If you’ve been following the blog for any length of time you will know by now that I’m a huge fan of Mike Michalowicz’s Profit First approach to business finance. If you haven’t already read the book, I highly recommend it (you can get a copy here). I also highly recommend implementing the Profit First method in your business as early in its development as possible – ideally, right from the start, but if you have an established business it’s never too late to start!
Here’s the thing, there aren’t many books out there on accounting and finance. The ones that do exist generally fall into two camps: the highly specific ones designed for accountants and finance experts like myself (or people training as professionals), and the basic introductions/guides designed for people who have no professional experience in finance but need to make financial decisions.
Some are designed for managing personal finance, but a lot are geared towards business.
And the majority of finance books are unbelievably disappointing.
I say this not only from my own perspective as a professional, but from experience speaking to numerous clients, business owners, and entrepreneurs who come to me frustrated by their inability to get a handle on their finances.
They’ve read the books, and they’re not helping.
While reasons vary, the majority of people seem to have some variation of the same core complaint: these books don’t provide an actionable plan that will produce tangible, immediate results, and the bottom line is that they always end up with a disappointing bottom line.
In other words, even if these guides succeed in explaining finance concepts and methods in an accessible way people can understand, the information doesn’t give them a practical way of increasing their profits.
Enter Profit First, the accessible, practical, actionable blueprint for creating and steadily increasing your profits.
A Beginner’s Guide To Profit First
Essentially, Profit First is a book about cash management, but in reality it’s so much more than that. The perfect accounting hack for busy entrepreneurs who are time-poor and overwhelmed, this is a system that is rooted in human nature and psychology , easy to understand, and perfect for business owners.
Sound too good to be true? Trust me, it’s real!
Here’s everything you need to know about Profit First to become a hugely successful entrepreneur, and build a strong, profitable business…
The Profit First Principle
The core principle behind Profit First is flipping the traditional view of accounting and cashflow on its head by changing the equation used to calculate profits and literally placing profit first, ahead of expenses. The traditional method of calculating profit, as we all know it, is:
Mike Michalowicz’s innovative Profit First approach is to reverse this equation, encouraging entrepreneurs to prioritise the level of profit they want to achieve and find a way to manage with the level of expenses they have left to work with. More importantly it is changing your mindset around profit:
When profit comes at the end of the equation we are making do with what’s left over. There’s a little theory called Parkinson’s law which tells us that work always expands to fill however much time we have available to complete it.
If there are 6 months available to complete a project, we will spend 6 months working on it. Give us only 1 month, however, and we’ll get exactly the same amount of work done in ⅙ of the time.
Often, taking less time over something actually improves the results, because we are more focussed and motivated. More than that we surprise ourselves when given a finite amount of time to do things, because we defy our expectations of failure and still get them done.
We achieve the seemingly impossible.
Profits and expenses work under the same principle. When profit is at the end of the equation all the money we have coming in is up for grabs. The ‘time’ factor in Parkinson’s law is replaced by the money factor – if we have X amount of money available to us our expenses will increase, gobbling up all that money.
If we have less money available to spend, we will find a way to do the same thing for less.
The problem with viewing profit last is that your expenses are free to expand into that space.
Flip it around, and the amount of money available for expenses is suddenly reduced. It’s finite. The amount we want to earn in profit simply isn’t available and we get the job done with what’s left over.
And it’s not a magic trick. It’s not going to come at the expense of the quality of our services or the products we produce. Rather, is forces us to stick to what is actually available – this much money, no more. We hustle a little harder, think a little deeper, and come up with innovative and creative new ways to do things, or create new methods that don’t require as much capital to be spent on expenses.
We surprise ourselves.
We do that which we perceived to be impossible.
The Link Between Profit And Psychology
There are huge psychological benefits to this simple reframing technique, and it’s easy to see why – especially if you’re not a finance professional.
I’m the first to admit that accountants and bookkeepers are…different in their thinking to the majority of other people (save perhaps some types of scientists) because they think in numbers.
Numbers come naturally to us, and that simply isn’t the case for most people.
There’s a theory of thought that says everyone either thinks in words or images. Neither is better or worse than the other, it’s simply a different way of forming thoughts. Those who think in images are better at visualising things and doing tasks that require pictures, like reading sheet music, while the word-thinkers sometimes struggle with this but are better at other things. A lot of people have a mixture of words and images, and just a few think in totally abstract concepts.
Equations and calculations of any kind can be really tough for people to grasp because it requires them to literally change the way they think.
This is why so many entrepreneurs who are incredibly capable, creative, intelligent and hands-on in their business really struggle with their accounts: they think in words, or pictures, not numbers.
