Profit First: Transform Your Business from a Cash-Eating Monster to a Money-Making Machine

by Mike Michalowicz

The Small Business Administration (SBA) states that there are 28 million small businesses in the United States alone. The SBA defines a small business as a company that generates $25 million or less in annual revenue. That includes my business, and I suspect it includes yours. Shoot, that even includes Justin Bieber’s (his “small business” music sales pulled in only $18 million last year).

When you look at the full size of our global entrepreneurial family, you’ll see that the number of small businesses soars past 125 million.*

You work hard, you have good ideas, you already give 100 percent to your business. Profit First is a system designed to work with who you are already. You don’t need to be fixed. The system does.

Yeah, sure, it makes mathematical sense, but it surely doesn’t make human sense.

If you aren’t profitable, the natural assumption is that you haven’t grown fast enough. I have news for you, people. You’re completely fine. You don’t need to change. The old formula to profit is what’s wrong. It needs to change.

You know the formula I’m talking about: Sales − Expenses = Profit. That crusty, bifocal-wearing, old-person-smelling formula at first blush makes total sense. Sell as much as you can, then pay the bills, and what is left over is profit. Here’s the problem: there are never any leftovers.

The old profit formula creates monsters of businesses. Cash-eating monsters. But we stay loyal to the formula, and things get worse. The solution is ...

I will teach this to anyone and everyone. I will not stop. I am here to eradicate entrepreneurial poverty.

You started your business, I suspect, for two reasons. First, to do something you love. And second, for financial freedom. You did it for some degree of wealth. You did it to put profit in your pocket.

All you need to do is commit to study this and then do it. Don’t skip the doing. Pleeease do not skip the doing. You can’t read this book, think “awesome concept,” and go back to business as usual. You need to get off your butt. As Debbie did, you need to push past your feelings about the choices you made in the past. And like Keith, you need to put this into action as you read the book and follow the action steps at the end of every chapter. Your (profitable) life depends on it.

Growth is the battle cry of nearly every entrepreneur and business leader. Grow! Grow! Grow! Bigger sales. Bigger customers. Bigger investors. But to what end? Bigger business means bigger problems for sure. Yet it surely does not guarantee bigger profits, especially when profit is a hopeful residual.

Most business owners try to grow their way out of their problems, hinging salvation on the next big sale or customer or investor, but the result is simply a bigger monster. (And the bigger your company gets, the more anxiety you deal with. A $300,000 cash-eating monster is much easier to manage than a $3,000,000 one. I know; I have survived operating both.) This is constant growth without concern for health. And the day that big sale or customer or investor doesn’t show, you will fall to the ground and curl up crying like a baby.

The perfect size for your business? It will happen naturally, when you take your profit first. You will reverse engineer all the elements of your business, and as Fried says, “the right size will find you.”

So why are entrepreneurs programmed to pursue bigger and bigger and bigger? Because of an assumption that at a certain point all that revenue will yield a profit. You think you just need one more big project or one more new client or just a little bit more time, and finally that profit will pour in. But it never does. Profit is always within sight, but never attainable. It’s like the donkey with a carrot dangling over its head.

Here’s the deal, my friend: Profit is not an event. Profit is not something that happens at year-end or at the end of your five-year plan or someday. Profit isn’t even something that waits until tomorrow. Profit must happen now and always. Profit must be baked into your business. Every day, every transaction, every moment. Profit is not an event. Profit is a habit.

Here’s the reality if you want healthy, sustainable growth—which, not so surprisingly, will spawn more healthy growth—you need to reverse engineer the profit. Take profit first. You can’t grow out of your profit problem. You need to fix profit first, then grow. You must figure out the things that make profit and dump the things that don’t. When you focus on growth, it is inevitably a scramble to grow at all costs. Yes, at all costs (including the quality of your life). When you focus on profit first, you inevitably figure out how to make a profit consistently. Profitability. Stability. Sanity. Forevermore.

Any sale feels like a good sale because sales help to temporarily lift us out of crisis.

we can’t discern profitable income from debt-generating income. Instead of being the world’s best at one thing, mastering the process of delivering perfectly and super-efficiently, we end up doing a greater variety of things and becoming less and less efficient at each step while our businesses become harder to manage and costlier to run.

Part of the problem is bank balance accounting—looking at the money in your bank account as one pool from which you can operate your business without first addressing tax issues or your own salary, never mind profit. This leads to top line thinking—focusing on revenue first, last, and always. That thinking is further supported by the traditional accounting method public companies must use and most small businesses elect to use: GAAP (Generally Accepted Accounting Principles).

