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Develop Your Business With Profits in Mind

We want to dive into how to make your business profitable, by talking with author Mike Michalowicz. Mike wrote the book on how to achieve success in the industry by focusing on profits first.

The Profit First Ideas

The original concept for writing this book was to fix my own challenges. I became aware that I wasn’t the only one going through financial challenges.

We want to talk a little bit about how you came up with this profit first system and why. Then, a little bit about the nuts and bolts.

Quite a few accountants and bookkeepers read the book and think it’s anti-accounting. However, there are those that see this as an umbrella over accounting. It’s necessary for many entrepreneurs.

My accountant would tell me to never look at my bank account.

“It’s not a representation of where your business stands. What’s representative of it is your income statement, your balance sheet, your cash flow statements, KPI’s, budgets, etc.”

All of that stuff would fly over my head. And still does. I can barely read an income statement and am mostly faking my way through it.

What I would do is revert to is what I call bank balance accounting. I would log into my bank account, see what money is available, and react in a couple different ways.

If there was a lot of money I’d go, “Oh, I can spend it!”

If there’s no money I’d say, “Oh, damn.” And panic would ensue and I’d sell anything to anybody.

It was a very reactionary cash management system. But it was my ultimate shortcut.

What I came to realize is that it’s a very poor cash management system. But I also realized I had to do something more effective, but couldn’t find a way to actually do it.

I think this is typical for many entrepreneurs. We are really good at being promoters for our business and operators.

When it comes to the numbers we think we’re really bad. So we revert to this ultimate shortcut.

I think to change our behavior, even if we know there’s a way that will serve us better, is really hard.

I developed this system so that I don’t need to change anything. In fact, I continue to do what I’ve always done:

I log into my bank account daily. However, by using the Profit First system, I start channeling my natural behavior to bring the results I want.

That’s the key. Don’t try to change yourself, change the system that can channel your existing behavior to get the results you want.

The essence of Profit First is this: Historically, most businesses have one maybe two bank accounts. They have one primary checking account that all their deposits go into and all the bills get paid out of it.

The problem that happens is when we’re looking at that account, when money comes in we say, “Wow, I got a lot of money. We can spend it.”

When there’s no money there it invokes this panic.

The reason is one account acts as a serving tray. When you’re serving a family meal you don’t bring out the serving tray, tell everyone to grab their knife and fork and go at it. What you do is serve a portion to everyone’s plate to make sure everyone at the table has something to eat.

The serving tray is simply a serving platform. But you don’t eat directly from the serving tray.

That’s the essence of Profit First. We’re going to set up multiple bank accounts. One account is going to be your serving tray, where the money comes in but you never pay a bill from there ever again.

Then we’re going to portion money to different accounts that serve different purposes. One of them serves profit, another one makes sure that the owner or owners are being paid. Another is for ensuring tax liabilities are addressed. Another is for operating expenses.

Then you know prior to utilizing your money, what the intended purpose is. You see how much money is allocated to profit. You see how much is allocated to pay yourself. You see how much money is available to truly run your business.

The final part I want to share is the reason I called the book “Profit First”. One of the foundation flaws in accounting is we’re told profit comes last.

It’s a logical argument because it makes sense mathematically. You have to have income, you have to subtract the expenses you incur, what’s left is profit.

You Can’t Change Human Behavior

The problem is from a behavioral standpoint. When something comes last, behaviorally it means it’s insignificant.

If you were rushed to the hospital and they said you have to change your diet. You have to start exercising because otherwise, you’re going to die, you’re not going to put your health last. You’re going to put your health first.

It’s human nature that whatever comes first gets addressed. What comes last gets delayed or even ignored.

We’ve been trained that profit comes last. We call it the bottom line. We call it the year-end. Which means it can wait until later.

The fundamental shift in the psychology around profit is there’s a new formula: Sales, minus profit, equals expenses.

Every time there is a transaction we take our profit first. Then run the business off the remainder. Mathematically we’re swapping variables, but effectively it’s the same.

From a behavioral standpoint now profit is the priority and we force it to happen. Therefore assuring profitability in our business.

What typically happens with our customers, when we look at it as a whole, is that many small business owners run their business mixed into their household budget. Our customers use their personal credit card and they also use their business card.

