Mike Michalowicz’s Profit First criticizes traditional business accounting methods by claiming that they are unintuitive, and that their unintuitive nature leads many entrepreneurs to failure. He then outlines an alternate accounting system, which he calls the Profit First method. This method, he says, allows an entrepreneur to do their business accounting in a simple and intuitive way, and to increase their business’s profitability and stability. (Shortform note: Michalowicz claims that the financial stability offered by the Profit First method will help reduce your levels of stress, which is supported by psychological studies. Specifically, studies found higher levels of anxiety among those who have trouble properly managing their finances.)
In this section, we’ll explore the main principles of traditional accounting, Michalowicz’s argument for why they don’t work, and the main tenets of his Profit First accounting method.
First, let’s clarify what Michalowicz is referring to when he talks about traditional accounting. Specifically, he’s referring to three main principles in his arguments, which he claims are the common wisdom of the business world.
While traditional principles work for some, they also lead many businesses to failure. Michalowicz argues that this high failure rate exists because traditional accounting principles clash with the way most people think and make decisions.
(Shortform note: Research supports Michalowicz’s claim that traditional accounting methods can clash with the way people think. A study revealed that even professional accountants still allow some of their personal, unconscious bias to get in the way of their logical, rational accounting work, often turning out inaccurate results that favor their clients.)
Michalowicz identifies one major clash in particular: Entrepreneurs interpret the traditional principle that growth is success to mean they should reinvest all their money—including their profits and personal funds—back into their expenses. They think that this increase in expenses will be covered by the increased income from their larger business. However, reinvestment into growth makes a business unstable, as it creates high costs and eliminates cash on hand. This instability can make slow sales periods fatal for a business.
(Shortform note: Behavioral psychology studies on gambling support Michalowicz’s claim that people naturally think continuing to put money into their business will eventually result in success. Studies suggest that while gambling, losing money makes us want to spend again, and makes us think that doing so will earn us rewards. This research could be interpreted to suggest that if entrepreneurs are losing money growing their business, they will psychologically want to spend more money on growth to chase success.)
The instability that comes from a rapidly growing business is also very difficult for most entrepreneurs to fix, says Michalowicz. He outlines three additional ways traditional principles clash with natural decision making and explains how these clashes prevent entrepreneurs from stabilizing their businesses.
1) Many entrepreneurs become used to the extra expenses they reinvested their profits on, and don’t want to get rid of them. They might have a hard time recognizing that they don’t need the company car or office space they have grown accustomed to, for example. (Shortform note: Research on compulsive spenders supports Michalowicz’s argument that people attach emotions to the things they buy, which makes cutting expenses much more difficult. Studies suggest that people tend to believe that buying things will make them happier, or compulsively buy as a way to try and cope with shame.)
2) Financial documents are often complex and difficult to navigate, even for accountants. This can make it difficult for entrepreneurs to even recognize when their business is financially unstable. (Shortform note: Michalowicz’s claim that small business entrepreneurs have trouble understanding their accounting is backed up by a recent survey, which found that 40 percent of small business owners would label themselves financially illiterate, and 66 percent wish they knew more about their finances.)
3) Financial instability and uncertainty often lead entrepreneurs to make irrational or panicked decisions, which only put a business into further trouble. Often, these decisions involve looking for increased growth and sales even if they come with expenses or opportunity costs. (Shortform note: Psychological research supports Michalowicz’s claim that as people lose money, they will make worse financial decisions. A study found that as gamblers lost money, they would be more likely to recklessly and impulsively spend more, believing that doing so would earn them money back. The study suggests that this is because losing money is an emotional event, and so it doesn’t encourage rational decision making.)
Now that we’ve shown how traditional accounting clashes with normal thinking and decision making, we’ll outline Michalowicz’s accounting system: the Profit First method. In this system, a percentage of income is taken as profit before any expenses are paid. The Profit First method works on four main tenets, which allow an entrepreneur to avoid the challenges of traditional accounting by using the natural way they think to make healthy financial decisions.
Michalowicz’s first tenet is to allocate a specific percentage of your income for expenses (we’ll discuss how to do this later on). By allocating only a percentage of your income to expenses, you’ll force yourself to spend that money more efficiently. That’s because of Parkinson’s Law: the theory that the more resources we have available, the more resources we will use. This theory works the other way as well: the fewer resources we have available, the fewer we’ll need to use.
(Shortform note: Michalowicz’s definition of Parkinson’s law isn’t quite accurate. Instead, it’s a common misinterpretation of an essay on government bureaucracy published by historian and author Cyril Northcote Parkinson. What Michalowicz (and many others) calls Parkinson’s law is actually just the article’s first sentence, which describes the “commonplace observation” that people use all available time to complete work. Parkinson’s actual law is an equation explained later in the article, which tries to predict bureaucratic growth. Because of this misinterpretation, keep in mind moving forward that this first tenet is founded not on behavioral psychology, but rather on a common-sense principle.)
The next tenet Michalowicz outlines is to allocate your income in order of importance, starting with profit to emphasize that it’s your first priority. This works due to what psychology calls the primacy effect: When given multiple pieces of information, our natural tendency is to better remember and place more importance on the first one given to us.
(Shortform note: Michalowicz claims that you’ll place the most focus and importance on whatever comes first. However, behavioral psychology suggests several other factors which might cause us to place more focus elsewhere in a list. Besides the primacy effect Michalowicz cites, there’s also the recency effect, which says that we’ll better remember and focus more on information given to us most recently. Also, there’s evidence that an item in a list emphasized more than others might also be better remembered, no matter where it is in the list.)
For the third tenet, Michalowicz advises that you remove the temptation to reinvest money into growth by creating savings accounts for profit and other essentials, and making those accounts inconvenient to access. By making that money harder to access, you’ll be less tempted to misuse it. (Shortform note: Michalowicz’s suggestion of changing your circumstances to avoid temptation may raise questions, as most people tend to think about temptation as an internal struggle to maintain our willpower. However, studies show that changes in external circumstances can be an easier and more effective way to increase self-control, supporting Michalowicz’s tenet.)
Finally, Michalowicz’s fourth tenet is to make a habit of dividing your income between profit and expenses and paying your bills consistently. By making a habit of dividing income amongst your business’s bank accounts, you can recognize financial changes just by looking at their account balances. Then, you can react to those changes calmly because you’ll have seen them coming.
(Shortform note: You might be wondering how good habits will help you react calmly to change. According to Chip and Dan Heath in The Power of Moments, habits help us stay calm because they help us prepare responses to change ahead of time. These prepared responses mean that when change does occur, we’ll respond more calmly because we’ll have already decided how to do so in advance and so won’t be caught by surprise.)
Now that we understand the benefits of the Profit First system, we’ll discuss how to set it up step by step. The process involves four different steps, all of which make it easier to understand your business’s finances.
You’ll first open new bank accounts. Michalowicz recommends organizing your accounting with seven bank accounts, so you can understand your business’s finances by checking their account balances. First, he advises you to open five checking accounts at your primary bank: an income account, a profit account, an account for your personal salary, an account for tax money, and an account for all other expenses. In addition to your checking accounts, open two savings accounts at a separate bank: one for tax money, and one for profits. Transfer money from your tax and profit checking accounts into these savings accounts regularly, and make them inconvenient to withdraw from so you aren’t tempted to misuse their money.
(Shortform note: Alternatively, if checking your financial documents is a task you have trouble with, you can work with a bookkeeper. The U.S. Small Business Administration recommends sending your financial information to a reliable bookkeeper once a week. They can compile your financial documents then answer any questions you have, so you can understand your financial situation each week. Michalowicz does disagree with this suggestion, though, arguing that even bookkeepers can misinterpret or fail to understand financial information.)
Once you have your bank accounts set up, Michalowicz says it’s time to assess your business’s current financial health. He explains that you should find the percentage of your income you’re spending on each aspect of your business: profit, your personal salary, taxes, and expenses. Then, you can compare these to a healthy business’s percentages. The more similar they are, the healthier your business is. (Shortform note: While this section of the guide provides a simple way to assess your business’s financial health, it isn’t as comprehensive as what a skilled financial advisor can offer. Michalowicz himself mentions that you should work with your accounting team throughout the book, so don’t use this as a substitute for that kind of support.)
To assess your business’s financial health, Michalowicz first outlines how to find what percentage of your income is allocated to each aspect of your business.