Having profit at the end of the equation is, for most people, a clear indication that it is the end result of your efforts. It’s a visual cue and a matter of word-order, making it difficult for non-number-thinking people (who are, by the way, in the majority!) to make it a priority because it comes last.
It’s what’s left over after you’ve done everything else.
We naturally focus on things that come first, and when profit is at the end of the equation we seek to increase it by increasing the front. So for a lot of people, the only conceivable way to increase your profits is to increase your revenue.
Reducing expenditure is something that simply doesn’t occur to many people. And if it does, it’s swiftly followed by thoughts of:
‘I can’t, all these expenses are absolutely essential.’
Or, ‘But I have plenty to cover all these expenses, with money left over – I don’t need to reduce them!’
Both of these are understandable perspectives, but they make it very difficult to increase your profits and, most crucially, ensure your business is profitable right from the start.
This is where Profit First comes in, because the simple reframing used to place profits before expenses means that expenses are the end result.
The thing that’s left over after everything else is done.
It’s so simple, but it’s an incredibly powerful shift in mindset.
The Benefits Of The Profit First Method
Although this simple shift in mindset is, in itself, a huge benefit to the Profit First system, it is by no means the only one. Profit First expands far beyond a model for managing your business cash, and becomes a tool that can be used for actively promoting the growth of your business as a whole.
It can even be applied to your personal finances, truly helping you to create the life and business you have always dreamed of – balanced, abundant, and stress-free.
This is the next huge benefit of using Profit First – it doesn’t require agonising over financial decisions. Once you set the system up for your business, it pretty much runs itself. The key is to ensure that you have it set up to suit your business, as every business is different. You need only check in occasionally and recalculate to make sure you’re still using the optimum percentages for your current financial situation.
A situation that, if you’re using Profit First correctly, will constantly be improving.
And that’s the true and greatest benefit: the ability to create real tangible improvements in your finances – both personally and professionally – on an ongoing, scalable and sustainable basis.
This is something a lot of entrepreneurs really struggle with, not just growth, but sustainable growth, and it is once again because they’re placing profit at the end of the equation, rather than putting it first – they prioritise growth over profit.
It can work in the short-term, but in the long run the growth you create is often unsustainable, and achieved at the expense of your profit margin.
The Problem With Growth Before Profit
Growth is a big buzzword in the business community, and for good reason. We’re all looking to grow our businesses, expand, and find ways of improving their success and profitability.
But it’s easier said than done, right?
Here’s a common problem a lot of businesses face: they devote years of effort to consistently increasingly sales. Year on year, their numbers go up, and they continually invest in new technology, methods, staff, and other things that seem vital to their continued efforts at growth.
They have a goal in mind. Maybe it’s $1 million, maybe $10 million, maybe even $100 million, but somewhere there’s a magic number.
If they can reach that number, they’ll have ‘made it’.
They’ll be successful.
And even when the number feels ludicrously high, it’s often very achievable. Just keep pushing those numbers up year after year, and eventually your revenue will hit the magic number.
The question so many businesses fail to ask is, ‘What’s it going to cost to get there?’
And beyond that, ‘What will we have to show for it when we finally ‘arrive’?’
A friend of mine recently shared that their business hit £100 million in turnover in 2017 (that’s about $182 million).
Pretty impressive, right?
Would you believe me if I told you that, in the same conversation, we were talking about his efforts to secure investors, and that without the investment he needed the business would be finished in 6 months?
They were in mountains of debt and had no way to cover their running costs.
It sounds impossible and yet it was happening. Despite a huge amount of very fast growth in this business, which is only a few years old, and an enormous amount of money coming through the business every year, there were zero profits.
In fact, at the time we were speaking, they were running at a loss!
$182 million dollars a year and all of it was going through the business, but never staying in the business.
I asked what he planned to do with the funding he was trying to secure, and how he was going to turn it around, and was astonished to find the grand plan involved spending all that invested capital on further growth.
“If we can just get to here,” he told me, “it will all turn around.”
It had never occurred to him that this would only perpetuate the problem, not solve it.
While this is an extreme example, it’s a common problem. Businesses invest so much in growth that they have little or even zero profits to show for it, and while business is booming and turnover is skyrocketing, profits never grow at all.
Growth is put before profit, in the belief that it will lead to profit, but what actually happens is you sacrifice profit for the sake of growth.
If this goes on, you can end up in serious trouble, and so can your business, because that growth is unsustainable.
The Benefit Of Growth Through Profit
Flipping your perspective on growth so that you place profit first, and growth second seems counterintuitive – how can you profit if you don’t grow? But actually it’s a very growth-friendly model: profit leads to growth.