They’re not managing the profit, the payroll, the utilities, etc. well enough. They’re not thinking about it until it’s time to buy supplies for a big order. Then they look at their money and go “Oh crap. I need to use these three credit cards in order to get this deal out.”

Then their personal debt goes up. Once they get the check from the customer they pay their car payment or other bills. There’s this big mix.

In the end, just like Mike mentioned, they’re left looking for the profit. Because it’s mixed, it then disappears.

Running your business and personal finances becomes merely survival.

We’ve read your story Mike and you went through that a few times.

Yeah, and hopefully have eradicated that from my life. I think that is a very normal, common entrepreneurial phenomenon.

I call it entrepreneurial poverty. It is this outward perception of the world around us that thinks we’re wildly successful.

I suspect the day you start your t-shirt printing business all your friends are going to think, “Holy cow you’re an entrepreneur. You must be making so much money.”

Top Line vs Bottom Line

They hear about the top line sales. You get a sale for $5,000 or even $10,000 and they think “Wow, you’re making $10,000!”

When the reality is we’re spending $12,000 to support that $10,000 sale. Internally we’re struggling. We’re surviving check-by-check.

There are massive swings in volatility of inbound cash and outbound cash. Yet we feel we have to perpetuate this persona of success.

We look wildly successful while inside the stress is unbelievable.

The resolution comes back to this system of profit first. Which isn’t actually a new system. But perhaps a new application of an existing system: the envelope system.

My mom brought that system to our house. She worked at a local factory and she’d cash in her check and divide it up into different envelopes. The food envelope. The mortgage envelope. The community envelope. And so forth.

When she went food shopping she’d grab the food envelope, drive to the store, and open her envelope when she got to the store. That was her budget.

We have to realize that even with volatile income when we have to spend money we still have to work within the confines of the envelope. Which can force innovation?

I also realize there are certain fixed costs. A t-shirt is a t-shirt. If a customer orders 100 t-shirts you can’t say, “Hey, we’re going to deliver 25 are you good with that?”

That’s a fixed variable cost. Meaning it’s a necessary cost. It varies based on the demand of the customer. We need to allocate that as well.

Know Your Foundational Accounts

What I shared earlier is what I call the foundational 5 accounts. Operating expenses, profit, owner’s pay, taxes, income account.

For certain businesses, you need additional accounts. Particularly in this business where you have raw materials (t-shirts) that you need to buy, we would set up an account for that. You can call it Inventory purchases.

What happens is when money comes in, say a $10,000 order, and the cost of the raw materials is $5,000, we allocate that percentage immediately. $5,000 goes to the Inventory account.

Then the remaining $5,000 is truly what your business is making. If you visualize this, you took $10,000 from the customer, but you didn’t really take it for your business.

You took half that money to give to the t-shirt supplier. The customer, in theory, could have given that money directly to the t-shirt company. You’re just managing the transfer of money.

The other $5,000 is what you’re truly being paid to run your business. We have to run the Profit First system off that remaining $5,000. That’s what we allocate out.

That’s how you replenish the accounts to make these purchases and so forth. The problem is when you don’t have a system like this.

People see $10,000 come in, they say, “Ooh, I earned $10,000. How should I spend it?” It’s a haphazard approach.

The goal in the envelope system is to always divide the money up before you do anything else. Those accounts will give you clarity on the intended use of those funds.

One last trick is when you divide the money up and there’s not enough to pay your bills. You’ve taken your profit and you look at your operating expenses and you don’t have enough.

That is your business giving you direct feedback that you have inefficiencies in how you’re running your business.

We’re reverse engineering your profit. When you take your profit first and you’re compensating yourself first, the remainder is what you have to run your business off of.

If you can’t run your business off of it, it’s not that you should cut your profit. It means you’re not running your business to support that profit. We have to fix your business.

We love that because we’ve had at least one business like that. Back in the day credit card companies would send you blank checks in the mail where you could write yourself or others a check. That’s how we ran one of our businesses.

It’s great to have those next big sales coming in. You still have money in the bank account. That looks really rosy, right up until the time you have to close down the business.

The bank account looks really good for a brief period of time. Until you start writing those checks

Don’t Forget About Supplies and Incidentals

When you go to a bank for a loan, they’re going to look at your average bank balance. It’ll look good at first because you’re bringing money into that account. But at the end of the day, you’re not actually making any money.