Now, you can compare your percentages to Michalowicz’s in the table below for the appropriate adjusted revenue bracket. The closer your percentages are to those in the table, the healthier your business is financially.
| Adjusted Revenue Bracket (R) | A = Profit Result | A = Owner’s Compensation Result | A = Taxes Result | A = Expenses Result |
| 0 - 250k | 5% | 50% | 15% | 30% |
| 250k - 500k | 10% | 35% | 15% | 40% |
| 500k - 1m | 15% | 20% | 15% | 50% |
| 1m - 5m | 10% | 10% | 15% | 65% |
| 5m - 10m | 15% | 5% | 15% | 65% |
| 10m - 50m | 20% | 0% | 15% | 65% |
(Shortform note: Michalowicz acknowledges that these numbers aren’t industry specific, but keep in mind that depending on your industry some of these numbers might not be realistic for your business. Percentages can range wildly from industry to industry—for example, the advertising industry has an average profit percentage of 3.1 percent, while the video game industry has an average profit percentage above 29 percent. Depending on your industry, then, Michalowicz’s percentages might be too conservative or too optimistic.)
While the percentages Michalowicz gave in the previous section are a good general example of where a healthy business allocates its income, he also provides the following instructions for finding your own ideal allocation percentages. (Shortform note: Once you determine these ideal percentages, think of them as good initial goals for your business. They shouldn’t remain fixed forever—Michalowicz acknowledges that you’ll likely make adjustments over time to your ideal percentages based on your business’s needs and circumstances.)
1) Your ideal profit percentage: To find your business’s ideal profit percentage, look up the records of successful public companies in your industry similar to your business’s size, then divide their profit by their revenue for the past three to five years. The average of those results will give you a good idea of an ideal profit percentage.
(Shortform note: Michalowicz claims that when determining your profit percentage, you’re calculating money strictly for your personal use. This contrasts with Greg Crabtree’s Simple Numbers, Straight Talk, Big Profits!, which argues that a financially healthy business needs a minimum profit percentage of 10 percent (before taxes) reinvested into expenses. This is because of three extra costs Crabtree says are often ignored: Debt payments, interest on debts, and depreciation (reduction of value in an asset over time, like from equipment wearing down). Crabtree argues that reinvesting 10 percent profit is needed to cover these additional costs and break even.)
2) Your ideal salary percentage: To determine an appropriate salary for yourself, Michalowicz recommends you pay yourself the same amount you would pay an employee to do your work. Divide this salary by last year’s adjusted revenue for your ideal salary percentage.
(Shortform note: You might be wondering why Michalowicz's methods encourage you to determine for yourself a salary appropriate for an employee, rather than the elevated salary more typical of a CEO. Paypal founder Peter Thiel offers an explanation in Zero to One, where he outlines two reasons why a CEO should have a low salary. He argues that a CEO with low pay will work harder to help the business succeed, since they won’t just be getting paid for showing up. In addition, a CEO with low pay inspires other employees to work harder by showing their dedication to the company.)
3) Your ideal tax percentage: Michalowicz emphasizes here that your ideal tax percentage covers your business’s taxes and your personal income taxes. Find your ideal tax percentage by adding the amount you paid last year on your business and personal taxes together, then dividing that number by your adjusted revenue from the last year. (Shortform note: When Michalowicz refers to “your business’s taxes,” he can be referring to a number of possible taxes depending on what your business does and where it’s located. Be sure to check with an accountant or the IRS website for a list of taxes your business might have to pay.)
4) Your ideal expense percentage: To calculate your ideal expense percentage, subtract your profit, salary, and tax percentages from 100%. This is the “leftover” money you’ll use for expenses. (Shortform note: This ideal percentage is probably going to be a lot lower than your current one. To make sure you continue towards this goal and don’t give up, David Goggins recommends you visualize your success in Can’t Hurt Me. He says that when you visualize what succeeding will look like, you remind yourself what you’re working towards, and that it’s a worthy goal.)
Once you’ve found your ideal percentages, Michalowicz says not to match them too quickly–if you allocate too much money away from expenses, you’ll often end up without enough money to keep your business running. Instead, gradually change how you spend your money. Michalowicz outlines three new financial habits for doing so. (Shortform note: When creating these new habits, try adding them onto your existing financial habits or routines. This way, it’ll be easier to stick with your new habits, according to James Clear in Atomic Habits. By connecting new habits to existing behaviors, following your existing behavior will remind you to follow your new habit as well.)
1) When you change your current percentages to meet your ideal percentages, start by only changing three percent. Subtract three percent from a percentage currently higher than its ideal, and add it to a percentage currently below its ideal. (Shortform note: Michalowicz claims that by making small changes, you’ll be more likely to stick with those changes. James Clear agrees and further explains why this is the case in Atomic Habits. He asserts that people have an easier time sticking with easier behaviors, and so smaller changes are better when forming new habits. In addition, by creating a smaller version of a habit, you can connect more behaviors to that existing habit, which makes it easier to stick to both.)
2) Allocate income to your bank accounts and pay your bills twice a month, so you can keep track of how much you spend and when you spend it. (Shortform note: If you have less money than you thought you would when paying your bills consistently, that could mean your business is experiencing cash flow issues. Often, businesses have cash “trapped” in inventory or in accounts receivable. They earn the revenue for their business to work in theory, but have trouble actually receiving this revenue as cash on hand. By maintaining the habit of allocating income and paying bills bimonthly, however, you’ll avoid being surprised by this issue again.)
3) Take half of the money in your profit savings account for yourself at the start of each quarter as a reward for yourself, and to leave the rest of the money in the account as an emergency fund. (Shortform note: If you don’t want or don’t need all the profit for yourself, don’t automatically plan on reinvesting it into your business. Instead, consider giving some of the profit distributions to your employees by setting up a profit-sharing plan as part of their retirement fund. An estimated 19 to 23 percent of U.S. businesses do so.)
Once you’ve set up the Profit First method, you can start using it long-term to improve your financial stability and profitability. To do so, Michalowicz offers detailed instructions for improving your business by cutting expenses and increasing efficiency.
Michalowicz explains that as you increase your profit percentage, you’ll need more money available for your profit allocation. However, he emphasizes that increasing your income is not how to get this additional money, because cutting expenses is a faster and easier way to make money available. Michalowicz recommends you cut costs by compiling a list of all expenses from the last year. Then, for each expense, ask yourself, “Is this necessary for keeping my business running or making customers happy?” If the answer is no, cut that cost. If the answer is yes, then consider ways you can accomplish the same thing in a cheaper way.
How Best to “Tidy Up” Your Expenses
If you’re having trouble finding unnecessary expenses, try using the practical techniques author Marie Kondo recommends for determining the things you do or do not need. Kondo offers these two guidelines in her book The Life Changing Magic of Tidying Up which can be particularly useful when cutting costs.
Discard in one go: When going through the process of getting rid of what you don’t need, Kondo recommends you get together everything you have and work through it all in one go. This doesn’t necessarily mean doing it all in one sitting, but rather working to power through everything whenever you can. When you declutter in one go, you keep up your momentum and don’t drag the process out. For your business, use all the time you have available to assemble your list of expenses and keep, improve, or remove them until you’ve reached your current goal.
Sort categorically: Kondo recommends that you sort by category when determining what to keep and what to get rid of. By doing this with your costs, you’ll have an easier time noticing which costs are redundant and cuttable.
- For example, when you sort your costs into categories you might realize how many online subscriptions you’re paying for, and then can cut those costs.
In addition to cutting expenses, Michalowicz also suggests you improve your business by specializing in whatever makes the most profit. He suggests two areas to consider when looking for profitability: services and clients.
Specialization in your most profitable services reduces the time and money spent on a given sale by narrowing your focus on fewer, more consistent tasks, and only providing these profitable services means every sale you make will have a high profit margin.
(Shortform note: If you’re having trouble understanding how to find your most profitable services, then consider reframing it as the process of cutting down on services that are only useful in specific circumstances. Often, companies will spend disproportionate amounts of money on offering complex and niche services just in case a client asks for them. These services are inefficient, because they require extra costs for something that doesn’t bring in a significant amount of revenue.)
Michalowicz also recommends you focus more on serving your most profitable clients—clients who consistently ask for your main product or service and aren’t difficult to work with. If you have any clients who are only interested in difficult to provide services or are difficult to work with, he says to drop those clients because they’ll reduce your profits.
How to Focus on Profitable Clients
While Michalowicz recommends you focus more on profitable clients, you might be wondering what practical steps you can take to do so. To focus on profitable clients, the management consultancy Strategex recommends taking practical steps in these two areas of your business:
Delivery: Strategex recommends that your business delivers services and products to profitable clients before anyone else. When you do this, your business will better satisfy its profitable clients and be more likely to keep them. You will take longer to deliver to less profitable clients since they’ll be a lower priority, but even if they leave you, you won’t be losing much.
Sales: Strategex also recommends that you spend the majority of your sales time making calls to potential new clients who are profitable, and cut the time you spend calling less profitable clients to keep the overall hours spent on sales the same. This will make you more likely to get sales that will be profitable and benefit your business, while cutting down time spent trying to sell to unprofitable clients.
