How Financial Profit First Works
How Financial Profit First Works –
It’s funny how losing nearly all of your money can cause you to watch a lot of late-night network TV. What? Before you side-eye me, this was right after I lost all of my money to my own arrogance, so cable TV was the first thing to go. Insomnia brought about by anxiety does not equal better quality sleep, so that pretty much left me with two options: Stare at the ceiling or watch late-night network TV, courtesy of my twelve-dollar, indoor rabbit-ear antenna (yes, antennae still work and, even with the fancy modern digital signal, the reception still sucks).
Most infomercials pitch instant cures. Eat only grapefruit for ten weeks, and presto! You’re thin. Drink this magic goo three times a day and before you know it you’ll be able to bounce a quarter off your ripped abs! Wrap this electromagnetic thingamajig around your waist, electrocute yourself every five seconds, and you’ll have a teeny-tiny waist in less than six weeks, all while never getting off the couch to clean the Doritos off your shirt!
One late night, I had had enough of the infomercials and turned on PBS to find, sure enough, a fitness guy talking about diets. (Was God trying to tell me something? I stopped working out for a little bit, but. . . jeez!)
The fitness expert explained to the studio audience that the quick fixes lauded by late-night infomercials didn’t work (thank you!) and that they weren’t sustainable. He said that what we really need are simple lifestyle fixes that do not require us to change our natural tendencies, changes that make an impact before we have a chance to screw it up with our unhealthy food choices. And his first fi x suggestion? Smaller plates.
Now riveted, I watched as the man explained that our natural human behavior is to fill our plates with food and, because Mom said so, clean that plate right up by eating everything on it. I still don’t get Mom’s logic—there are children starving in Africa, so I need to get fat? But the “clean-your-plate club” was instilled in me and probably in you, too. The message is ingrained. Changing that habit for a day is a no-brainer. But changing it permanently? That’s hard. Some would say it’s nearly impossible. This is why so many people who diet gain the weight back, why people rarely follow through on New Year’s resolutions past the end of January, and why it’s so difficult to be disciplined with your spending.
As I continued to watch the program, the expert went on to say that rather than work to change our “eat everything on the plate” behavior we simply need to change the size of our plates. When we use smaller plates, we dish out smaller portions, thus eating fewer calories while continuing our natural human behavior of serving a full plate and eating all of what is served.
I sat straight up on the couch, my mind alert with this new revelation. The solution is not to try to change our ingrained habits, which is really hard to pull off and nearly impossible to sustain; but instead to change the structure around us and leverage those habits.
It was then that I realized: Every penny my company made was going onto one plate, and I was gobbling it all up, using every last scrap to operate my business. Every dollar that came in went into one account, my operating account, and I was “eating it all.”
It hurts to admit this, but I was never good at money management. I thought I was, but looking back now, I realize how bad I was at managing money. I thought I was frugal in principle, or because I was a savvy entrepreneur. But in truth, I was frugal in my businesses because it was forced upon me.
When I started my first company, a computer network integrator (today it would be called a managed service provider), I had no money. I was able to sell, service, run my office—I could do all that stuff with practically no money because I didn’t have any. As the business grew, I started to spend. The more I made, the more I spent, and I believed that all expenditures were necessary. We needed better equipment, a better office (an unfinished basement is no place for a business). I brought on people to do the work so I could sell more. Every step forward in sales growth required an equal step up in my infrastructure, human resources, grade-A office space or whatever (all fancy terms for expenses).
After losing it all, I discovered that I work with whatever is put in front of me. Give me a hundred dollars and I will make it happen. Give me a hundred grand and I will make it happen. And while a hundred thousand- dollars made it easier to make it happen, it also made it way easier to make mistakes. Totally waste a few hundred dollars when you have a hundred thousand at your disposal, and you feel nothing. Totally waste a few hundred bucks, when you only have a few hundo to your name, and you feel that pain fast and hard.