Since the dawn of time—or shortly thereafter—businesses have kept track of their earnings and expenditures using essentially the same method: Sales − Expenses = Profit If you manage the numbers like most entrepreneurs, you start with sales (the top line) and then subtract costs directly related to the delivery of your offering (product or service). Then you subtract all the other costs you incur to run your business: rent, utilities, employee salaries, office supplies, and other administrative expenses, sales commissions, taking your client out to lunch, signage, insurance, etc., etc. Then you pay taxes. Then, and only then, do you take your owner’s distribution (owner’s salary, profit distribution, etc.).

Finally, after all that, you post your company’s profit. And if your experience is like the majority of entrepreneurs, you never get to “finally.” When you’re waiting for the leftovers, at best you’ll get scraps.

The particulars are updated regularly, but the core system remains the same: Start with sales. Subtract direct costs (the costs you directly incur to create and deliver your product or service). Pay employees. Subtract indirect costs. Pay taxes. Pay owners (owner distributions). Retain or distribute profit (the bottom line). Whether you outsource your bookkeeping or keep a shoebox of receipts under your bed, the basic idea stays the same.

GAAP both supersedes our natural behavior and makes us believe bigger is better. So we try to sell more. We try and try and try to sell our way to success. We do everything we can to make the top line (revenue) grow so that something, anything, will drip down to the bottom line. It becomes a relentless cycle of chasing after every shiny object disguised as opportunity (that’s “little pumpkins” to my peeps—you know who you are). Throughout this haphazard, desperate growth process, our expenses are lost in the wash—we just pay as we go. They’re all necessary, right? Who knows? We’re too busy hunting down sales and trying to deliver on all our promises to worry about the impact of expenses!

We try to spend less without considering investments versus costs. We don’t think about leveraging our spending to get way more mileage out of way less expense. We can’t. The more variety of stuff we sell, the more our cost of doing business rises. They say it takes money to make money. But no one ever tells us what that translates to in the real world: It takes more money to make less money.

GAAP’s fundamental flaw is that it goes against human nature. No matter how much income we generate, we will always find a way to spend it—all of it. And we have good reasons for all our spending choices. Everything is justified. Soon enough, whatever money we had in the bank dwindles down to nothing as we struggle to cover every “necessary” expense. And that’s when we find ourselves in the Survival Trap.

A secondary flaw is this: GAAP teaches us to focus on sales and expenses first. Once again, it works against our human nature, which urges us to grow what we focus on. It’s something called the Primacy Effect (more on that in the next chapter)—we focus on what comes first (sales and expenses) and actually become blind to what comes last. Yes, GAAP makes us blind to profit.

There is a saying: “What gets measured, gets done.” GAAP has us measure sales first (it is the top line, after all), and therefore we sell like mad while expenses are treated like a necessary evil to support—you guessed it—more sales. We spend all that we have because we believe we must. And we use terms like “plowback” or ...

Accountants define profit differently than entrepreneurs. They point to a fictitious number at the bottom of an accounting report. Our definition of profit is simple: cash in the bank. Cold. Hard. Cash. For us.

At the end of the day, the start of a new day, and every second in between, cash is all that counts. It is the lifeblood of your business. Do you have it or not? If you don’t, you’re in trouble, and if you do, you are sustained.

GAAP was never intended to manage only cash. It is a system for understanding all the elements of your business. It has three key reports: the income statement, the cash flow statement, and the balance sheet. There is no question that you need to understand these reports (or work with an accountant and bookkeeper who do), because they will give you a holistic view of your company; they are powerful and highly useful tools. But the essence of GAAP (Sales − Expenses = Profit) is horribly flawed. It is a formula that builds monsters. It is the Frankenstein formula. To successful...

We need a system that can instantly tell us the truth about the health of our businesses, one that we can look at and know instantly what we need to do to get healthy and stay healthy; a system that tells us what we can actually spend and what needs to be reserved; a system that doesn’t require us to change but automatically works with our natural behaviors.

The great news is that Profit First is within your natural path. It is directly in alignment with the shortcut of looking at your bank account. It is unavoidable, designed to complement your natural human behaviors; therefore, it works.

Profit First sits in front of your accounting. It will tell you when you have a red flag and need to dig into the complex accounting stuff (with your qualified* accountant or bookkeeper), and it will show you exactly where your cash stands at any given moment. You’ll know your profitability, your reserves for taxes, what you are getting paid, and the amount you have to run your business operations. All that and more.