In Profit First, Mike Michalowicz presents his own system of business accounting and financial management, which allocates a percentage of income as profit before calculating money for expenses. Michalowicz claims that this method allows an entrepreneur to create and maintain financial habits which will make their business more efficient, stable, and profitable.
Mike Michalowicz is an author, entrepreneur, business makeover specialist on MSNBC, and lecturer. In the 1990s, he found initial success starting and selling two multi-million-dollar tech companies. By 2008, though, he had lost all of his money on ill-fated startups and ended up in debt. By studying his mistakes, he developed new methods and techniques to get himself out of debt and regain financial stability. Over the next decade, Michalowicz paid off his debt and now runs two multi-million dollar companies and authors books on how to run a successful business.
Connect with Mike Michalowicz:
Publisher: Portfolio, an imprint of Penguin Random House
Mike Michalowicz self-published Profit First in 2014, and Portfolio later published a revised and expanded version in 2017. (This guide covers the 2017 version of the book.)
While all of his books are about entrepreneurship, Profit First is his best known work and is devoted specifically to money management and accounting. Profit First was Michalowicz’s third book, following his guide to startup success, The Toilet Paper Entrepreneur, in 2008 and his guide to business growth, The Pumpkin Plan, in 2012. Michalowicz has continued writing since the release of Profit First, his most recent books being a children’s money management guide (My Money Bunnies) and a marketing guide (Get Different).
The Profit First system of money management was originally a theory described in a brief section of Mike Michalowicz’s first book, The Toilet Paper Entrepreneur. After hearing from entrepreneurs who had tried his theoretical system and found success, he decided to expand and develop on that original theory by writing Profit First.
It fits into the category of books for simplifying accounting and financial management for entrepreneurs, particularly those running small to medium sized businesses. This includes books like Gregory Burges Crabtree’s Simple Numbers, Straight Talk, Big Profits! (2011) and Dawn Fotopulos’s Accounting for the Numerophobic (2014). Michalowicz attempts to distinguish his book from others in the genre by pitching an alternative accounting system instead of trying to simplify existing systems.
Profit First is on the Kindle best-sellers list for business accounting and the Apple Books best-sellers list for business and personal finance.
Michalowicz has also built a larger Profit First brand based on the methods explained in the book. The brand includes speaking engagements, a podcast, online courses, conventions, a blog, merchandise, and more. In addition, he’s created a network of accountants, bookkeepers, and coaches who use the Profit First system and help businesses adopt it.
The majority of reviews of Profit First are positive, and many come from accountants and entrepreneurs who successfully adopted the Profit First system for their own businesses. There are also many positive reviews from other authors in the genres of business accounting and entrepreneurship. These reviews appreciate the simplicity of the book’s approach and the money and stability the Profit First system can offer a business owner. These reviews also emphasize Profit First as a way of life that reduces stress and makes all finances easy to understand.
Negative online reviews tend to criticize the book for being repetitive or for having a lack of significant ideas. Others say that the methods and techniques the book recommends are unnecessary, adding extra complexity to standard business accounting which works fine as is.
Profit First approaches its main arguments in two steps: First, Michalowicz presents anecdotes, testimonials, and examples of entrepreneurs and authors he knows who have experienced the problem being discussed or who have successfully used methods from the book. He uses these and behavioral psychology to create a narrative of a typical entrepreneur: An owner of a small or medium business who struggles with spending discipline and maintaining growth and profitability. Michalowicz then outlines why his method or guideline works for the typical entrepreneur and gives step-by-step instructions on how to implement it.
While this approach makes the book easy to read and understand, it also means that a reader who doesn’t fit the author’s description of a typical entrepreneur might be more likely to question how necessary his guidelines are, or why they are better than traditional business accounting methods. A reader that doesn’t have serious struggles with debt, spending discipline, or tracking their finances might find the book less relevant to their financial circumstances.
Profit First is divided into three clear parts. Part one (chapters one and two) explains what the Profit First business accounting method is and how it’s better than traditional business accounting. Most of the book’s main ideas are explained in the first two chapters of the book. The second part of the book (chapters three through six) explains how a business can set up the Profit First method. Finally, the third part of the book (chapters seven to 11) consists of how to use the Profit First method to address various problems your business might encounter, as well as additional optional tips and tricks that can be used to maintain spending discipline and financial health.
By establishing the book’s main arguments in the first two chapters, Michalowicz creates a solid foundation that allows a reader to connect all future points back to those original main ideas—although his consistent callbacks to those main ideas can make the book repetitive. Unlike parts one and two, the third part of the book has a vaguer focus, and as a result the later chapters overlap more often.
This guide is split into three parts. The first part defines the Profit First method by contrasting it with traditional accounting methods, as well as by outlining Michalowicz’s main Profit First tenets. While the book goes back and forth comparing the two, we’ve separated traditional and Profit First accounting into two separate chapters for clarity and straightforwardness.
Michalowicz’s instructions for how to set the Profit First method up for your business are in part two of this guide, while in part three we’ve organized many of Michalowicz’s recommendations for managing specific aspects of your business into an overall guide for how to use the Profit First long-term. This structure allows us to clearly define what Michalowicz recommends you do early on and separates this advice from his suggestions on how to improve your business and financial stability over a longer period of time.
Our commentary provides psychological and business research to support or contrast with Michalowicz’s claims of how entrepreneurs think and act. It also provides practical steps for improving your business when Michalowicz offers more general, overarching recommendations. These practical steps come primarily from other books and articles by entrepreneurs and business consultants.
Mike Michalowicz’s Profit First criticizes traditional business accounting methods for encouraging excessive growth at the cost of a business’s profitability and financial health. He then outlines an alternative to traditional accounting, which he calls the Profit First system of business accounting. In this method, you subtract profit from income to determine how much money you have available for expenses (as opposed to the traditional method of subtracting your expenses from your income to determine profit). This, along with other guidelines used in the Profit First method, helps you keep track of your business’s finances, increase its profitability and stability, and maintain your spending discipline.
(Shortform note: Michalowicz claims that the Profit First method’s stability and easy-to-understand nature will reduce your financial stress. Research supports this claim by indicating that financial instability and uncertainty correlate strongly with levels of anxiety and stress. This study found that those with higher levels of financial stress typically have trouble managing their money and have unstable finances due to high debts and a lack of assets. However, it also found that people with financial literacy (the ability to understand their finances) have significantly reduced levels of financial stress and anxiety. This suggests that if the Profit First method does offer stability, money management, and understandable finances, then it can also reduce levels of stress and anxiety.)
In this first part of the guide, we’ll define the Profit First system—showing how it contrasts with traditional accounting and then outlining its main tenets. In order to build a foundational understanding of the drawbacks of traditional accounting, in this first chapter we’ll explore its core principles and Michalowicz’s explanation of why they don’t work for most people.
First, let’s clarify what Michalowicz is referring to when he talks about traditional accounting. His definition includes both commonly accepted wisdom of the business world as well as the GAAP (Generally Accepted Accounting Principles) used by the U.S. Securities and Exchanges Commission.
(Shortform note: Michalowicz refers to traditional accounting as a whole as GAAP, but the GAAP are actually smaller in scope than that. The GAAP are government standards for clear and legal business accounting, rather than a guide for traditional accounting methods.)
In particular, Michalowicz emphasizes three traditional principles:
The first main traditional accounting principle states that when doing your accounting, begin with your income and subtract all of your business’s expenses–whatever is left is your profit. (Shortform note: This is a simplified version of the calculations done on a profit and loss (income) statement.)
This second principle of traditional accounting says to constantly seek to grow your business and put growth as your first priority. Growth leads to an increase in your income as well as the overall value of your company in case another company wants to buy it.
(Shortform note: Michalowicz doesn’t mention another large reason why traditional accounting wisdom emphasizes growth: Economies of scale—the theory that the more products you produce, the lower the cost to make each product will be.)
The third traditional accounting principle recommends you keep a constant eye on your financial documentation. In theory, consulting this paperwork thoroughly and regularly allows you to always know how well your business is doing.
(Shortform note: The U.S. Small Business Administration recommends you review and analyze your financials every week, even when on vacation. It claims that small businesses that review and analyze their financials annually have a 25 to 35 percent success rate, while those that review and analyze their financials weekly have a 95 percent or higher success rate.)
While traditional methods certainly work for some, Michalowicz claims that those who do succeed do so more often out of luck or extraordinary circumstance rather than by simply working harder. He goes on to note that half of all businesses fail within their first five years, and eight out of 10 businesses overall end in failure—and the vast majority of those businesses used traditional accounting methods.
(Shortform note: Research indicates that many small business owners who have failed or are failing aren’t doing much accounting at all—whether that means not making a business plan or not understanding their finances. One could see this as supporting Michalowicz’s argument that traditional accounting scares away many entrepreneurs, who are unable to understand it. Alternatively, one could also argue that this means many failed businesses didn’t really use traditional accounting methods, because they hardly used any accounting methods at all.)