When you are creating real profit in your business, you’re in a position to invest in true growth opportunities when they occur. And you’re able to do it without putting your current business and the success you have achieved in it at risk.
Six months down the line if it proves to be less than profitable, your existing profit margin (before you expanded) will still be there. You may have failed to increase it, but you certainly won’t have decreased it.
It’s natural to want to put all your profits back into your business, thinking you’re planting the seeds for growth. What you’re actually doing is sowing a future disaster.
You can still hit your magic number, and you can still grow, but with the Profit First system you have a profit ‘buffer’ that protects your business and ensures that every stage of growth is sustainable.
Whenever your business expands it does so in the strongest way possible.
How To Use The Profit First System
Now we’ve covered exactly why using Profit First is such a good idea, let’s get down to the system itself, and how you can put it into practice in your business.
The concept is actually very simple, though at first glance it can seem complicated.
Rather than taking the bottom line as profit – the leftovers – you take a small percentage of the top line. Whenever money comes in, the percentage you have calculated is immediately taken away and reallocated so it can’t be spent on expenses.
Some of it you give to yourself, as wages or dividends, and the rest goes into an untouchable savings account – a ‘rainy day’ fund.
Profit First is as simple as setting up a few bank transfers, but there’s quite a bit of thought that goes into exactly how much those amounts will be for, and how you will effectively manage your business now that expenses have to come out of the bottom line.
Even if you’re comfortable with numbers implementing this system presents some challenges. The most important thing to remember as you work through these steps is that Profit First is more of a mindset shift and change in habits than it is a technical accounting system. The greatest challenge you’re going to face is not with the numbers, but with yourself and getting used to changing life-long habits. But if you have a true desire for change it’s entirely achievable. To help you out I’ve put together a step-by-step guide…
Step 1: Rethink What You Really Need
Here’s the thing about expenses – they all seem perfectly reasonable. There are also obvious ways of saving money, like downsizing from an expensive office space to a more affordable one. And when we do things like this to reduce our expenses, what expenses remain seem even more reasonable.
The thing is, this is based on your perceptions of what constitutes ‘reasonable’, rather than what your business is telling you is genuinely a reasonable amount to spend. Now, I know what you’re thinking, “Erm, Laura, businesses don’t talk!”
But they do.
They really do.
Your profits are literally screaming at you, loads of really valuable insights into your business, and you’re simply ignoring them.
When you don’t have a reasonable level of profitability in your business, that is your business shrieking at you, “You’re spending too much money!”
It doesn’t matter how much you’re spending, if your profits aren’t where you want them to be, your expenses are not ‘reasonable’ they’re too high, and you need to find a way to reduce them.
So before you do anything else, rethink what you really, genuinely need to spend money on.
Step 2: Put Your Profit First
When you’re allocating money before you even get to your expenses and how much you’ll spend on what, allocate your profit margin first. When you’ve done that, allocate your taxes.
The part most people find difficult is figuring out how much profit they actually want!
This is a question addressed by Mike in the Profit First book, who says the following:
“Of all these businesses in all different fields, I discovered that a healthy million-dollar business will be taking a profit of about 15%. Now, that’s above and beyond the owners being paid $200,000. Then, $150,000 is reserved for corporate tax responsibilities and personal tax responsibilities of the owner.”
If we follow this model you should be allocating around 15% of your revenue to profits, 35% to tax, and the remaining 50% is what is left for your operating budget, including payroll, overheads and any other expenses.
And you don’t need to have a million-dollar business for these numbers to apply. You can apply the same model to any business, of any size, and the principle remains the same. Based on these numbers, Mike developed the Profit First Instant Assessment, which you can take now for free to help you calculate how much your profit margin should be, and how much you have for expenses.
Run through the assessment and use it to calculate your Target Allocation Percentages (TAP).
Step 3: Take Baby Steps
Let’s say for the sake of argument that your profit margin is 15%. If you jump right in an immediately start setting aside 15% of your revenue using this method, you’re going to short-circuit your brain and it’s not going to work.
As I said at the start, this really is a mindset shift, and you are going to want to ease into it.
Jump right up to the full level of profit you’re aiming for, and you’re going to find it next to impossible to cut down your expenses quickly enough to meet it. You run the risk of ‘borrowing’ money from your profits to cover the shortfall, which seems perfectly reasonable, but it’s actually stealing from yourself.
It completely defeats the purpose of the whole system.
So give yourself time to reduce your expenses, allowing you to take – and keep – the amount you set aside in Profit. If this means starting at 1% rather than 15% so be it.
