I have always loved reading business books because of the vast knowledge and techniques they teach to entrepreneurs and new small business owners like myself. Whenever I finish reading these books, I post reviews of them so that other people can get an idea of what they are about.
The book I am reviewing today is “Profit First” by Mike Michalowicz
I first learned about this book after listening to an episode of my favorite podcast “Entreleadership.” The author, Mike Michalowicz, discussed how a small business owner could transform their company from a “cash-eating monster” into a lucrative and profitable business. That was what compelled me to buy his book “Profit First.”
What is the book “Profit First” about?
Mike Michalowicz’s “Profit First” is based on his own life experiences as a business owner and the mistakes he made along the way. He does a great job of pointing out how he learned from his previous mistakes in the business world and hopes others don’t make the same mistakes he did.
Mike had a reputation for creating and selling new businesses quickly. That might seem unusual because most of us were taught to start a business and then build it until it grows to be successful. But Mike had a different idea and expressed in his book how he didn’t make much money while growing his business. Even when his business was massive, he still had large tax bills and no money to pay them. After all, growing a business means more expense, but it doesn’t necessarily mean more profit.
One of Mike’s best points in his book was about entrepreneurs. He said that entrepreneurs were great at coming up with creative ideas and taking action to make them a reality. But unfortunately, entrepreneurs don’t usually consider the money and financial side of starting and running a business. Instead, they want to jump into the business with little financial planning.
Entrepreneurs might look at their bank account balance and assume they can use that money to purchase anything for the business, such as new equipment or software. But when an entrepreneur has a professional accountant to advise them, they will learn very quickly that those bank account funds need to be used for other business expenses, such as lease payments, payroll, loan repayments, etc. When business owners spend money on new purchases without consulting their accountants, it makes the accountants extremely frustrated.
As a result, the loan repayments get delayed, or the business owner has to borrow more money to pay their existing debt obligations. Either scenario is never a good thing and only costs the business owner more interest and debt. So don’t let yourself fall into this trap.
Financial Documents
Accountants use various financial documents to help the business owner make better financial decisions for the company. One common financial report prepared for the business owner is the Income Statement, also known as the Profit and Loss Statement.
An Income Statement shows the profit available after the total company expenses are subtracted from the total company revenue.
Revenue – Expenses = Profit
This is the standard formula used on Income Statements. However, the formula assumes you have complete control over the revenue and expenses of your company but no control over the profit amount. But according to Mike Michalowicz’s “Profit First” model, you can reinvent this calculation by controlling the revenue and profit amounts rather than the expense amounts.
Here is the Profit First model’s formula:
Revenue – Profit = Expenses
For instance, let’s say your business earns $500k in revenue, and you want 50% profit out of that amount. Here is how that would be calculated with the Profit First model:
$500,000 (revenue) – $250,000 (profit) = $250,000 (expenses).
The $250,000 in expenses is what you can expect to pay to sustain the operation of your company for one year. That is the amount you would budget to run your business and achieve the $500,000 in revenue you’ve already calculated for the company. In other words, it is a projection business model where the $500,000 is your revenue goal, and the $250,000 profit is what you want to take out of it.
Therefore, no historical calculations are made with the Profit First model formula because it is focused more on planning for your company’s future.
Focus on Profit More Than Revenue
Profit First stresses the importance of focusing on profit more than revenue. Small business owners tend to do the opposite by focusing too much on revenue and growing their companies. But if you make revenue the most important part of your business model, it could put you in a terrible financial situation like it does for many entrepreneurs.
There are actually companies worth millions of dollars that don’t turn a profit. Can you believe that? The reason is that business owners have always been taught to spend money in order to make money. But that way of thinking may cause you to spend too much money without producing any income in return. That is why Mike Michalowicz tells business owners to stop focusing on revenue and start setting profit goals.
You can only reach your profit goals if you know your expenses, which is why the Profit First formula calculates the expenses rather than the profit.
Think Outside the Box
You can meet your profit goals with good expense management and increasing revenue. However, it will require you to budget your money and put more restrictions on your spending. Of course, many business owners view the word “budget” negatively because they feel budgeting prevents them from achieving their business objectives.
The truth is that budgeting is the way to achieve your business objectives. You just have to get more creative in how you spend money for your business. You can relate this concept to your own personal spending and budgeting too.
For instance, if you spend too much money on restaurants, fancy clothes, and other unnecessary expenses, you won’t have enough money to pay your rent and utilities. Then your whole lifestyle disappears because you cannot even afford a roof over your head.
Running a business is pretty much the same thing. You need to budget your company money to keep your business growing and operating. Avoid spending it on unnecessary things, such as employee gift cards, holiday decorations for the workplace, new office furniture, etc.