According to Michalowicz, the main cause of this high failure rate is the logic of traditional accounting clashing with the natural ways people think and make decisions. We’ll now examine the four main reasons Michalowicz identifies for why traditional principles and natural decision-making clash, as well as how those clashes lead to failure.
Michalowicz explains that the biggest clash has to do with the traditional principle regarding growth. Because traditional accounting suggests that growth leads to success, many entrepreneurs interpret this principle to mean that they should constantly try to grow their business as much as possible, by any means necessary. This means reinvesting all the money they can—including their profits and personal funds—back into their expenses. They plan to cover their growth-driven increase in expenses with the increased income they predict that their larger, more expanded business will create.
However, this puts a business in a precarious position—when sales slow down, the business will have high costs and no cash available with which to pay them. Fluctuations in sales are inevitable, and overemphasizing growth makes slower periods potentially fatal for a business.
(Shortform note: Michalowicz argues that entrepreneurs believe that if they keep putting money into their business, they’ll eventually find success and make money back. His claim that this is the natural way people think is backed up by psychological research on the common phenomenon of “loss-chasing”: throwing good money after bad to try and recoup losses. Studies suggest that losing money makes us want to spend again and makes us think that doing so will earn us rewards. This research could be interpreted to suggest that if entrepreneurs are losing money growing their business, they will psychologically want to spend more money on growth.)
Michalowicz explains that slow periods are particularly dangerous for unstable, growth-centric businesses because unlike income, expenses are often tied up in our lifestyles, agreements, contracts, and relationships with other people. This means that while increasing your expenses is easy, it can be difficult and painful to lower them quickly if necessary. This means that while increasing expenses to achieve constant growth, you put yourself in a position you can’t easily get out of if circumstances change.
(Shortform note: Research on compulsive spenders supports Michalowicz’s argument that people attach emotions to the things they buy, which makes cutting expenses much more difficult. Studies suggest that people tend to believe that buying things will make them happier, or compulsively buy as a way to try and cope with shame. This indicates that our purchases are emotional events, and that we attach emotions to the things we buy—which would make getting rid of or cutting back on our purchases emotionally difficult, as Michalowicz suggests.)
If problems do arise for a business that uses traditional accounting, then it can be difficult to even recognize. This is, according to Michalowicz, because the principle of consistently checking financial documentation doesn’t work when those documents are too complicated to understand. Traditional accounting is very complex, involving a large amount of data and many different metrics and equations that can be used to interpret that data. Even if you hire an accountant, the vast number of possible documents, equations, and metrics they could use means that two accountants using traditional methods might end up with two different conclusions about a business’s financial health.
(Shortform note: Studies support Michalowicz’s argument that traditional accounting is too complex and that its complexity can even lead accountants to conflicting interpretations or blatant errors. One survey of 50 accountants interpreting the same tax information led to 50 different answers, while a later repeat of that survey resulted in no accountant submitting an error-free tax return.)
This can be a serious problem when it comes to understanding how much money you actually have available because traditional accounting will still show you’ve made a profit even when you’ve reinvested all of that money into your business. Most people define profit as cash on hand, though, so it’s easy to misunderstand how much money you have available and then spend money you don’t have.
(Shortform note: Michalowicz’s claim that small business entrepreneurs have trouble understanding their accounting is backed up by a recent survey, which found that 40 percent of small business owners would label themselves financially illiterate, and 66 percent wish they knew more about their finances.)
The instability that comes from a rapidly growing business often leads to irrational and panicked financial decisions, says Michalowicz. When an entrepreneur reinvests all of their available money into expenses, they won’t have any cash on hand to stay open through a rough patch—their business will consistently be one bad month away from failure.
This instability, plus a growth-first mindset, leads many entrepreneurs to make panicked decisions—specifically, it leads entrepreneurs to seek any increase in income even if it comes with many more expenses or serious opportunity costs. Doing so will only increase instability, which will then inspire more panicked decisions in a vicious cycle.
(Shortform note: Psychological research supports Michalowicz’s claim that as people lose money, they will make worse financial decisions. A study found that as gamblers lost money, they would be more likely to recklessly and impulsively spend more, believing that doing so would earn them money back. The study suggests that this is because losing money is an emotional event, and so it doesn’t encourage rational decision making. Financial loss (like from an unstable or failing business) is also an intensely emotional event, which based on this study could also lead entrepreneurs to more impulsive and reckless spending in a desperate attempt to earn money back.)
Consider if you conduct your accounting by traditional principles, and how that might affect the way you run your business.
How much has your business’s revenue grown in the past year?
List how often you check each of the following: your profit & loss statement, your balance sheet, your cash flow statement, your accounts receivable report, your accounts payable report, and your inventory report.
In the past three months, how often have you had to scramble to cover your business’s costs? What was your strategy for doing so?
In the previous chapter, we saw four ways that traditional accounting methods can lead businesses into failure. All of those cases show that while traditional accounting depends on clear logic and rational decision-making, Michalowicz believes that the way people think and make decisions—especially when they're losing money—isn’t logical or rational.
(Shortform note: Research supports Michalowicz’s claim that traditional accounting methods don’t work well with the way people think. A study revealed that even professional accountants allow some of their personal, unconscious biases to get in the way of their logical, rational accounting work—often interpreting financial information in a way favorable to their clients, even if by doing so, they fail to recognize errors or fraud. Since even professionals have trouble remaining fully logical while doing business accounting, it’s not hard to imagine the difficulties Michalowicz suggests entrepreneurs have with managing their finances rationally.)
A preferable accounting system would allow an entrepreneur to use the existing ways they think and make decisions instead of depending purely on logic and reason. Michalowicz decided to develop a system that does this, and he ended up with the Profit First method. While traditional methods use the income minus expenses equals profit equation, the Profit First method uses a different equation of income minus profit equals expenses.
(Shortform note: Michalowicz suggests that the Profit First method can act as a replacement for the GAAP, but this isn’t quite correct. Many businesses in the US are legally required to comply with the GAAP, and many financial experts recommend businesses that aren’t legally required to still apply these principles. However, the GAAP don’t conflict with the Profit First method, as they provide requirements for clear, ethical, and consistent accounting, but they don’t require a specific method of accounting—in other words, the Profit First system can be understood as a system to reframe the way you comply with the GAAP.)
In this chapter, we’ll explain the four main tenets of the Profit First method as well as how they work in harmony with the natural ways people think and make decisions.
Michalowicz’s first tenet is to limit your resources by giving yourself less money for expenses. He argues that this will force you to use that money more efficiently. This tenet works with Parkinson’s Law: The theory that the more resources we have available, the more resources we will use. This theory works the other way as well: The fewer resources we have available, the less we’ll need to use—in other words, we’ll find ways to make do with what we have.
Michalowicz’s system limits resources available for expenses by only allocating a percentage of income to a checking account specifically for expenses (we’ll explore this in more detail in the next chapter). This way, you’ll make decisions about expenses based on the amount of money you actually have available for them, rather than on how much income you have as a whole. You’ll force yourself to find a way to make do with this smaller amount.
(Shortform note: You might be confused by what this “percentage allocation” would look like, or what it means for your accounting. If so, it might help to reframe this process as making a budget. While Michalowicz doesn’t call it that, his suggestion to earmark a portion of your income for certain expenses is a key part of making a budget for your business.)
The Origin of Parkinson’s Law
Michalowicz’s definition of Parkinson’s Law isn’t quite accurate. Instead, it’s a common misinterpretation of an essay on government bureaucracy published by historian and author Cyril Northcote Parkinson. What Michalowicz (and many others) calls Parkinson’s Law is actually just the article’s first sentence, which describes not a scientific law or theory of behavioral science, but rather the “commonplace observation” that people use all available time to complete work.
Parkinson’s actual law is an equation explained later in the article, which tries to predict bureaucratic growth based on a study of the British civil service. Because of this misinterpretation, keep in mind moving forward that this first tenet is founded not on behavioral psychology, but rather on a common-sense principle.
The next tenet Michalowicz outlines is to allocate your income in order of importance. His system allocates profit before anything else, and he argues that this emphasizes the importance of profit. This is because of what behavioral psychology calls the primacy effect: When we interpret multiple pieces of information, our natural tendency is to better remember and place more importance on the first information given to us.
When using the Profit First method, Michalowicz says you should set aside a percentage of your income as profit before anything else, and calculate money for expenses last in your accounting. Allocating your profit first helps you focus on staying profitable, and placing less importance on expenses means you’ll better recognize which expenses aren’t actually important to your business.