As an order comes in, you’re going to have to do something about paying taxes. Whether it’s sales taxes or eventually business tax. A piece of that money from the order needs to go there.

You’re going to have to order shirts, ink, and/or embroidery thread. A portion needs to go into those accounts.

If you do all of that math and for some reason, you can’t find any percent into the profit area then you’re playing a risky game with your business. You’re probably going to get stuck and you’re not going to grow.

You’re one disaster away from being out of business.

The one thing I’d like Mike to differentiate for us is between profit and owner compensation.

Profit is a reward to the shareholder, the risk-takers in the business. These are people who’ve invested in the business.

Sometimes it’s cash. Other times it’s sweat equity – raw effort. And usually, it’s a combination.

Look at a publically traded company. For example, I own stock in Ford. Ford does a quarterly stock distribution. What they’re doing is rewarding the shareholders.

I don’t work for Ford. I don’t do anything with Ford, except that I’ve invested in their stock. Ford distributes the profit because they’re rewarding the shareholders.

Here’s what’s also interesting. When I get my distribution check – which is usually like $13 – I don’t look at the check and think, “Ford could really do better if they had the profits reinvested in the company. I’m going to return this money to Ford.

“If all the shareholders did this, Ford could buy a new building. They could do amazing things. Hey guys, let’s give our money back.”

No, what I do as a shareholder is I took on risk. The value of the stock could go up hopefully. This is a reward for me being a risk-taker.

We as small business owners have taken the ultimate risk. It’s the inception of a business. When that profit comes out, it’s a reward for doing what 97% of the world population will never do.

It’s never to be reinvested. This is a reward for taking on massive risk.

Pay Yourself First!

Owner’s comp is what is called the Owner/Operator pay.

As an owner of a small business inevitably, you’re working in the business. You’re an employee of the business. This the reward for the most important employee you have.

You may have other people that work for you, but I suspect as the owner no one works as hard as you. No one is as devoted to the business as you are. No one knows it as well as you. No one else is making sacrifices as you do.

And all the things you do to make this business run. That is the definition of the greatest employee.

The owner’s comp is the compensation for being a phenomenal employee. We have to secure that.

Profit is a reward for being a shareholder. These are two different things.

Owner’s compensation, by the way, is what should support our lifestyle. Just like our employees. They’re taking a salary from us that supports their lifestyle.

Our owner’s comp should support OUR lifestyle.

The profit is a bonus above and beyond. Just like a public company it comes out every quarter. When it comes out, go celebrate with it.

The rule is to never put it back into the business. If the business can’t run off what’s been allocated to its operating expenses, there’s something that needs to be improved in the business.

Inevitably it’s cutting unnecessary costs and there’s usually 10-20% in most business that I’ve analyzed. Usually, what most people miss are huge margin opportunities.

How do you grow your margins? There’s a huge upside there and we need to pursue that.

A lot of the people that go into the custom apparel business their mindset is simply that they want to fire their boss and work for themselves.

They’re just trying to replace the salary they used to make, only they’re not getting any of the side benefits. Nobody’s helping to pay their insurance. Nobody’s filling up the water cooler or paying for the air conditioning.

Really they’re becoming that Pro-preneur that’s spending their time working in their job just to get a paycheck. Profit is the point of being in business.

It’s the extra money after the expenses are paid after you’ve made your salary. Your profit is your reward for starting a business. It’s not the job you do.

You are a brand new entrepreneur, you have a full or part-time job, and you finance a piece of equipment. You’re trying to achieve the “American Dream” per se.

Invest In Equipment with Profit In Mind

You purchase a piece of equipment that you can sell something with a high margin. Then you work on building that business until you get to the point where you can fire your boss. The business can support you.

At what point in time do you start to pay yourself? If my first order is 9 shirts, how do I even do that?

The best time to start was yesterday. And if you missed that then it is now. The key though is to start slowly.

It’s the same as the question “when should I start exercising?” The answer is today. But most of us like to delay it. “If I wait long enough then I’ll be ready.”

If you don’t exercise you build a propensity to not exercise. The key though is when you do start, most people make the mistake of going full board. Then they injure themselves or it’s too painful. It’s actually starting slowly and building muscle that helps.