Get in the habit of setting aside that 1% and leaving it alone, without borrowing from it for expenses. Get in the habit of managing with a little less, and spending a little less.
Once you’re used to it, bump it up to 2% and again, take time getting used to the habit.
Keep increasing it in increments and you’ll find it a lot easier to adapt to the change.
Baby steps win the race!
Step 4: Be Brilliant At One Thing
I few weeks ago I was blogging about the power of niche marketing, and the week after that I was discussing the problems with upper limits and the importance of your ‘zone of genius’. Both of these concepts are key to really mastering the Profit First mentality, so if you haven’t already had a read of those take a quick look and come back.
If there’s one area that’s going to trip you up in this plan it is the ‘upsell’ mentality. It goes hand-in-hand with the growth mentality, and the notion that entrepreneurs should be constantly pushing for growth. The theory is simple: sell your clients something, then upsell them on something BIGGER.
Keep on upselling so that you’re constantly pushing bigger, better, and more expensive things.
There is some logic in this, at least from the perspective of increasing your revenue. Repeat business is the key to creating a high client lifetime value in your business, after all, but there’s a huge difference between a client who buys from you repeatedly, and a client you are constantly upselling on something new.
Upsells have their place, but don’t get carried away.
Constantly upselling can actually kill your profit.
When you’re always offering new things it requires you to create new content, buy new tools and materials, learn new things. But more than that it takes you outside your core skill set – your zone of genius – and leaves you doing tasks that you might be capable of, but you’re not particularly spectacular at.
And that’s okay – nobody’s good at everything!
On the surface it appears that upsells are great for your profit because they increase your top line. But because of the practicalities and limitations that come with all these new things, you’re unlikely to make any extra profit, and may even eat into the profit you would have had if you’d stuck to the first thing and nothing else.
This is where you zone of genius comes in. Instead of diversifying, get spectacularly good at one very specific thing.
That’s your niche.
Stay in it.
Your niche, your zone of genius, is where you can create the most profit.
Step 5: Create Your Profit First Bank Accounts
Once you’ve got all that sorted out it’s time to set up the (slightly) technical bit. Create some extra bank accounts to act as small ‘buckets’ for different functions. This is a lot easier if your bank has great online services so you can simply do it via online banking. If not, just pop into your local brand and speak to someone who can help you open any additional accounts needed (this shouldn’t cost you any money!).
There are certain accounts with specific functions that you will want to set up, though you may find you want to use additional ones as well:
- Profit – Savings Account
- Tax – Savings Account
- Owner’s Pay – Savings Account
- Revenue – Transaction Account
- Operating – Transaction Account
Make sure that all your incoming money from invoices and any other sales and sources is deposited in your Revenue Account.
It’s a very good idea to have a reliable and efficient accounting tool that will help you to automate everything and keep on top of things. If you don’t have one, or don’t like the thought of trying to manage your accounts yourself, investing in a great bookkeeper to help you is a fabulous alternative. It may be a on-time job to get you setup, or you can hire someone on an ongoing basis.
Step 6: Transfer Your Money
Exactly how you do this part will vary slightly. If there are certain payments you have coming in on a regular basis from subscriptions, standing orders, direct debits, or other regular payment methods, you can set up bank transfers that automatically transfer the correct percentage of your deposited funds into the right account.
If your income isn’t that regular, or you have some income that is irregular, you can manually calculate and transfer the amounts. It’s a good idea to do this every two weeks, by calculating the amount of deposited funds since the last time your allocated your percentages, and transferring the relevant amount to the right account.
The most important thing at this point is to discipline yourself so that you don’t take money from the wrong account. This is absolutely crucial. Take another look at the accounts we set up in the last step:
- Your profit account is where you will accumulate profit – don’t touch this money, leave it exactly where it is.
- Your tax account contains money set aside for GST and tax purposes. Again, don’t touch this (unless it’s to pay your GST or tax bill!).
- Your owner’s pay account is money used to pay your own wages or drawings (this you can touch, but only for personal use, not to cover business expenses!). You can use an existing personal account for this.
- Your operating account should be used to pay your day-to-day expenses and running costs.
- Your revenue account in the where all your incoming money is deposited. No spending from this account!
Getting the Profit First system setup can take a little time and patience, and don’t be surprised if it takes you awhile to get used to it.
Starting any new habit is tough, and money habits are particularly tricky. Persevere, it’s well worth it!
If you’re totally sold on this idea and want to implement it in your business but you’re still not sure where to start, or simply don’t have the time to figure it all out, head over to Profit First Australia to find a Profit First Professional near you.
Profit First can benefit the growth of your business from DAY ONE!
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