(Shortform note: Michalowicz suggests that if you calculate profit in your accounting first, then you’ll place the most focus and importance on it. However, behavioral psychology defines several other factors which might lead you to place focus elsewhere. Besides the primacy effect Michalowicz cites, there’s also the recency effect, which says that we’ll better remember and focus more on information given to us most recently. Also, there’s evidence that an item in a list emphasized more than others might also be better remembered, no matter where it is in the list.)
In his third tenet, Michalowicz says that the easier something is to access, the more difficult it is to keep yourself from it—therefore, you can remove temptation by making it harder to access what tempts you.
Michalowicz advises that you remove the temptation to reinvest money into your business by creating savings accounts for profit and other essentials, and making those accounts inconvenient to access (we’ll explore how to do this in the next chapter).
(Shortform note: Michalowicz’s suggestion of changing your circumstances to avoid temptation may raise questions, as most people tend to think about temptation as an internal struggle to maintain willpower. However, studies show that changes in external circumstances—such as making bank accounts inconvenient to access—can be an easier and more effective way to increase self-control. This study suggests that while temptations usually grow stronger over time, something as simple as increasing distance from whatever tempts you can prevent that temptation from starting at all.)
Finally, Michalowicz’s fourth tenet dictates that you should maintain good financial habits. Specifically, he says you should regularly divide your income between profit and expenses and pay your bills consistently, making it habitual. This is because when you keep habits, it’s easier to recognize when changes happen and you can react to them more calmly than you would if you were caught off-guard.
Michalowicz argues that a habit of consistently doing your business’s accounting improves your financial decision making: By dividing income consistently amongst your business’s bank accounts, you can recognize financial changes just by looking through your account balances. Then, you can react to any changes calmly and rationally because you’ll have seen them coming.
(Shortform note: You might be wondering what the “stability” created by good habits looks like, as well as how it helps you react calmly and rationally to change. According to authors Chip and Dan Heath in The Power of Moments, habits create stability because they help you prepare your responses to change ahead of time. This preparation means that when change does occur, you’ll automatically respond rationally and won’t have to make decisions while emotional. Chip and Dan Heath recommend you practice your habits to the point where they become an automatic response. This way, you won’t panic when encountering change because you’ll automatically know what to do.)
Now that you understand the benefits of the Profit First system, we’ll discuss how to set it up step by step.
In part two of this guide, we’ll be covering the following steps:
This chapter covers step one: Opening new bank accounts. Michalowicz recommends organizing your accounting with seven bank accounts, rather than using a spreadsheet or financial software. Doing this allows you to continue your existing habit of making business decisions based on your bank balances, but you’ll also make financially healthier decisions because you’ll have a clearer idea of how much money you have available for each part of your business.
To organize your accounting through bank accounts, Michalowicz instructs that you open five checking accounts at one bank, and two savings accounts at another, each used for one major component of your business’s finances.
You can open these checking accounts at your primary bank. Use them to keep track of your income and where you allocate it.
In addition to your checking accounts, Michalowicz advises you to open two savings accounts at a separate bank and make them inconvenient to access. This uses the Profit First tenet of reducing temptation by making it harder to get what you want–in this case, making it harder to spend the money in these accounts on other things.
Make Informed Bank Accounting Decisions
While Michalowicz recommends that you set up your accounts at banks that don’t have too many fees, you might be wondering what specific fees you should look for or avoid. Here’s a specific list of fees you can check for when setting up your new accounts, as well as how they might impact your bank accounting:
Minimum balance requirements: Many banks will have monthly fees for accounts with a balance below a certain minimum. This fee is important to consider for your income, tax, and profit checking accounts because they’ll regularly have all the money in them transferred out.
ATM fees and ATM access: You’re no doubt familiar with this fee—almost all ATMs now charge you for use if they aren’t with your specific bank. These fees are important to consider if your business often needs to pay for things in paper money. Knowing which banks can offer you easy access no-fee ATMs will save you a significant amount of money in the long term.
Overdraft fees or insufficient funds: If you end up spending more than an account currently has, your bank will typically charge an additional fee—whether the charge went through or not. This makes it important that you know how much money is in each account, and that you maintain spending discipline to avoid additional fees on top of your other expenses.)
Michalowicz recommends you use your profit and tax checking accounts to hold money until it’s transferred to your savings accounts. This is because transfers between checking accounts at the same bank are instant, meaning that transferring money from your income account to your profit and tax checking accounts instantly updates how much money you have in each.
On the other hand, transferring money between banks takes a few days, so if you transfer directly from your income account to your savings accounts, your income will temporarily seem greater than it really is, and you might make bad decisions based on that misleading number.
(Shortform note: Michalowicz argues that being unable to fully recognize your financial information in this instance will make impulsive behavior more likely. Research backs up this claim, suggesting that a core component of impulsive behavior is acting before fully processing all of the information available to you. Transferring money from your income to your profit and tax checking account makes it easier to process information—Because of that, this research would suggest that it also prevents impulsivity.)
You might ask, “Why open all of these bank accounts and not just use a spreadsheet or financial software?” Michalowicz addresses this point, arguing that a typical entrepreneur isn’t checking their financial documents frequently, and doesn’t consult them when making decisions about spending. For such a person, multiple bank accounts improve financial decision making without requiring the habit of checking accounting documents regularly.
(Shortform note: Alternatively, if checking your financial documents is a daunting task you have trouble doing regularly, you could also work consistently with a bookkeeper. The U.S. Small Business Administration recommends you send your financial information to a reliable bookkeeper once a week, have them compile your financial documents, and then ask them any questions you might have about what they mean. This way, your bookkeeper will help keep you accountable to a habit of checking these financial documents once a week, and will also make sure you understand what these documents mean. Michalowicz does disagree with this suggestion, though, arguing that even bookkeepers can misinterpret financial information.)
Once you have your bank accounts set up, Michalowicz says it’s time to assess your business’s current financial health. In this chapter, we’ll outline how you can find the percentage of your income you’re spending on each aspect of your business: profit, your personal salary, taxes, and expenses. Then, we’ll provide examples of what percentage of income a healthy business spends on each category. By comparing your current percentages with the example healthy percentages, you’ll be able to assess how financially healthy your business is.
(Shortform note: While this chapter of the guide provides a simple way to assess your business’s financial health, it isn’t as comprehensive as what a skilled financial advisor can offer. Michalowicz himself mentions that you should work with your accounting team throughout the book, so keep in mind that the principles in this chapter aren’t a substitute for that kind of support.)
To assess your business’s financial health, Michalowicz outlines a step by step process to find what percentage of your income you currently allocate to each aspect of your business. If in any given step you aren’t sure about a number, just use your best guess—being “close enough” is fine here.
| A-value: | A = Profit | A = Your Salary | A = Taxes | A = Expenses |
| Percentage: |
(Shortform note: Michalowicz acknowledges that these numbers aren’t industry specific, but keep in mind that depending on your industry some of these numbers might not be realistic for your business. Percentages can range wildly from industry to industry—for example, the advertising industry has an average profit percentage of 3.1 percent, while the video game industry has an average profit percentage above 29 percent. Depending on your industry, then, Michalowicz’s percentages might be too conservative or too optimistic.)
These healthy percentages came from Michalowicz analyzing successful businesses in each revenue range and averaging their allocation percentages. The allocation percentages which are ultimately best for your business depend on additional factors like your industry, but the percentages listed above are a good place to start.
He explains that the healthy expense percentage grows with revenue, since a larger business requires more employees and more time spent organizing. In addition, as revenue grows, the healthy profit percentage increases while the salary percentage decreases. This is because your salary is based on what you’d pay an employee to do your work, and as your company grows you’ll be doing less employee work and more large-scale organizational work.
While the percentages Michalowicz gave in the previous section are a good general example of where a healthy business allocates its income, he also recommends that you use your business’s financials to find ideal allocation percentages specific to your business. In this chapter, we’ll cover Michalowicz’s steps for finding an ideal profit, salary, tax, and expense percentage specific to your business, industry, and circumstances.
(Shortform note: Once you determine these ideal percentages, think of them as good initial goals for your business. They shouldn’t remain fixed forever—Michalowicz acknowledges that you’ll likely make adjustments over time to your ideal percentages based on your business’s needs and circumstances.)
To find your business’s ideal profit percentage, Michalowicz advises you use any combination of the following three methods.
Using your financial website of choice, look up the records of successful public companies in your industry that are similar to your business’s size. Check their income statements, and optionally their cash flow statements and balance sheets from the last three to five years. Divide their profit by their revenue for each year, then find the average of your results. This average gives a good idea of an ideal profit percentage.
Look at your taxes for the last three to five years and find your most profitable year. Calculate the profit percentage for that year, and use it as your ideal. If your business has consistently struggled to be profitable or had one complete outlier of a year, try one of the other methods instead.
