Mike Michalowicz tips the typical accounting formula on its head in this revised and expanded edition, citing four simple principals that will make it easily more manageable to run a profitable business.
No stranger to unconventional business ideas in his previous books, the author’s simple, if not counter-intuitive approach here is to pay the profits first.
Where most bookkeeping strategies subtract the expenses from the proceeds, classifying anything left over as profit, Michalowicz’s unorthodox method is to decide what you want your surplus to be up front, deduct that amount from your proceeds, leaving a balance to use for expenses.
It’s a process that forces a business to tighten its purse strings and get crystal clear on which outgoings are absolutely necessary. In adhering to this more incisive budgeting approach, a company gains a better overview of where it wants to be, and how it will get there.
The sad fact is that most businesses are:
Out-of-control cash-eating monsters
Most entrepreneurs are lost in a nightmare of debt.
Starting a business requires a lot of preparation and a solid vision of the bigger picture. More often than not, projects are dreamt up and launched into the world without much thought for where they’re going or what they will look like five years down the track.
A bit of talent and a few great ideas will only get you so far. There comes the point when you realise your limited resources were never enough. You’re not quite sure how it happened, but it becomes apparent that your outgoing expenditure has wildly surpassed the money coming in. Overwhelming stress and sleepless nights take hold as you become gripped by the reality of approaching financial burden.
You hadn’t planned it out. You thought the cold hard cash would last forever.
Bigger is not better
You want your business to grow, and you want it to be profitable. But the size of the company does not necessarily correlate with the size of the profits. In fact, with bigger business comes bigger problems.
The rate of growth can easily overshadow the rate of return, leaving businesses floundering to pay off excessive amounts of debt. Even though business owners struggle to keep it all together, their one driving force is – BIGGER! They have little regard for the financial health of the company. It’s the classic gamblers high – they think if they can just secure one more big project or client, everything will be all right. But they usually end up digging themselves into a deeper hole.
The perfect size for your business will happen organically – when you take your profit first.
Profit is not an end-result; it should happen every day from the start. It must become an ongoing habit. It’s futile to live with the hope that you’ll magically find the profit someday.
The Survival Trap
In the beginning, a business owner has a passion for a product or service, and a dream to create a revenue stream around it. There is a clear-cut vision of making money from what they love to do.
The business grows, and the cash flow is good. Then things grow too quickly, and the financial pressures start to flood in.
At this point, the owner has a new vision – to get out of debt. He is practically willing to sell his soul to get back on track. He will do whatever it takes.
So he ends up offering services or products well outside his original plan of attack. Anything he thinks will bring in fast money. But easy money = more cost. He now needs to finance new resources for his new services. It becomes harder to manage and more costly to run. Rather than generating lucrative income, he is now producing debt-generating income. It becomes a rollercoaster ride of bad decisions, and it’s only buying time.
Michalowicz stops to reminisce about his own financial misfortune, and how it was his 9-year old daughter who taught him the meaning of financial security when she offered up her piggy-banked life savings, secured with tape and rubber bands – save your money and block access to it, so it doesn’t get stolen (by you!).
Late night TV provides the answers
Having fallen into a pit of despair, Michalowicz spent hours watching late night infomercials over beer and Cheetos.
It was most unexpected, but a fitness guru explaining why diets don’t work somehow had the answer to all his financial woes.
The expert argued that permanently changing habits is a tough thing to do. Humans are not geared that way. And when it comes to mealtime, we were always told to eat every last morsel of our large servings, on our even bigger plates. We were told to finish what was in front of us and not waste good food.
The key to losing weight and gaining better health, however, is merely dishing out less food onto smaller plates. Then we don’t take off more than we can chew. We don’t end up with more than we need. And we’re no longer in a position where we eat more just because it’s there.
And so it is with money. Michalowicz was spending every last cent that was put in front of him, regardless of the portion. The solution was to create the experience of having less cash on hand than he actually had.
And so came about …
The four core principles of Profit First
Parkinson’s Law: Why your business is like a tube of toothpaste
Parkinson’s Law states that the demand for something expands to match its supply.
The more we have of something, the more of it we consume.
When you have a brand new tube of toothpaste, you happily dollop it out with gusto. Nice big glistening portions. And if you waste some, it doesn’t matter because you’ve got plenty more where that came from. But when the paste looks like running out, you find yourself squeezing every last bit you can. You try everything you can think of to get that damn paste out. You ration it to make it go further. It just goes to show, you didn’t need to use as much as you were in the first place to have clean teeth and fresh breath.
When supplies are low, Parkinson’s Law triggers two types of behaviour:
1. You become more frugal.
2. You become more innovative.
And with finances, you need to intentionally make less toothpaste (money) available to brush your teeth (operate your business).
When less money is available (from taking your profit first) – you’ll find innovative ways to get successful results with less.
The Primacy Effect: Why the first part of ‘profit first’ matters
The principle of the Primacy Effect is: we place greater significance on whatever we encounter first.
For example, when presented with a series of words, we are prone to identify more with the first couple of words we see.
When we follow the conventional accounting formula: Sales – Expenses = Profit, we tend to focus more on Sales and Expenses and treat Profit as an afterthought. We then behave accordingly, making money and spending money. Profit gets pushed aside.
By putting Profit in the limelight, however, it is never forgotten.
Remove Temptation: Once you take your profit first, put it away
If you’re trying to lose weight, you know you have to abstain from foods laden with fat and sugar. If you have these treats in the house, there is a greater temptation to eat them. The best strategy is to remove all traces of these goodies and not have them in the cupboards in the first place. “Out of sight, out of mind”.
It’s the same when it comes to money. If you deduct your profit first and put it out of sight and out of mind, you know you won’t have access to it. You will then find innovative ways to make do with the funds to which you do have access. Just like the piggy bank method.
Enforce a Rhythm
The best way to keep your finger on the pulse of your business is to get into a rhythm with your cash management.
It’s simple. Have your morning coffee. Log into your bank account. Take a quick look at your account balances. Log out. Repeat.
You will know what your cash flow is doing on a daily basis, and you can take immediate action accordingly.
There is a misconception that a business will never grow if it continues to take the profit first.
In reality, taking the profit first sparks faster growth because it tells you instantly whether you can afford the expenses you are incurring. It shows you which adjustments need to be made to streamline your cash flow, thus keeping you out of debt. It also shows you which things are making money and which are not.
Michalowicz expands on his new accounting formula and provides detailed advice on how to apply this and the four core principles to your business. He delves further into assessing the health of your business, and how his Instant Assessment can help determine your financial outlook. He also guides you through the process of how and where to cut costs.
He wants you to look at who your best clients are – and clone them. Then ditch those who are not doing you any favours. Financial strain and personal stress – gone!
In addition, he shares examples of real-life people who had similarly fallen into financial chaos but were able to turn their business around using the Profit First method.
The resounding catchcry to this book – Profit First is a way of life.
The rewards are not only seen in business, but also reaped in so many other ways.