As I continued to watch the program, the expert went on to say that when we use smaller plates, we dish out smaller portions, thus eating fewer calories without changing our ingrained behavior of serving a full plate and eating all of what is served. I sat up straight 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 huge 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.”

There is more to a healthy diet, and it is based on four core principles of weight loss and nutrition. 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. Serve Sequentially—If you eat the vegetables, rich in nutrients and vitamins, first, they will start satisfying your hunger. When you move on to the next course—your mac and cheese or mashed potatoes (they don’t count as veggies!)—you will automatically eat less. By changing the sequence of your meals by eating your vegetables first, you automatically bring a nutritional balance to your diet.

Remove Temptation—Remove any temptation from where you eat. People are driven by convenience. If you’re anything like me, when there’s a bag of Doritos sitting in the kitchen, it calls out to you constantly—even when you aren’t hungry. 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. Enforce a Rhythm—If you wait until you are hungry to eat, it is already too late and you will binge. Then you are likely to eat too much and stuff yourself. You go from starving to stuffed, and back to starving again. These peaks and valleys in your hunger result in way too much calorie consumption. Instead, eat regularly (many researchers suggest five small meals a day) so that you never get hungry. Without the peaks and valleys, you will actually eat fewer calories.

Let’s start with small plates. In 1955, a modern philosopher named C. Northcote Parkinson came up with the counterintuitive Parkinson’s Law: that the demand for something expands to match its supply. In economics, this is called induced demand—it’s why expanding roads to reduce traffic congestion never works in the long term because more drivers always show up in their cars to fill those extra lanes.

Here is what’s fascinating: Parkinson’s Law triggers two behaviors when supply is scant. When you have less, you do two things. The first is obvious: you become frugal. When there is less toothpaste in the tube, you use less to brush your teeth. That is the obvious part. But something else, far more impactful happens: you become extremely innovative and find all sorts of ways to extract that last drop of toothpaste from the tube.

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.

The second behavioral principle you need to understand about yourself is called the Primacy Effect. The principle is this: We place additional significance on whatever we encounter first.

When we follow the conventional formula of Sales − Expenses = Profit, we are primed to focus on those first two words, Sales and Expenses, and treat Profit as an afterthought. We then behave accordingly. We sell as hard as we can, then use the money we collect to pay expenses. We stay stuck in the cycle of selling to pay bills, over and over again, wondering why we never see any profit. Who’s the sinner now? When profit comes first, it is the focus, and it is never forgotten.

Money works the same way. As you implement Profit First, you are going to use the powerful force of “out of sight, out of mind.” As you generate a profit (which, remember, starts today), you are going to remove the money from your immediate access. You won’t see it, so you won’t access it. And just like anything that you don’t have a reasonable degree of access to, you will find a way to work with what you do have and not worry about what you don’t. Then, when Mr. Buffett (ahem, your profit account) releases money to you, it will serve as a bonus.

When we get into a rhythm (I will explain in Chapter 6 a twice-a-month method that I call the 10/25 rule), we don’t get into the reactive mode of crazy spending when we get big deposits and panicking in the face of big cash dips.

When you get into a rhythm with your cash management you’ll have your finger on the pulse of your business. You will monitor your cash position every day by just looking at your bank account.

Profit First sparks faster growth because it makes you reverse engineer your profitability. When you take your profit first, your business will tell you immediately whether it can afford the expenses you are incurring; it will tell you whether you are streamlined enough; it will tell you whether you have the right margins. If you find that you can’t pay your bills after taking your profit first, you must address all those points and make the fixes.

Taking profit first will help you figure out which of the many things you do makes money, and which don’t. Then the direction is obvious—you do more of what is profitable, and you fix (or dump) what is not. You will focus on what makes profit for you, naturally, and you will get better and better at it. And when you get better at what your customers already want and like, they will like you more. All this translates into fast, healthy growth. Boom!

To grow the biggest and the fastest, you need to be the best at one thing you do. And to become the best at something, you need to first determine what you are best at and do it a whole lot better. To get there, you take your profit first and the answers to being the best at something will reveal themselves.

And we start with a simple new Profit First formula: Sales − Profit = Expenses

It is the concept of “pay yourself first” meets “small plate servings” meets “Grandma’s envelope-money management system” meets your preexisting natural, human tendencies.