Check your projected income for this year, and pick a profit percentage that would give you a dollar amount that you consider your ideal yearly profit.
Profiting Versus Breaking Even
Michalowicz claims that when determining your profit percentage, you shouldn’t be thinking about how much of it might go back into expenses—instead, he says, your profit should go to you. This contrasts with author and entrepreneur Greg Crabtree’s book Simple Numbers, Straight Talk, Big Profits!, which argues that a financially healthy business needs a minimum profit percentage of 10 percent (before taxes) reinvested into expenses.
This is because of three extra costs which Crabtree says are often ignored in business accounting: amortization (or consistent debt payments), interest on your debts, and depreciation (the reduction of value in an asset over time, like from equipment slowly wearing down or breaking). All of these things require your business to have money available that isn’t already tied up in other expenses, and so Crabtree argues that only by reinvesting a 10 percent profit can help your business cover these additional costs and break even.
When finding your ideal salary percentage, Michalowicz says it’s important to find an appropriate amount and not to go below it. Many entrepreneurs, when faced with expenses too high for their income, end up taking the difference out of their own paychecks.
Michalowicz stresses that you should not do this, because the goal of running a business is to gain financial freedom, not financial obligation. To determine an appropriate salary for yourself, Michalowicz recommends you use one (or all) of the following three guidelines.
Pay yourself the same amount you would pay an employee to do your work. Your paycheck should reflect the work you’re doing, and can occasionally include a bonus for your efforts.
Alternatively, you can determine your salary by using the healthy percentage recommended in Michalowicz’s table multiplied by your business’s yearly income.
The larger your business grows, the less you’ll focus on day-to-day operations and the more you’ll spend time organizing, directing, and teaching your employees. Your pay should reflect this as well: You do less employee work, and so you earn a smaller salary. However, your increased entrepreneurial work will be compensated by your higher profit percentage.
The Benefits of a Lower Salary
You might be wondering why Michalowicz's methods to determine an “appropriate” salary percentage encourage you to allocate yourself a salary appropriate for an employee, rather than the elevated salary more typical of a CEO. Paypal founder Peter Thiel offers an explanation in his book Zero to One. He outlines three reasons why a CEO should have a lower pay than is standard for their position.
Giving a CEO a high salary encourages them to coast, or maintain the status quo. Since they are getting a large amount of money just by showing up, they’ll be less motivated to work hard and improve the company.
Instead of a salary, a CEO should instead make most of their money through profit or equity. That way, the CEO will have a personal stake in the company’s success, which will help motivate them.
Thiel asserts that paying a CEO a lower salary will also motivate their employees to work harder. This is because they’ll see that the CEO isn’t just in it for the money, but has a genuine belief in the company and its ability to succeed—and employees will follow that example.
Michalowicz emphasizes that your ideal tax percentage should be enough to cover both your business’s taxes and your personal income taxes. Paying your personal taxes with your business’s money, he says, is part of the financial freedom that all business owners want. Michalowicz provides three methods for determining your ideal tax percentage, all of which are relatively simple.
Add the amount paid on your business and personal taxes together, then divide that number by your adjusted revenue. Do this using documents from the last three years to get an idea of your ideal tax allocation percentage.
Alternatively, an accountant can calculate your year-to-date personal and business tax liability, which you can add together then divide by your year-to-date adjusted revenue.
Finally, you can also add your personal income and your business’s profits together, then multiply that number by the tax rate of someone in your income bracket. Then, divide that number by your adjusted revenue to get a rough estimate of your ideal tax allocation percentage.
Knowing What Taxes You Pay
When Michalowicz refers to “your business’s taxes,” he can be referring to a number of possible taxes depending on what your business does and where it’s located. The IRS provides a list of taxes a small business might have to pay. Here’s a brief explanation of what these taxes (besides income tax) are, as well as which businesses might have to pay them:
Self-employment tax: This is a Medicare and social security tax for the self-employed, and all small business owners not subject to exemptions have to pay it.
Employee tax: A tax on the money you pay your employees, if you have any.
Sales tax: Depending on where you live and which products or services you provide, you may have to pay sales tax on each sale you make.
Excise tax: This is a group of many different taxes on different kinds of products, businesses, or equipment. Examples include taxes on motor fuel, coal, or indoor tanning. Check with your accountant to see which of these taxes you may or may not owe.
Last of all, you can calculate your ideal expense percentage quite easily—just subtract your profit, salary, and tax percentages from 100 percent. This is because, as Michalowicz stresses, his method uses leftover money for expenses, following the second Profit First tenet to deemphasize their importance.
(Shortform note: This ideal percentage is probably going to be a lot lower than your current one. David Goggins (Can’t Hurt Me) recommends that you visualize your success to ensure you continue towards this large goal and don’t get too discouraged. He says that when you visualize what succeeding will look like, you remind yourself what you’re working towards, and that it’s a worthy goal. Goggins also recommends you visualize struggles you might face while pursuing your goal and make a plan of how you’ll overcome them. This way, if you do face these obstacles, you won’t be caught off guard and will already know how to address them.)
Start to plan how you can apply the Profit First system to your own business, and how it will change the way you do your accounting.
Besides using a different bank, what are other strategies you can use to make your tax and profit savings accounts difficult to access? Try to think of three.
Find the difference between each of your current percentages and Michalowicz’s listed healthy percentages, then order them from most to least different. What does this list suggest is the least healthy part of your business? What in this list surprises you most?
Find the difference between each of your current percentages and their ideal counterparts, then order them from least to most different. Where are you putting too much money? Too little? Does your experience running your business suggest you’re putting too much or too little money in those places?
Decide what you’ll prioritize when first reallocating three percent of your income: profit, your salary, tax, or expenses. Explain your answer.
Once you’ve found your ideal percentages, Michalowicz says you shouldn’t try to match them too quickly—if you allocate too much money away from expenses right away, you’ll often end up without enough money to keep your business running.
This chapter will explain his methods for setting up a pattern of sustainably moving towards your ideal percentages by gradually changing how you spend your money. Michalowicz provides several techniques and financial habits which will help you accomplish this.
First, Michalowicz suggests that when you change your current percentages to meet your ideal percentages, you start by only changing three percent. Subtract three percent from a percentage currently higher than its ideal, and add it to a percentage currently below its ideal.
Make this three percent shift in your allocations right as you’re setting up the Profit First method. After that, set out to make another shift towards your ideal allocation percentages every quarter. Reallocate more if you think you can, and less if you’re in particularly dire financial straits. What’s most important is that you continue to get closer to your ideal percentages over time.
(Shortform note: While you might want to reallocate a large percentage of your income right away, you shouldn’t immediately do so—Michalowicz claims that by only changing three percent at a time, you’ll be more likely to stick with your new percentages. Clear agrees and further explains why this is the case in Atomic Habits. He asserts that people have an easier time sticking with easier behaviors, and so smaller changes are better when forming new habits.)
Now that you have a sense of what percentage of your income you’ll be allocating to each of your new bank accounts, Michalowicz outlines several routines and habits for allocating your income easily and consistently. Following these habits means you’ll never be caught off guard by how much money you do or do not have, and can clearly see where your money is going when. Michalowicz recommends you follow three habits when conducting your business’s accounting throughout the year.
(Shortform note: The following habits allow you to automate your accounting, which David Bach says is crucial for financial stability in The Automatic Millionaire. Bach explains that if you automatically divide your income when you receive it, then you won’t even consider the money you put into your savings spendable and won’t have to make the (often agonizing) decision of whether you should spend or save it.)
Create this habit by allocating your income to your other accounts and paying your bills twice a month on two specific days—one in the middle of the month, and one at the end. Paying bills twice a month helps you keep track of when in the month you’re spending more or less of your money. It also means your expense account balance will more consistently reflect your available money.
If you can’t pay your bills regularly in this way, it’s an indicator of serious financial trouble and you’ll need to cut your expenses (more on this later).
(Shortform note: If you have less money than you thought you would when paying your bills consistently, that could be a sign that your business is experiencing cash flow issues. Often, businesses have cash “trapped” in inventory or in accounts receivable. They earn the revenue required for their business to work, but they have trouble actually receiving this revenue as cash on hand. By maintaining the habit of allocating income and paying bills bimonthly, however, you’ll avoid being surprised by this issue again.)
The second habit MIchalowicz recommends is taking half of the money in your profit savings account for yourself at the start of each quarter. Leave the other half in the account. If your business has multiple owners, then divide half the money in the profit account as appropriate amongst them. Keep the money you take out of your profit account for yourself—don’t reinvest it into your business. (Shortform note: If you don’t want or don’t need all this profit for yourself, don’t automatically plan on reinvesting it into your business. Instead, consider giving some of the profit distributions to your employees by setting up a profit-sharing plan as part of their retirement fund. An estimated 19 to 23 percent of U.S. businesses do so.)