With Profit First, the goal is to start immediately but to start slowly. Just allocate one percent of your income towards profit.

When that order comes in one percent goes to profit. The 99% can go to running your business as you have or paying off your debt.

I realize in the beginning you have more debt than you do income. However, it’s still important to start that profit muscle. Once you start to see that account filling up you start to see your business from a different perspective.

“What can I do to sustain this profit?” You start to reverse engineer profit.”

The people who wait and put it off, rarely ever get started.

The people who start abruptly and try to do the whole system from day one have the highest failure rates.

The people who start the system but start slowly and persistently grow it over time have the greatest success rate.

This is how I might envision our customers doing it:

You start having realizations as you start going through this process. “The t-shirts that I’m ordering are too expensive for what I’m charging.”

There are only two fixes:

“If I price higher my competition might beat me.” Which is a very bad conversation to have in your head. Thinking the competition is the same.

“How do I dictate a higher price point where the customer’s thrilled to pay the higher price point?”

What happens is our business starts forcing these questions.

In the old scenario, every dollar that came in we used going out the door. We sacrifice ourselves because at least the customer won’t complain.

However, there’ll be a day when you resent your business. “It’s sucking my soul and my cash.”

Profit First forces hard, internal conversations immediately in your business. So you’re running your business more effectively.

Those conversations are going to happen anyway. That’s the day you face bankruptcy or you’re in that moment where if you don’t get a sale you’re not going to be able to cover payroll.

That happens for every business if you don’t start doing the system.

That conversation is coming, we’re just going to force that conversation early so you can position your business to be healthy.

Use Good Financial Tools & Software Too

We’ve used QuickBooks and worked with an accountant. As sales and marketing professionals we know that we bought this for $X and sold it for $Y. We know we made so much money.

We know we made that money, but we can’t find it anywhere. We look in QuickBooks at the end of the month:

I know I made a lot of money. I bought 1,000 shirts for $10 and sold the shirts for $25. But we’re looking in our one bank account and we can’t find any of it.

Going back to QuickBooks, a lot of people say, “Do I really need to do this? It’s a pain in the butt. It’s a lot of reconciliations and moving money around. Plus my bank will charge me fees. Why don’t I just do this in my accounting software or a spreadsheet?”

It’s a fatal flaw. The final nail in the coffin. Your accounting system is already doing this. Your accounting system has a chart of accounts.

It maintains all the different allocations of money – profit, how much you’ve paid yourself, etc.

How’s it serving you? Their reply is “I’m not profitable.” That’s exactly it.

We need to intercept our natural behavior. If our natural behavior is to log into our bank and check what our money situation is, we need a system that is at our bank and allocates the money.

When money is pre-allocated to its purpose you know its intended use.

The sequence of how we do this is actually important. 

1. Profits

If you have that order for t-shirts come in, the first thing you do is allocate the money to Profit.

Even though it’s a percentage based system, there’s a behavioral reason behind this. When we allocate money to a Profit account first you’ll trigger a reward mechanism. “I just took a profit! That’s cool!”

2. Owner's Comp

Then the second thing you do is Owner’s Compensation. Paying yourself, “Hey, that’s cool!”

3. Taxes

The third thing you do is pay taxes. “Hey, that kind of sucks. I hate paying taxes, but at least I’m adhering to the law and am not going to jail.”

4. Operating Expenses

Then the final allocation is to the operating expenses. The expenses of the business. That’s an awareness point.

At that point, when you can’t pay your bills, that’s your business telling you that you’re not in a position to currently afford those bills. We need to fix something.

You can cut cost, but you can only get so far until you cut into the muscle of the business. So cut unnecessary costs. But really look for ways your expanding on the value of what you’re delivering, for it to dictate a premium.

There are so many podcasts and blog posts about what you can do to help fix some of that final problem Mike mentioned. Where you’re not making enough money. It’s about selling better t-shirts, selling to the right people, selling to the niche markets.

Everyone immediately tries to save $4 on a roll of vinyl or a few dollars on thread. Essentially what’s happening is your business is bleeding and you’re attempting to fix a large wound with a few tiny band-aids.

For one, you have to make sure your business is healthy. Then turn around and start doing things to make more money and better money. You’re not trying to shave pennies off the cost of blanks and supplies.