Let’s say you want to host a Christmas Party at the workplace. Rather than spending hundreds or thousands of dollars on fancy decorations and food caterers, you could allow each employee to bring in one food dish to be shared with the rest. Then you wouldn’t have to spend any money on food caterers. As for decorations, you can purchase cheaper decorations for less than $50 by going to a dollar store.
This is an example of creative budgeting and spending. Find a way to make each dollar work for the company’s benefit and avoid overspending on things that don’t benefit the company. This will be the most challenging when your business expands because your spending will expand along with it. But if you can find ways to perform business activities cost-effectively without spending too much extra money, you’ll start to see the profits roll in quickly. Just stick to your budget.
How to Apply the “Profit First” Model
Now you should have a better understanding of Mike Michalowicz’s “Profit First” business model. The next step is applying his business theories to your organization.
Mike Michalowicz doesn’t want entrepreneurs to put all their money in one bank account because that is how money gets misspent. For this reason, he wants business owners to create at least five separate commercial bank accounts. Each bank account is categorized based on how the funds will be used.
The five categories are as follows:
- Profit Account
- Income Account
- Tax Account
- Owners Compensation
- Operating Expense
If you already have a commercial bank account, you can open four more accounts rather than five. Then you can allocate your company’s money to the various bank accounts based on how it will get spent. Michalowicz suggests assigning specific percentages of your company’s revenue to the bank accounts. The business owner can come up with their own allocation percentages, but they should follow a similar allocation size as described in Michalowicz’s example below:
Profit = 5%
Tax = 15%
Owner’s Compensation = 50%
Operating Expenses = 30%
Each payment your company receives should be allocated using percentages like these. For instance, if your company gets a $2,000 payment, then you would put $100 of it in your “Profit” bank account, $300 in your “Tax” bank account, $1,000 in your “Owner’s Compensation” bank account, and $600 in your “Operating Expenses” bank account.
Make sense? Of course, you can adjust these percentages based on your company’s current performance.
Conduct an Instant Assessment
Mike Michalowicz wants entrepreneurs and business owners to use their existing financial data to conduct an “Instant Assessment.” The purpose of an Instant Assessment is to study the difference in the actual expense and profit of the company and the potential expense and profit from using Michalowicz’s Profit First business model.
Click here to see an example of an Instant Assessment
Follow the steps on the PDF to understand how to make the calculations.
Figure 2 has six columns and six rows. The first row will feature the title of the last five columns: Actual, Target Allocations, Target $, The Bleed, and The Fix. The first column will feature the titles of the rows: Real Revenue, Profit/Reserves, Owners Pay, Taxes, and Opex (Expenses).
Fill the spaces in the “Actual” column to see calculations populate the Target $ column by multiplying Real Revenue by Target Allocations. The difference between the Owners Pay, Actual Profit, Expenses, Taxes, and Target $ will appear in The Bleed column. As for the Fix column, it will tell you whether each item must decrease or increase to reach the target allocation percentages.
How to Reduce Operating Expenses
Business owners usually discover they have too many operating expenses after conducting the Instant Assessment. Fortunately, Michalowicz’s book reveals strategies for reducing operating expenses, such as reviewing every line of the company’s Income Statement and putting a mark next to each expense.
The marks could represent one of the following three things:
- A necessary expense, but look for cheaper alternatives. (e.g., open-source software)
- A necessary expense to generate more income (e.g., box supplies, postage, etc.)
- An unnecessary expense with no useful purpose for the company (e.g., magazine subscriptions, office cafeteria, etc.)
It can be difficult for business owners to judge which company expenses are necessary and unnecessary because they are accustomed to having certain services and conveniences available. But you must overcome your need for comfort and determine which expenses your company can forfeit without affecting productivity or profit.
How to Handle Debt
What about a company in debt? I kept thinking about debt while reading Michalowicz’s book because most companies generate substantial debt. It turns out that Michalowicz and I both agree that companies should avoid accumulating too much debt. So do whatever you can to avoid adding more debt to your company’s operations.
Meanwhile, use 99% of the new money added to the “Profit” bank account to pay down your company’s debts. Michalowicz still wants you to keep 1% of the money and purchase something nice for yourself, such as a movie ticket. After all, a business owner should spend money on small luxuries like ice cream, food, or whatever the 1% allows them to afford.
The Profit account was initially set up with a 5% target allocation, so it should have money in there already from customer payments. You don’t need to eat into those profits, but take 99% of future customer payments to pay down your debts.
Conclusion
Mike Michalowicz’s “Profit First” system is original and effective for small businesses. I am currently applying this system to my company’s allocation of funds. I already have five different commercial bank accounts ready to go.
If you read Michalowicz’s book, you’ll read several stories of other entrepreneurs becoming successful through his system. Perhaps the same thing can happen to you and your small business too. So just add the “Profit First” book to your educational library and see how well it can inspire you to change the profit growth of your small business for the better.