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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.