This habit helps keep you financially stable in two ways: First, by only taking profit once every quarter, you won’t be accessing the profit account frequently and therefore will be less tempted to misuse the money in it. Second, since you’re only taking half of the money in your profit account, you’ll have cash on hand at all times to run your business in case of an emergency. Even if your income sharply drops, this money ensures that your business can still survive for a time, so you won’t panic.
(Shortform note: You might be concerned that by making a habit of withdrawing money from your profit account, you’ll be more tempted to take money from it when you shouldn’t. However, Gretchen Rubin (The Happiness Project) claims that planned exceptions to your personal “rules” won’t weaken your good habits. Rubin explains that an exception planned ahead of time, like the habit of withdrawing profit quarterly, has a clear starting and stopping point which helps you clearly define when the behavior is allowed and when it isn’t.)
Here’s around how much time a given profit allocation percentage will buy you annually, should your income suddenly drop to nothing:
Note that by doubling your profit percentage, you’ll buy more than double the amount of time. Michalowicz explains that this is because the reallocation not only builds a bigger emergency fund, but also lowers your expenses. (Shortform note: You might be confused by Michalowicz’s advice to put half of your profits into an emergency fund, since many financial experts would call such an emergency fund a reinvestment of your profits—something Michalowicz strongly advises against throughout the book. You can avoid this confusion by interpreting Michalowicz’s definition of “reinvestment” as “putting profits into growth or expenses.”)
When you use the above habits, the only additional accounting step to manage at year’s end is taxes. Pay your taxes using money you’ve allocated into the tax savings account. If there isn’t enough money in the account to cover your taxes, chances are you either weren’t diligent enough in estimating your tax liability throughout the year, or your tax percentage wasn’t high enough. If you don’t have enough to pay your taxes, Michalowicz says you can take money from your profit account to cover the difference. He emphasizes that you shouldn’t make a habit of this, though, and should prevent the same mistake from happening again by adjusting your tax percentage.
(Shortform note: If you’re still unable to pay your taxes even with the money in your profit account, don’t panic—the IRS is willing to work with people unable to pay their taxes, through both long-term and short-term payment plans. Remember, though, that maintaining proper financial discipline is crucial when working with the IRS so you can avoid legal consequences.)
Once you’ve made your bank accounts, found your ideal percentages, and created your income allocation habits, you can start focusing on using the Profit First method long-term to improve your financial stability and profitability. In this final part of the guide, we’ll explain how to improve your business by cutting expenses and increasing efficiency. Then, we’ll explore how to maintain your financial stability by avoiding common mistakes Profit First entrepreneurs make and by adopting the Profit First method for your personal finances.
In this chapter, we’ll look at Michalowicz’s recommendation for how to cut expenses. He explains that as you increase your profit percentage, you’ll need more money available for your profit allocation. However, he emphasizes that increasing your income is not how you should get this additional money, because cutting expenses is a faster, easier, and simpler way to make money available.
(Shortform note: You might think that calling expenses simple to cut here conflicts with Michalowicz’s earlier claim that many entrepreneurs have difficulties cutting their expenses. In that case, Michalowicz is talking about the emotional difficulty of getting rid of what you’re used to in your lifestyle and your business. He’s also explaining that there’s a delay between when you cut an expense and when you actually have more income available to spend, since expenses are often a part of longer agreements or contracts. When improving your business this delay can be worked around, but when your business is unstable and growth-centric then cutting expenses can’t get you fast cash to save it.)
Michalowicz recommends four methods for cutting your expenses, all of which center around determining what your business needs and getting rid of what it doesn’t.
Michalowicz first suggests finding the costs you don’t need, and then cutting them. He recommends you cut 10 percent of your expenses immediately after starting the Profit First method, and even more than that as you continue on. Starting with a 10 percent cut is a good way to ensure that you’re consistently able to spend less of your income on expenses each quarter. This is because cutting an expense doesn’t immediately get you all of that money back, but instead means that less of the income you earn going forward will need to go into expenses and can instead be reallocated.
(Shortform note: Throughout this chapter, Michalowicz is working on the assumption that your business has expenses that are far too high. However, if that doesn’t describe your business, then you might not need to make the sweeping cuts that Michalowicz recommends here. That being said, these methods still might allow you to find some places where you can save money.)
When deciding where to cut costs, the key question you need to ask yourself is: Which expenses are necessary for keeping my business running and making my clients happy? Michalowicz creates five steps for applying this standard to your business’s expenses:
How Best to “Tidy Up” Your Expenses
If you’re having trouble identifying unnecessary expenses, try using the practical techniques Marie Kondo recommends for determining the things you do or do not need. Kondo offers two guidelines in The Life Changing Magic of Tidying Up which can be particularly useful to identify cuttable costs.
Discard in one go: When you’re going through the process of getting rid of what you don’t need, Kondo recommends that you get together everything you have and work through it all in one go. This doesn’t necessarily mean you have to do it all in one sitting, but you should work to declutter as much as you can until it’s done, rather than only doing a little at a time. When you declutter in one go like this, you keep up your momentum and don’t drag the process out over a long period of time. To use this with your business, use all the time you have available to assemble your list of expenses and keep, improve, or remove them until you’ve reached your current goal.
Sort categorically: Kondo recommends that you sort what you’re decluttering by category, so you’ll have an easier time noticing what you have too much of. In your business, organizing your expenses by category will help you notice which are redundant and can be cut.
- For example, when you sort your costs into categories you might realize how many online subscriptions you’re paying for, and then can cut those costs.
Labor costs are a kind of expense, and Michalowicz’s second expense-cutting method involves managing them just like your other expenses—in other words, thinking about your employees within the “keep, improve, or remove” framework. (Shortform note: When considering which employees to “remove,” Michalowicz emphasizes that you act decisively, fire who you need to, and then ensure your other employees that their jobs are secure. This allows you to keep morale and satisfaction up amongst your employees, which research suggests directly contributes to customer satisfaction.)
In order to determine each employee’s categorization, Michalowicz recommends examining two points: how efficient your employees are and how many employees you need.
Often, cutting labor costs means getting better work done for your money rather than just firing employees—“improving” the expense instead of “removing” it. When managing your labor costs, Michalowciz suggests you first make sure that you and your employees are working effectively. He offers three different guidelines for this.
Michalowicz recommends that as you manage your labor costs, consider the kind of work you’re doing—are you able to take on more work, instead of outsourcing it? Keep in mind that you should be doing the work of an employee when your business is small, and will slowly transition towards doing big picture organizational work as it grows. Don’t delegate all of your daily operational work to your employees early on—if you do, you’ll be paying someone else to do work that you could still be doing for your existing salary.
When managing the labor your employees do, Michalowicz advises that you make sure the way you want your business to run is clear to your employees. As an entrepreneur, you have a good idea of how best to do the daily work your business requires. Write it down, creating instructions or guidelines to help your employees do their work the way you want them to.
Finally, go through the roles and responsibilities of each of your employees and determine which are not necessary for running your business or keeping customers happy. If an employee’s role doesn’t do either of those things, then Michalowicz says they need to be reassigned or fired.
Efficient, Cohesive Labor
While Michalowicz offers individual methods for making your existing labor more efficient, Peter Thiel (Zero to One) argues that you need a specific mindset to truly get the most out of your labor—one where everyone is excitedly pursuing a shared goal. Thiel explains how to ensure you and your employees have a shared goal, as well as how these goals can benefit your business.
Maintain focused leadership: When you’re considering how to balance your entrepreneurial and employee responsibilities, Thiel advises you to think about your overall goals for your business, and to make sure that your large-scale entrepreneurial plans match up with your practical, day to day business goals. By making sure the two align, you’ll keep a consistent strategy that will be clear to you and your employees, which is important for making sure everyone is doing the work you want them to.
- For example: When planning his business strategy, Steve the entrepreneur decides his goal is to provide quality products to a select group of clients. However, when running his business day to day, Steve’s goal is to get more customers in the door. Because these two goals conflict, Steve is going to get in his own way–his high-quality products will limit his ability to sell to lots of customers, and catering to as many customers as possible will limit his ability to operate in a profitable niche.
Hire full-time: Thiel also says that hiring mostly full-time employees will help you better systematize your labor, for two reasons: First, employees working full time will quickly get used to how your business runs, as well as the work you want them to do. Second, they’ll all be more invested in helping your business succeed in the long term, since they stand to benefit more from its success.
Clearly divide workload: When determining the roles necessary for your business, ensure that each employee has their own clearly defined role separate from everyone else’s. Doing so prevents redundancy in your labor, and helps you better evaluate your employees, since you can more easily identify the specific work they are doing. In addition, having clearly defined roles will prevent competition among your employees, which focuses them on the common goal of helping your business succeed (rather than the goal of being better than a rival, for example).