There are a lot of strategies in our series on how to make more money next month. Just being aware that the point of your business is not to drive up the top line. You can’t judge the success of your business on the revenue.

Focus on Revenue, Not Sales

There’s a saying that revenue is vanity, profit is sanity, and cash is king. It’s so true. It’s unbelievable how many people are persuaded by the size of the business.

I now consider revenue as a stress point. If I’m doing a million dollars in revenue, I have a million dollars’ worth of responsibility to other clients. I have to deliver a million dollars of promises. That’s stress.

Profit is the stress-release pill. The more profit brings that balance about.

I am far more impressed by a company that does $100,000 in revenue and is taking home $50,000 in profit. Over a company that does a million dollars in revenue and only takes $50,000 in profit.

I buy t-shirts and other embroidered goods. There was one thing my guy did that I thought was so impressive, and I paid a premium for it.
I was buying shirts for our staff and he asked a question that no one in the past had. “What’s the reason you’re doing this?”
I explained that we’re doing an employee loyalty program to help retain employees.
He had an idea, “Let’s do your shirts, but let’s embroider something internally on the shirt that touches their heart.” That came out as we were talking – the motto of our business is to eradicate entrepreneurial poverty. “Let’s embroider that also on the inside of the shirt. Something that will touch their heart at all times. And is known to them.” I thought that was a genius idea. He wasn’t now making a commodity shirt, he was serving the intended purpose of retaining employees. My employees were thrilled – they had never seen anything like this. I was thrilled because it served my purpose. And he was thrilled because he charged a premium for doing something that no one else proposed to me. What’s so great about that, is these are things we talk about. Ask your customer the purpose – why are they buying the shirts?

Why do they want cheaper shirts? Is it for their business? You may find out it’s for their employees who work outdoors all day. The cheapest t-shirt is not the solution. They’re throwing money away.

When it comes to profitability we need to sort our clients. Not all clients are built the same. I think there are two typical categories.

Commodity shoppers – they see the item they need as a necessity, but readily available anywhere. They represent the majority of customers in any market. They’re looking for the cheapest, most convenient solution.

The minority, but the best customers are the ones who see this service as lifesaving. What I mean by that, I like to use the analogy of doctors. A general practitioner is a commodity.

If my GP says he’s moving his office 50 miles away or a different state, I’m not going to follow him. I’ll go to a local.

But then there are lifesavers like a heart surgeon. If I have heart disease, I want the world’s best and I don’t care if I have to traverse the entire globe to get to the best heart surgeon for my life-saving needs.

Customers see us in one of those two categories. Convenient or is important to their business.

There are consumers, and I’m one of them, that see shirts and the uniform as life serving. It’s critical to represent ourselves in a certain professional format. Therefore I’m willing to pay a premium and I’m willing to navigate the globe, if you will, to find the right solution.

We as vendors need to categorize our customers. What customers we have right now are commodity shoppers. Which ones are the ones that see the true additional value-add that we have?

Those customers are the biggest opportunity we have for more profitability and more growth.

Cater to the ones who see value in you. The ones that don’t see value in you, quite frankly they’re secondary customers. If they’re looking for price, you go up a little bit, and they move one – that’s a commodity shopper.

Let’s focus on value-based customers.

Mikemichalowicz.com is my personal website. And you can get 2-5 chapters of my book for free download.

The other thing is that I used to work for the Wall Street Journal. If you sign up on my website you can get all my articles for free.

What I think will have a massive impact is real simple: start slow and call your bank today. You get rewarded for action, not for idleness.

Set up one account for profit and allocate 1%. If you can run can run your business off $400, you can run your business off $396.

The impact to running your business is inconsequential. The impact of moving profit is massive.

You start to see the small but consistent growing profit account. I believe it’s only a matter of time before you change that 1% to 2, 3, or 5%.

It’s the equivalent of getting a gym membership and just going there to do stretching exercises. That’s how you start and over time you’ll be bench pressing.

It may be months or it may be years, but you’ll be extraordinarily profitable if you start today.

Have a great business!

 

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Develop Your Business With Profits in Mind

We want to dive into how to make your business profitable, by talking with author Mike Michalowicz. Mike wrote the book on how to achieve success in the industry by focusing on profits first.

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