As we’re getting deeper into reading Profit First by Mike Michalowicz, let’s get deeper into the material. Last week we talked about the basics: why profit is important, and some of the reasons why businesses fall into the Survival Trap and stay unprofitable.
Now, let’s dive into the core principles and first action steps of this strategy of ensuring that your business becomes truly profitable.
But first, a major caveat and expectation setting: you can’t just implement the steps of Profit First and expect to magically be profitable. The steps will help show you what you need to do in order to be profitable. You will probably need to cut expenses. You may need to increase sales. You will need to work smarter. The steps of Profit First can help show you how to do that, and enable you to systematically put aside your profit. But you will need to do work outside of these steps.
What is Profit First:
The author says, “I’m simply asking you to remove the profit first, and operate on less.”
But that’s easier said than done. Taking profit first is not just a mindset change, but rather also a physical systems change. The plan is to put systems in place to make you get used to having less to spend on your business, securing more profit.
Here are the 4 Core Principles of Profit First
- Use Small Plates
- Our needs grow to fit our means. All expenses feel necessary, especially when you’re used to having enough money to pay for them. But when you don’t have that money, you tend to get more creative and can get by with less.
- “When less money is available to run your business, you will find ways to get the same or better results with less. By taking your profit first, you will be forced to think smarter and innovate more.”
- Serve Sequentially
- According to the idea of “Primacy,” what we see or do first sets our expectations. If you pay your expenses first, expenses will be the most important thing. When we think profit first, profit becomes most important. This is done by first setting aside money directly from our income into accounts for profit and each type of expense.
- “Always, always allocate money based upon the percentages to the accounts first. Never, ever, ever pay bills first… And if there isn’t enough money left for expenses? This does not mean you need to pull from the other accounts. What it does mean is that your business is telling you that you can’t afford those expenses and need to get rid of them.”
- Remove Temptation
- If we see money somewhere, we’re very likely to dip into it and fall back into the Survival Trap. Solve that temptation by taking and hiding that money. Make it inconvenient to look at it, and even more difficult to use it.
- “Move your PROFIT account and other ‘tempting’ accounts out of arm’s reach. Make it really hard and painful to get to that money, thereby removing the temptation to “borrow” (i.e., steal) from yourself. Use an accountability mechanism to prevent access, except for the right reason.”
- Enforce a Rhythm
- If the money in your bank accounts are inconsistent, you’ll be inconsistent with your spending. If you’re inconsistent with your spending, it’ll be a lot harder to secure profit. Take control by making transfers and payments twice a month, or automatically.
- “Don’t pay only when there is money piled up in the account. Get into a rhythm of allocating your income, and paying bills twice a month so that you can see how cash accumulates and where the money really goes. This is controlled recurring and frequent cash flow management, not by-the-seat-of-your-pants cash management.”
How to Enact Profit First:
From those Profit First principles, the author lays out the first steps of implementing them in your business. You can also check out the Profit first One-Sheet for a simple instruction guide.
Step 1
If you just want to get a taste of the Profit First process, this is the first step the author recommends you follow in order to make sure you can put aside profit first.
- Open up a separate Profit account.
- Use the same bank you currently use for your business and open a second Checking Account that you’ll use to store away your profit.
- Use the account nickname feature to call this account PROFIT.
- Transfer 1% of your current bank balance into it.
- Each time you get a deposit or income from sales, transfer 1% of it to this account.
- You can set up automatic transfers, or just calculate and transfer it manually.
- Don’t touch this money.
- Michalowicz says, “You have “seeded” the account. Don’t touch it. Never transfer it. Just let it sit for now.”
The author writes, “Your goal for now is to get started immediately and decisively… But something magical will happen. You will start proving the system to yourself… You will have a flavor of how powerful it is to reserve your profit in advance… The goal is for you to realize that this unfamiliar process of taking your profit first isn’t so scary after all. Then once you are digging the Profit First vibe, you are set for greater success. Because you will be staged perfectly to do the rest of the system, and your heart will be in it.”
