulb moment. He equated this to his businesses. He had been “eating” from a large plate full of money and consumed it all.
What if he created a smaller plate of cash for his business? The business would have to run on this smaller amount. And what about the extra? Profit — he would take the profit first!
The principles of weight loss were all rooted in behavioral science. Business is usually rooted in accounting theory, which does not take into account the human psyche.
A paradigm shift was necessary.
Chapter 3: Setting Up Profit First For Your Business
You may have heard of the envelope method of personal budgeting. My parents actually did this. There was an envelope for mortgage, food, utilities, etc. When dad got paid the appropriate amounts were placed in each envelope. When the envelope was empty you couldn’t spend any more until the next paycheck.
The same system can be used in your business. Michalowicz advises creating 5 separate bank accounts:
Next, go to a different bank to set up 2 more accounts! This is done in order to keep the money out of sight and out of mind. One account is Proft hold and ther other is tax hold.
Once you’ve completed step one, creating 5 accounts, and step 2, opening 2 hold accounts in another bank you’re ready for step 3. Step 3 is to NOT install any conveniences on your hold accounts. You don’t need an app on your phone or an internet log in. These accounts should not be easy to access.
Chapter 4: Assessing the Health of Your Business
The next step is difficult and often painful. It’s human nature to gloss over the parts of your business finances that are not healthy. But it’s crucial to know your numbers, even if they’re ugly.
Here is the chart offered in Profit First that you should fill out for the prior year.
A1 is the total revenue from sales.
A2 If you’re a manufacturer, retailers or reseller list yur costs of materials (not labor) This is only if your materials cost 24% or more of your sales.
If subcontractors deliver the majority of your service put the cost of subcontractors in A2
If you are a service company or if your material or subcontractor costs are less than 25 of sales put $0 in A2
A3 Subtract A2 from A1 to get your real revenue number.
A4 Write your actual profit here
A5 Record how much you pay yourself
A6 Write down how much your company paid in taxes. This is not what you paid personally in income taxes.
A7 Include all your other expenses here
B4-7 Will be filled in following the chart below. TAP stands for target allocation percentages and it is where you want to go, now where you are now.
CHART ON PAGE 68
C3-7 Copy your real revenue from A3 in this box. Then multiply the TAP percentages from each row and write down the number in the corresponding PF $ cell.
D4-7 In the Delta column take the actual number and subtract the PF$. You’ll probably have a negative. Do the same for the other categories
E4-7 In these cells you will have either the word increase or decrease. If the number in Delta is negative put “increase” and vice versa.
This exercise gives you the target allocation numbers to work towards.
Chapter 5: Allocation Percentages
The target allocations calculated in the previous chapters are guides and goals. They are not set in stone and may get tweaked along the way. You need to slowly and deliberately work to get closer to your TAP.
In order to have a better understanding of your target profit for your industry research some industry norms. Look at your tax returns for the last few years percentage-wise.
There are forms available in the resources section at MikeMichalowicz.com
Chapter 6: Putting Profit First Into Motion
There are a couple of things to do in order to actually implement the profit first method.j
Firstly, you should get your bookkeeper and accountant on board. This is not the usual way accounting is done. The most common is the GAAP (generally accepted accounting principles) method. They may balk, but you should hold firm.
Next, in order to work towards your TAP (targets) start with CAP current allocation percentages. These can increase over time. Take your contribution levels for profit, owner’s comp and taxes as they stand and add 1%. Then take your operating expenses and adjust it -3%. See the chart below
These will be your Day 1 CAPs. It allows you to start nice and slowly.
To take action, look at the balance you have in your original account (that we renamed operating expenses), back out outstanding checks and transfer the rest to your income account.
From there you can make your first allocation. You’re on your way to ALWAYS have profit in your business!
Start cutting expenses wherever possible. Twice a month, on the 10th and the 25th transfer money to your accounts using the CAP.
Every quarter take a profit distribution check. This is over and above owner’s compensation. Transfer half of it to the profits to the hold account you set up.
Chapter 7: Destroy Your Debt
The fact that your business is making money does not mean it’s profitable. Oftentimes firms have a line of credit from their bank. They can borrow from it at any time up to the limit. It’s very easy, when you need more equipment or other capital expense, to tap into the credit line.
However, your bank can call in the entire amount at any time. Most companies could not pay it off were that to happen. That’s why you took out credit to begin with!
This chapter walks you through many exercises and steps to get your debt under control. Generally, you need to track average monthly revenue. Calculate your target expenses and cut that 10%. Then start cutting costs. Brutally roll back your costs in every aspect of the business.
The reason for cutting expenses 10% below TAP is that you may at some point need to readmit an expense that was cut and is found to be crucial to the life of your company.
Michalowicz stresses that the Profit First model should be implemented BEFORE you pay off debt. He goes back to the diet analogy. If you go on a strict 1200 calorie diet with a heavy exercise regimen you’ll lose weight.
