Today I am presenting my first book summary. This idea took root because I want to read more, and I LOVE learning about business best practices. I am on the hunt for great business books, and I will review them when I find them. So enjoy…
Profit First – Mike Michalowicz
Transform your business from a Cash-Eating Monster to a Money-Making Machine
I decided to pick up this book after hearing the author on a podcast episode of Entreleadership. I liked what he was saying since I was currently working for a company that was a “Cash-Eating Monster” as the tagline of the book speaks to. I always love the idea of increasing profit, so I picked up this book.
The Basics of Profit First
First, I want to say that Mike Michalowicz (the author) writes this book from the perspective of his experience as a business owner. I appreciate when folks take their life experiences, learn from their mistakes, and then teach others how to avoid those mistakes. He comes from a background of building businesses fast and then selling them. Although not many of us will relate to that narrative, he talks about how he always felt like he knew how to grow, but he was not making a profit. At the end of the day, he was shocked at how little money he took home even though he was growing his business to a large scale! He also was baffled when he was hit with huge tax bills even though he had no money to pay those bills! Does that sound familiar? I hope not, but if it does, there’s hope….
He goes on to explain some fundamental differences in how the “entrepreneur type” think and how it doesn’t jive well with traditional accounting. Many entrepreneurs tend to be IDEA people and ACTION takers, which is what makes them so awesome. They love to jump in head first and fully execute on things that they are convinced will be successful. They tend to not stop and think about the financial consequences of their actions though. If they do take a second to think about the funding, they will likely look into their bank account and determine if the amount they see there will cover the action they want to take. If the entrepreneur with this mindset sees $100k in the bank, they might think it’s a good time to buy that new piece of equipment, onboard a marketing firm, or hire a new employee to execute his plan.
This idea of looking at a bank balance alone to make decisions is something that makes accountants CRINGE! Accountants know that the $100k that was in the bank is needed to pay for things like upcoming payroll, rent, loan repayments, and next month’s tax payment. If the CEO spends the money on his new idea, the accountant is put in a place of either having to delay payments (incurring interest) or borrowing money (not a good habit to get into).
Accountants rely on a multitude of reports before making decisions. One of the most fundamental reports is called the Income Statement (or Profit and Loss Statement). This statement is based on a basic accounting principle:
REVENUE (Money In) – EXPENSES (Money Out) = PROFIT (Leftover)
This calculation of Revenue – Expenses = Profit assumes that the profit is the runoff of whatever the difference is between revenue and expenses. It insinuates that you don’t know what profit will be, but you can control revenue and expenses in the calculation. For example, let’s say you make $200k in revenue during the year and you spent $150k to make it happen (expense). Excluding taxes in this equation, your profit would be $50k (200k-150k).
The Profit First model flips that around and says that you should change the calculation to:
REVENUE – PROFIT = EXPENSES
This new way of thinking about the calculation now assumes that you control the revenue number and the profit number, which thus dictates what your expenses will be. In application, let’s say you make the same revenue of $200k in your business, but instead you want to take 45% profit – which would be $90k. So you would do the calculation to be $200k – $90k = $110k. This calculated $110k is what you will then use as your target to operate your business for the year. Use the $110k as your budget to accomplish your revenue of $200k. This calculation is set up to be used prospectively (going forward). You can’t force this calculation on the past. This is important to know because Profit First principles needs to be implemented in planning phases of your business.
Seek Profit over Revenue
One of the things that Profit First preaches is that business owners tend to obsess about growth and increasing revenue. This focus on “MORE REVENUE AT ALL COSTS” is what gets many entrepreneurs into bad financial situations. Did you know that you can build a multi-million dollar company and still not make a profit? Business owners tend to think that they need to SPEND money to make money, and they spend like spending is the action that produces income. Well, that’s just not true. Mike Michalowicz is pleading with you to see if differently, and so am I.
Keeping a tight rein on your expenses is going to be the single most important factor in determining your ability to reach profit targets.
Rethinking the Norm
Now that we’ve discussed that managing expenses needs to be just as important as increasing revenue to reach your profit goals, let’s talk about why it’s GOOD to put restrictions on yourself. I believe it’s a great idea to budget. However, in personal and business discussions, the term “budget” has a bad connotation. Small business owners tend to cringe because budgeting seems to be a restriction to their hopes and dreams. I challenge you to think of it another way. What if you look at a budget as a framework to have creativity within? For example:
If I asked you to go plan a Christmas party for the office, and I didn’t give you a budget, what do you think you would do? You’d probably try to think about cost, but you’d likely spend a large amount of money going to the store and buying all the food, drinks, decorations and supplies that you think you “need”. Right? Now, if I were to give you $100 to plan a Christmas party for your office, how creative do you think you would need to be? Maybe you would call in favors, find free stuff, leverage resources from coworkers, or barter some services. I bet you would get really creative! You’d probably think hard about what was necessary and what was not necessary! You would need each one of those dollars to be efficient for you.