Step 2
When you’re ready to move onto doing more, and following the basic process of Profit First here are the next steps:
- Follow the process in the Step 1 section above.
- Have a total of 5 Checking Accounts
- The goal is to have a total of 5 Checking Accounts to use as buckets. The five accounts are:
- INCOME
- PROFIT
- OWNER’S COMP (COMPENSATION)
- TAX
- OPEX (OPERATING EXPENSES)
- If you already opened a PROFIT account in step 1, then use that. Rename your existing checking account to OPEX. Open 3 new checking accounts named INCOME, OWNER’S COMP, and TAX.
- Set up these accounts according to how you’ll use them. Your deposits will go directly into your INCOME account, your personal payroll will come out of OWNER’S COMP, pay your taxes from the TAX account, and all other expenses would come out of OPEX.
- Your income from sales goes into your INCOME account, and you would then transfer all of this money out into each of the other accounts, according to set percentages that you’ll determine based on your current spending and goals you’ll set.
- “Always, always allocate money based upon the percentages to the accounts first. Never, ever, ever pay bills first… Then you pay bills only with what is available in the OPEX account. No exceptions. And if there isn’t enough money left for expenses? This does not mean you need to pull from the other accounts. What it does mean is that your business is telling you that you can’t afford those expenses and need to get rid of them. Eliminating unnecessary expenses will bring more health to your business than you can ever imagine.”
Step 3
And here’s the next step of the Profit First plan:
- Follow the process in the Step 1 and Step 2 sections above.
- To meet the “out of sight, out of mind” part of the Profit First plan, open two Savings Accounts at a separate bank:
- TAX - HOLD
- PROFIT - HOLD
- Any time you transfer money into the TAX and PROFIT checking accounts, then immediately transfer everything from those over to each of these secondary HOLD accounts.
- Set up your allocations and payables to be twice a month, to limit the amount of time you spend working on this system. The author recommends the 10th and 25th of each month. This is when you would transfer money, then pay your bills, then pay yourself according to your established salary.
- Each Financial Quarter, pay your Taxes and then take your Profit.
- On the first day of each quarter take 50% of what is in the Profit Hold account and distribute it to equity holders/owners. This isn’t owner compensation, this is profit sharing. The other 50% stays in the account as your emergency fund. If you have more than a three month emergency fund, you can use the excess to spend on capital gains and improvements on the business.
- Adjust your allocation percentages to get closer to your target goals.
You can also check out the Profit first One-Sheet for a simple instruction guide.
Next week, we’ll run the Instant Assessment to see what financial shape your business is in now, and to determine what percentages you’ll divide up your income to transfer into each account.
We’d love to hear your answer in the comments:
- What are your initial thoughts on reading the principles of Profit First?
- Are you going to enact any of these action steps?
- Have you tried this already? What have you felt and seen so far?
Feel free to share any other thoughts you have about this book. We can’t wait to hear your thoughts in the comments below!
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Happy reading,
Pesso
@Doran @Lovewell I’m very happy to know that someone has already tried this out and that it is a sound concept. Like I said, I’ve used Square Savings for two years to help me set aside funds for the off season expenses when we are closed. But until I read this book I hadn’t figured out a good use for Savings Folders. This seems like a perfect alternative to setting up 5 (or more) separate accounts in various banks, especially since I have the discipline to just ignore my savings balance unless a) it’s time to use what I’ve put away or b) something catastrophic happens and that’s my only option.
It has been a little tricky converting savings percentages, though I think I fixed that. Profit First is based upon percentages of “real revenue” and Square Savings is based upon percentages of card-only processing volume (which doesn’t include cash sales, nor does it include sales tax and tips which ARE in card processing volume). Anyway, I hit upon a formula that gives me approximately how much my folders need based upon card processing volume. It was interesting because I realized that I can fund all of my savings folders with card processing funds and then use the rest plus funds from cash sales to “pay the bills.” That realization makes the ability to have “out of sight out of mind” savings be even less painful, I think.