Looking back at my companies, I realized that I grew them quickly but still survived check-to-check, only making the real money when I sold them. As my incoming cash increased (the darker line on Figure 2), my expenses increased at a similar rate (lighter line). The only time I would have a profit was when income jumped up and I didn’t have time to spend at the same rate. However, I would quickly ramp up my expenses to serve my “new level of sales.” Then sales would settle back down, or drop, while my new level of expenses remained higher. Losses accumulated. The desperate need to sell more, faster, increased.
I muted the television and began to connect the dots. I wondered, “If I reduce the ‘plate size’ of my business’s operating account, will I spend differently?” Looking back at my past behavior, the answer came quickly. Yes, I would. So rather than try to curb my spending habit, I would create the experience of having less cash on hand than I actually had. How did I know this would work? Because it already works for millions of people, with every paycheck—think 401K deductions.
Excited, I realized that, as with a 401K, if I were truly going to believe that the money I had left over in the bank after reducing my deposits from revenue (my small plate) was all I had to work with, whatever money I took off the top would have to go into a separate account that would not be easy for me to see, let alone access. Investment accounts charge penalties for early withdrawals to dissuade investors from drawing from their accounts, and I needed something similar in place to stop me from borrowing from the separate account.
But what would I do with the “other money?” Could I use it to— shock of shocks—pay myself a salary? Pay my taxes?
Hey. Hey wait. Wait one stinkin’ minute. Could I actually set aside some of it for profit—before I paid bills?
And that’s when it hit me—what if I took my profit first?
For a guy who built two businesses on top line (revenue focused) thinking, this was a revelation. At 3:00 a.m., it sounded like crazy talk. Who would have the audacity to take profit first?
WHAT THE DIET INDUSTRY KNOWS ABOUT GROWING A HEALTHY BUSINESS
A 2012 report by Koert Van Ittersum and Brian Wansink in the Journal of Consumer Research identifies the average plate size in America as having grown 23% between the years 1900 and 2012, from 9.6 inches to 11.8 inches. Running the math, the article explains that, should this increase in plate size encourage an individual to consume just fifty more calories per day, that person would put on an extra five pounds of weight… each year. Year after year, that adds up to a very chunky monkey.
But using smaller plates is just one factor. A Twinkie on a small plate is still a Twinkie.
There is more to a healthy diet, based on four core principles of weight loss and nutrition. These four principles are exactly the same foundation for business health.
1. Use Small Plates – Using smaller plates starts a chain reaction. When you use a small plate, you get smaller portions, which means you take in fewer calories. When you take in fewer calories than you normally would, you start to lose weight.
2. Serve Sequentially – Eat the vegetables, rich in nutrients and vitamins, first. If you leave them to eat last, you will rarely finish your vegetables. They’ll just sit there piled up on the side of the plate.
3. Remove Temptation – Remove any temptation from where you eat. People are driven by convenience. If when you’re hungry, junk food is easily accessible, you’re more likely to eat it. If you don’t have any junk food in the house, you’re probably not going to run out to the store to get it. (That would mean putting on pants.) You’re going to eat the healthy food you stocked, instead. My weakness is Chocodiles: Twinkies covered in dark chocolate and wrapped in love. Fortunately, they stopped making them. But if one sneaked into my house, even if it had expired in 1972, I would devour that delicious elixir of love and monounsaturated fats. Now, I always make sure I have healthy options with me, and the junk is locked away.
4. Enforce a Rhythm – Don’t eat when you’re hungry; it is already too late, and you will binge. Instead, eat frequently so that you never get hungry. You will actually consume fewer calories this way.
Profit First is a simple, “small plate” diet philosophy. In the Introduction I shared the basic formula of Profit First and how it differs from the accounting method most businesses use.
The old profit-as-“leftovers” formula (what I like to call the Frankenstein Formula):
Sales – Expenses = Profit
The new Profit First Formula:
Sales – Profit = Expenses
What you are about to learn isn’t anything new. It is something I suspect you have been aware of—in full or at least in part—but have never done. It is the concept of “pay yourself first” meets “small plate servings” meets “Grandma’s hidden stash of money in the cookie jar” meets your pre-existing natural, human tendencies.