But as soon as you go “back to normal” the weight will come right back on. If you tighten your belt to pay off debt nothing has really changed. The cash flow and expenses are the same. Debt will quickly creep up once again.
Another suggestion for paying down debt is the debt snowball. Pay down your smallest debt first. This is the easiest and a quick win. You’ll feel good. You’ll feel motivated to keep going.
The debt snowball approach to paying down debt is one in alignment with human psychology and behaviorism.
Chapter 8: Find Money Within Your Business
There are 2 avenues to explore in order to find more money in your business.
The first is to cut expenses. Scrutinize every dollar spent to find where money can be saved. A story the author shares as an exemplar is called “Split the Truck.’
An entrepreneur has a business delivering oil to 2 types of clients businesses that buy hundreds of gallons of oil and another that sells quarts of oil. This necessitated 2 trucks, an oil tanker and a box truck for the retail stores. Obviously, he also needed 2 drivers. As a result of all these costs, profit margins were very slim.
One day he came up with the idea: split the truck. He took a box truck and converted half of it into a tank and left the other half as storage for the quarts of oil. Voila, he had just cut his expenses in half!
The second way to find money is to find new ways to bring value to your customers. It’s always cheaper to make money from an existing customer than to acquire a new one. Looking for upsells and added values will increase your coffers.
Chapter 9: Profit First Advanced Techniques
This chapter deals with simplifying your accounting by adding more accounts. You already have 5 accounts, plus 2 Hold accounts. As your cash flow is stabilized in these accounts a Vault is the next goal.
This is an account that will hold at least 3 months of operating expenses in case of a downturn or emergency. This is to be used ONLY in a dire emergency.
Other accounts explained in this chapter are stocking account, a pass-through account, materials account, subcontractor account, equipment account, drip account, petty cash account and more.
He also addresses raising capital and when you can afford another employee in this chapter.
Chapter 10: The Profit First Life
Using Profit First system works in personal life as it does in business. By living from a smaller plate and creating accounts to pay yourself in addition to paying bills you can begin to enjoy financial freedom.
This is not necessarily a bottomless wallet. But planning for what is important to you and depositing into an account toward what brings you joy reaching your goal is inevitable.
Chapter 11: How to Keep it From Falling Apart
Some of the mistakes that Michalowicz enumerates in this chapter that should be avoided are as follows:
Mistake #1 Going it Alone
Having an accountability partner helps to stay on track. This is true of exercising, dieting and changing your business paradigm. A partner will hold you accountable and help you when the going gets tough.
Mistake #2 Too Much Too Soon
It’s common for a gungho entrepreneur to start this program by putting 20% or 30% of income into their profit account. They quickly find out it’s unaffordable and have to take money from the profit account to pay bills. This undermines to success of the Profit First model.
Michalowicz cautions several times throughout the book to start small. Your profit target may start out at 1%. Once this is working you can slowly increase the amount. This will ensure success.
Mistake #3 Grow First and Profit Later
This mistake is holding onto the old mindset until your company is larger. “I’ll start Profit First when my company is larger.”
You can be waiting a LONG time to the detriment of your bottom line. He points out that Twitter isn’t profitable after 10 years. If you wait to start Profit First you are in danger of slipping further behind instead of moving forward.
Cutting the Wrong Costs
Frugality is fundamental to this system, but knowing where to cut costs is essential. One example given is to hold onto old equipment to save the cost of more modern machines.
The old machines may not work as well, creating an inferior product. Also, newer technology may greatly increase productivity, allowing you to produce much more faster.
Mistake #5 “Plowing Back”
Taking money from one account to in order to reinvest is a bad decision. For example plowing back money from your profit account to operating expenses. This will cause you to start eating from a larger plate again.
IS PROFIT FIRST A GOOD MODEL FOR ENTREPRENEURS?
It depends on who you ask. Sigrun, a seasoned entrepreneur and coach, is adamant that it’s NOT good for businesses that want to grow quickly. She believes money is the fuel of your business. If your want your company to grow you must add more fuel.
She uses her consulting business as an example. In her first year she invested in FaceBook ads and joined a mastermind group even though she didn’t have the cash. These decisions are attributed to her six-figure growth in one year. Profit First would advise against this.
You can read her article here.
An accountant who analyzed Profit First gave it good grades on Medium.
Profit First is not just a lofty philosophy. Mike Michalowicz gets into the weeds and tutors the reads on the concrete steps to implement this money-management model. It is firmly based in human behaviorism and seems to be a concrete alternative to the Profit Last model.
ABOUT THE AUTHOR
Mike Michalowicz built and sold 2 multi-million dolar businesses before he was 35-years-old. He then became an angel investor and lost all his money. It was during this time of failure that he conceived of and created the Profit First model.
He is now an author and lecturer who has written 7 highly rated business books:
ANOTHER BOOK TO CHECK OUT
If you like business books with clear step-by-step guides check out The Common Path to Uncommon Success by John Lee Dumas