This same idea applies to all operating expenses. If you commit yourself to your profit goals, then you will have to learn how to work within your means. Michalowicz discusses Parkinson’s Law that states, “work expands so as to fill the time available for its completion”. In the same way that work expands to fit the time allotted, spending in a business also expands indefinitely without constraints. Sometimes sticking to a budget will require thinking outside the box, which can actually produce more benefits than just cost savings as you may invent something new or a new way of doing things efficiently. You CAN give yourself a budget AND learn to stick to it! Your profit depends on it!
How to Put Profit First
Now that the theory has been explained, let’s talk about application. How can we apply these theories so that we don’t end up as “Cash-Eating Monsters”. Since the author is convinced that entrepreneurs will always be “bank balance checkers”, he requires that companies implement his theory by setting up different bank accounts – Five to start with:
- Income account
- Profit Account
- Owners Compensation
- Tax Account
- Operating Expense
He wants you to literally go down to the bank and open 5 bank accounts (or 4 more if you have one already). The idea is that you physically separate out the amount of money dedicated to each account based on percentages that will be pre-determined by the business owner. Now, each type of business is going to have different needs, and each business owner is going to need to assess how much money they can allocate to operating expenses and profit. However, Michalowicz has given some example target percentages based on revenue in Chapter 4 (page 68 in my version). For example, a business making under $250k would have target allocation percentages of:
Profit = 5%
Owners Comp = 50%
Tax = 15%
Operating Expenses (aka OPEX) = 30%
Use these percentages to allocate money into each of the bank accounts that were set up above. So if you have a $1,000 payment come in, the idea is that you allocate $50 to profit, $500 to Owners Comp, $150 to taxes, and $300 to operating expenses. Now, it is likely that you aren’t quite ready to run this lean yet (30% OPEX), but it’s good to have some goals. We’ll look also at where your business is currently using the Profit First method:
Perform an Instant Assessment
The author has business owners do an “Instant Assessment” using their current financial numbers to determine what the difference is between their actual expense/profit and what expense/profit COULD be if they use this Profit First method. I transcribed the information from the Instant Assessment into a Google Sheet here for you. The sheet has the formulas preset, so all you have to do is provide your actual numbers.
Once the “Actual” column is filled, the “Target $” column will populate the calculation of the actual Real Revenue * Target Allocations. Then “the Bleed” column will take the difference between the actual Profit, Owners Pay, Taxes, and Opex numbers and the Target $ for each. “The Fix” column will tell you if each line item needs to increase or decrease to hit your target allocation percentages.
The most common occurrence with this assessments is that Operating Expenses are too high. But what did you find? Maybe you are paying yourself too much? What does “The Fix” column tell you?
Cutting Operating Expenses
If the Assessment revealed that you need to cut costs, no worries. We have some strategies for that. The book goes into details about trimming costs by looking at the Profit and Loss statement line by line and marking each expense as:
- Necessary, but need to consider lower cost alternatives (e.g. replace traditional phone system with cheaper VOIP system)
- Necessary for producing income (e.g. postage to send packages to customers)
- Unnecessary expense altogether (e.g. office lunches, software subscriptions not in use)
This is where an outside perspective can be extremely helpful. Most business owners will see all of their costs as necessary since they are so used to having those items or services. This is something that ClaraCFO Group can absolutely help you with. A quick coaching call would easily pay for itself by helping you identify areas that could be cut or reduced.
What if there is Debt?
While reading this book, I was constantly thinking, “Yeah, that’s a great idea, but what if the company is in debt!?” Thankfully, Michalowicz addresses debt. He shares a similar opinion to mine that we want to avoid debt at all costs in our business. Therefore, if you currently have debt, the first thing to do is STOP adding to your debt immediately. Remember, we are learning to operate well within our means. In order to pay off your existing debt, you will use 99% of your “Profit” account additions to pay towards your debt. He still wants you to take 1% and use it towards something nice, like a chocolate bar J. This is just to remind you that the profit account will be there for fun things eventually. You will have money in your profit account because you allocated the predetermined percentage (e.g. 5%) into your profit account when you received customer payments.
Summing things up
Overall, I do like the idea of the Profit First system. I am implementing the system in my own business to try it out in practice myself. Michalowicz has many examples in the book of successful business owners who have had great results with this program. Will it work for you? I think it will! IF you do it. This can’t be something you do half-way. It’s all or nothing.
Buy or Borrow
If you are like me, you don’t love buying books that you read once and then never open again. I like to use the library for my first read. If I think it’s great and has information that I want to reference later, I’ll buy the book. I borrowed Profit First from the library, and I recommend others borrowing as well. If you like it and want to reference further, buy it!
Want help implementing a profit optimizing plan?
Are you ready to gain control and clarity in your business finances? Ready to take the next step to maximize profits and make confident financial decisions? We’d love to talk with you about your financial needs and help you make a path to your goals. Let’s talk.
Disclosure: Some of the links on this page are Amazon affiliate links, meaning that as an Amazon Associate I earn from qualifying purchases at no additional cost to you.
Disclaimer: This blog and the linked videos are intended for educational purposes and should not be taken as legal or tax advice. You should consult with your financial professionals about your unique financial situation before acting on anything discussed in these videos. Clara CFO Group, LLC is providing educational content to help small business owners become more aware of certain issues and topics, but we cannot give blanket advice to a broad audience.