Here’s how Profit First is like a successful diet:
1. Use Small Plates – When money comes into your main operating account, immediately disperse it into different accounts in predetermined percentages. Each of these accounts has a different objective: one is for profit, one for owner pay, another for taxes and another for operating expenses. These are the four basic accounts and where you should get started, but you will get more advanced in account setup as we move along.
2. Serve Sequentially – Always, always move money to your Profit Account first, then to your Owner Pay Account and then to your Tax Account, with what remains to expenses. Always in that order. No exceptions. Move it, stash it and let it accumulate. 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, you can’t afford those expenses and need to get rid of them. This will bring more health to your business than you can ever imagine.
3. Remove Temptation – Move your Profit Account and other 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.
4. Enforce A Rhythm – Do your payables twice a month (specifically, on the 10th and 25th). Don’t pay only when money is piled up in the account. Get into a rhythm of paying bills twice a month so 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.
When I started applying this small plate philosophy to my company’s finances, I was doing consulting work and speaking on entrepreneurship. I also applied my new Profit First system to my one surviving investment, Hedgehog Leatherworks.
At the time, I was putting the finishing touches on my first business book, The Toilet Paper Entrepreneur, into which I inserted a small section about the concept of Profit First Accounting (PFA). After the book came out I continued to refine the system, exploring and living it, and everything changed. I started implementing it with other entrepreneurs. And it worked—for me, for them and for my readers. I started getting calls from people who had read the book and tried basic PFA, creating amazing results. I also decided to drop the “A” from PFA—partly because Profit First is not an accounting system (it simply plugs into your accounting system) and partly because, when I heard Facebook used to be called “The Facebook” and dropped the “The” to sound cooler, I thought I would follow suit and drop a word.
Fueled by my passion for entrepreneurship and my determination to be profitable now, not at some indeterminate date in the future, I set about to perfect my system. In that process I discovered other entrepreneurs and business leaders who were running their businesses check-to-check and desperately needed the Profit First system. But I also found entrepreneurs and business leaders who had been implementing a similar system to great success. People like my barber, Lou Leone, the second-generation owner of a barbershop that has been profitable from day one. And Phil Tirone, who, while building his first, highly profitable multimillion-dollar business, continued to rent the same studio apartment until he determined that he had secured enough profit to upgrade—to a one bedroom.
In the coming pages, I will share these stories and more: stories about people who are in lockstep with their profits and stories about other folks, like you and me, who were giving it their all but still ended up only breaking even on their best days—people who now turn a profit every month and enjoy the fruits of their labors. People like Jose and Jorge, two entrepreneurs who started using Profit First from the first day they discovered it and have not only experienced very respectable growth, but have continuously taken in a 7% to 20% percent profit, month after month.
Your story isn’t finished yet. Not in the least. It’s time to create your happy, kickass chapter.
GET YOUR BUSINESS PROFIT-READY
Step 1: Set up the small plates with your bank. You will need four accounts: Profit Account, Owner’s Pay Account, Tax Account and Operating Expenses Account.
You probably already have one or two accounts with your bank (checking and savings). Keep the checking account as your Operating Expenses Account and set up Tax and Profit as savings accounts (these are simply holding bins), with Owner’s Pay as another checking account.
Some banks limit the number of transfers in and out of savings accounts. This shouldn’t be a problem, since we will be using a rhythm. However, if your Tax or Profit Accounts are checking accounts, that is fine. The goal is not to get a little extra interest; the goal is to hold money temporarily and remove temptation. Some banks charge fees or have minimum balance requirements. Don’t let that deter you. Speak to the bank manager and negotiate the fees and requirements. If the manager is unwilling to negotiate, find a new bank.
Step 2: Set up two more external savings accounts with a bank other than the bank you use for daily operations. One account will be your no-temptation Profit Account. The second will be your no-temptation Tax Account. Set them up with the ability to withdraw money directly from the respective savings accounts in your original bank.
Step 3: Don’t enable any of the “convenience” options for your two external accounts. You don’t need or want to view these accounts online. You don’t want checkbooks for these accounts. You just want to deposit your income and forget it… for now.
You may love to read our resource on Spending Less Saving More