Mike Michalowicz has created three multi-million dollar companies and is the author of four published books including Profit First and Surge. His is a former columnist for the Wall Street Journal. One of his unique skills is using mnemonics to memorizes his keynote speeches. I (Kirk) was recently a guest on his podcast, Grow My Accounting Practice.
In this episode, Mike and I discuss his book Profit First. The thesis of the book is profit should be taken out of your revenue first, before expenses, instead of after. Mike used this strategy to rebuild his business after losing his first fortune.
Defining Profit First
What is the most important thing you can share about pricing?
You have to address the biggest critic of your pricing, which is you. Mike goes through an exercise where he quadruples the price of a product. Then he creates value to match the price. Next, he cuts the price of the product by half. The result is the value increases 4x and price increases 2x. He has addressed the value conversation first and the price conversation second.
The purpose of Mike's company is to “irradiate entrepreneurial poverty.” It is the motivation behind the book Profit First, which grew from Mike's financial failure. Once you and your team have a clear picture of your mission, selling becomes a form of serving.
Why is “profit first” important?
Entrepreneurial poverty is when the business makes money, but the owner(s) does not take money out of the business. Mike's original solution was to sell more. However, expenses always seemed to increase in proportion to revenue.
Then Mike found a study that said 83% of small businesses in the US exist check to check. Meaning, if they do not receive the next check in time, they will not be able to cover payroll and expenses. Are entrepreneurs really smart enough to earn revenue and yet not take home a profit?
Mike discovered a behavioral theorem called Parkinson's Law, which states that based upon the availability of an item or resource, our behavior will change to match its supply. For example, we adjust the amount of toothpaste we use based on how much is left in the tube.
Profit First leverages Parkinson's Law by taking profit out of the business first. The remainder is for expenses, which forces the business to be frugal and innovative. Profit First is the discipline to reverse engineer profit in your business.
What is the formula you use to calculate profit?
The traditional formula is:
Sales – Expenses = Profit
The traditional formula is based on the logic of accounting. Whatever is left over after expenses is profit. The problem is profit is the last priority.
The Profit First formula is:
Sales – Profit = Expenses
The Profit First formula is based on human behavior. It makes profit a higher priority than expenses. It forces the business to spend only what is left after profit.
Profit is not an event that occurs at the end of the year. It is a daily practice in your business. By depositing profit into a separate bank account, before any expenses are paid, you enforce the discipline of Profit First.
Implementing Profit First
What principle is shared by Profit First and the Total Money Makeover by Dave Ramsey?
“Pay yourself first” is the most effective saving principle. It was part of the book The Richest Man in Babylon. When you reserve money and hide it from yourself, your mind is incredibly resourceful to work with what is left. As more money flows into the business, the tendency is to take the easy path rather than be innovative.
A common example is the 401K, the most successful employee savings option in US history. It takes your gross pay, deducts a set percentage, and places it into a separate bank account. You then adjust your lifestyle to your net pay. Meanwhile, your 401K earns compounding interest to create wealth.
What bank accounts do you recommend for the Profit First system?
The first account is the income account. Any revenue you earn in your business is deposited into this account. However, you never pay a bill from the income account.
Setup four more bank accounts: profit, owner's pay, taxes, and operating expenses. Twice a month, deposit a specific percentage of the income account into the four other accounts. The income account goes back to zero.
The purpose of the profit account is to distribute money to the equity owners of the business on a quarterly business. Never reinvest profit in the business. It is your reward for taking the risk of starting a business. Owner's pay is your salary for working in the business.
The first step (baby step) may be to deposit 1% into the profit account. The most important thing is to start. Chip and Dan Health conducted a fitness study applying the same principle. One-hundred people were 80% likely to continue exercising after 6 months if they started by standing while watching TV. Gradually they progressed from standing to marching to walking and then to running.
Living Profit First
What is the most common mistake entrepreneurs make with money?
Entrepreneurs do not value money the way they should. It is the lifeblood of the business. Money is an amplifier. It can amplify bad habits, like the traditional accounting formula, or good habits, like the Profit First formula. You first need to be profitable. Then use the money to amplify it.
According to Suze Orman, to eradicate debt, you must get more satisfaction from saving money than spending money. As an entrepreneur, you have to be proud of spending less on expenses than more. Find ways to discuss how you save money.
What is the link between getting 2X results and Profit First?
Better questions produce better answers. A better question is how can I double revenue? Even better, how can I double revenue with half the expenses? Another example, instead of “How much does it cost to acquire a customer?”, ask “How much do we get paid to acquire a customer?” Learn to ask better questions.