In addition to methods of ensuring your labor is efficient, Michalowicz recommends you save on labor costs by using your adjusted revenue as a guideline to determine the number of full-time employees you should have. By basing your employee count on your adjusted revenue, you’ll ensure you don't spend too much money on payroll, while still having enough employees to complete all the work your business needs.
Michalowic advises that your business should generate 150k to 250k revenue for each full-time employee you have. This number also varies depending on how much you pay your employees and how much revenue a single employee generates—a business in an industry like tech which needs highly skilled laborers will generally have higher labor costs compared to its adjusted revenue, for example.
Further Managing Your Labor Costs
Michalowicz cites Gregory Burges Crabtree’s Simple Numbers, Straight Talk, Big Profits! for this ratio comparing labor costs to revenue. However, Crabtree also suggests that thinking about labor costs just in terms of how many employees you should have doesn’t guarantee efficiency, since it doesn’t take into account how much you should be paying each employee.
To properly manage every aspect of labor costs, he says, you need to determine the maximum amount you can spend on payroll. By setting a limit, you’ll spend money on employees more efficiently and effectively—an argument similar to the Profit First tenet of doing more with less. Below, you’ll see the five steps he outlines for how to find your own salary cap, as well as an example business’s salary cap.
Start with your total revenue from the last year. (Example business has a total revenue of 1 million.)
Multiply this number by your ideal profit percentage. (Example business has an ideal profit percentage of 10 percent, so it calculates:
Subtract the result from your total revenue. (Example business calculates:
Subtract all non-payroll expenses from your result, including your own salary. (Example business spends 400,000 on non-payroll expenses, so it calculates:
The result is the maximum amount Crabtree says you can spend on payroll. (Example business has a salary cap of $500,000.)
Michalowicz recommends that you reframe the way you think about your monthly expenses—as an individual piece of your business’s finances that will change over time, rather than as a static amount that must come before everything else. This will make it easier to recognize and accept which expenses need to be cut.
To reframe your expenses, he advises that when determining how much money you need to keep your business running, don’t just calculate your monthly expenses. Instead, calculate the income you’ll need each month to pay yourself a consistent salary, keep your profits up, and pay expenses. This way you still know how much money you need to keep your business running, but won’t put expenses as your first priority.
Don’t Forget About Cash Flow
Michalowicz’s suggestion to frame expenses in terms of income needed could potentially be less effective for ensuring you can pay your bills each month, depending on your cash flow. Remember that there’s often a lag between earning income and having that income as cash on hand.
- For example, you might be receiving cash on delivery, or be waiting for your client’s payment to go through.
By framing your expenses as the amount of cash on hand you’ll need each month to pay the bills, you’ll be planning around this lag. However, if you’re using Michalowicz’s recommendation and only thinking about income needed each month, then you can end up in a situation where you’ve technically made enough income to pay your bills but don’t yet have that income available to you as cash on hand.
When you do your accounting this way, you can also check on your business’s financial health just by checking your salary deposits into your personal account. This works with an existing habit, as just about everyone checks their personal bank account balance regularly. Here’s how to recognize how much income you need by checking your personal bank account:
Fully Gauging Financial Health
While Michalowicz suggests that this process will allow you to gauge your business’s financial health, many financial experts would argue that it can’t fully do so. Determining your income via your personal bank account will help you understand how much money is coming into your business, but it won’t help recognize where that money is—or needs to be—going. To get a full picture of your business’s financial health, experts recommend consulting your financial documents, with the help of a bookkeeper or accountant if necessary. These documents will help you understand things that a bank balance can’t, like how quickly you turn over your inventory or how much money you need to pay interest on your business’s debts.
The last method of expense cutting Michalowicz outlines is using the Profit First method to eliminate interest from business debts. (Shortform note: Most of Michalowicz’s cost-cutting methods already assume that your business is in debt, and that’s a fair assumption to make—one recent study shows that 79 percent of all US small and medium companies are in debt, and that 58 percent of all US small and medium companies are over $50,000 in debt.)
Your first priority when paying off debt is to find a way to make your expenses less than your current adjusted revenue. You can’t compromise on this, because if you do you’ll just continue to increase your debt. Reduce expenses using the “keep, improve, remove” method we explored at the beginning of this chapter, and be particularly vigilant in checking and rechecking them for ways you can save money. Continue to cut expenses until your expense allocation percentage is 10 percent below the typical percentage for a company of your business’s size. This extra amount cut is a safety net, just in case you need to take back a few expenses to keep things running.
Where to Cut Costs Quickly
The extensive cuts recommended here might leave you overwhelmed, and wondering where you should look first for money to save. In a situation where you’re looking for expenses to cut, experts suggest that most businesses can start by cutting administrative costs. Specifically, they recommend you improve two different components of your business-wide organization, which will eliminate unnecessary costs.
Improve communication: Improving communication throughout your business will allow you to save money, especially as you grow. This is because better communication makes it easier to spot redundancy in roles, tasks, or purchases—redundancies that are very common in larger companies.
- This could include something as small as making one company-wide purchase of paper instead of having different departments or employees making their own individual purchases. Or, it could include something as large as better circulating financial reports and analyses to prevent redundant research and make sure everyone knows the same information.
Streamline management: By streamlining your management, you can ensure there’s no redundancy in the supervision of your employees. If you’re confident in the abilities of your employees and they don’t need to learn any new skills, then they probably don’t need close management. Experts recommend that each year the work of your employees stays the same, you should reduce time spent managing them by 10 percent.
While in debt, cancel any and all automatic payments. You need to know exactly how much you are spending when and to be critical of every single expense you make—every expense paid will be a conscious decision. Cancel all automatic credit card charges (you can do this by getting a new credit card with a new number from your bank), stop all automatic withdrawals from your accounts, and pay with checks instead.
(Shortform note: While Michalowicz advises you to think about each expense you make, you might be wondering how to do so effectively. Dan Ariely recommends in Predictably Irrational that you pause before buying something and ask yourself several questions. He advises you to ask yourself how your preference for this purchase started, if the purchase is worth the time and money you spend on it, and if there’s a better way you can spend your money. Answering these questions allows you to rationally think about your behavior and recognize if your purchase is due to a habit or due to what you genuinely need.)
Once you’ve applied the first two methods to make sure you aren’t taking on any more debt, then you can start paying off your existing debts. Michalowicz outlines two guidelines you should follow while doing so.
When you take out half of the money in your profit savings account each quarter for your personal use, 99 percent of that money should go towards paying your debts. Keep one percent for yourself so you can still feel rewarded for your success. Doing this keeps you from spending your tax money or salary on debts and further incentivizes you to keep your business stable and profitable.
Pay your debts in order from smallest to largest, rather than by interest rate. Pay minimums for all other debts, and use what’s left to pay down the smallest one. This builds confidence in your ability to pay debts and makes paying them all off seem achievable.
Like much of the Profit First method, this emphasizes how the average person thinks over what’s the most logical. Paying your highest interest debts first makes more sense logically, but starting with your most daunting debts is far more likely to lead to you giving up. Instead, prove to yourself that paying back debt is possible and you’ll do so more consistently.
Practical Guidelines for Paying off Debts
While Michalowicz explains how to approach the process of paying off debts, you might still want practical advice on how to manage your finances while doing so. Dave Ramsey provides some practical tips in The Total Money Makeover—specifically, he explains how to prioritize debt payments in your finances, as well as how you can get started paying your debts.
1) If you have absolutely no cash on hand to start paying off even your smallest debt, then Ramsey emphasizes that you need to start selling your possessions. You’ll have to make sacrifices, but he says it’s all in service of having financial stability as well as the things you want in the future.
2) In contrast to what Michalowicz recommends, Ramsey advises that you use more than just your profits to pay off your debts. In addition, he suggests you stop contributing to any retirement funds (like a 401(k)) and use that money to pay off debt. This is because debt has to be your first priority—focusing completely on paying off debt over a few months means you’ll be better off financially than if you’d paid less debt off while still contributing to your retirement account. However, Ramsey does concede that if you’re likely to be in debt for over 18 months then you should keep making contributions, since you won’t be able to become debt-free in a short amount of time.
3) Finally, Ramsey suggests that maintaining an emergency fund should take priority over paying off debt. This means that if you have to use money from your emergency fund, you should fill it back up before you continue to pay off debt.
Michalowicz explains that, in addition to cutting expenses, you should also improve your business by increasing efficiency everywhere you can. In this chapter, we’ll cover his advice on how to do so by seeking innovation and focusing on your most profitable services and clients—all of which is in service of specializing in what your business does best and getting even better at it.
To make your business more efficient, you should always be looking for ways to improve via simplification, organization, and innovation. With the Profit First method, your limit on expenses forces you to find ways to do more with less. In other words, you’ll look for ways to earn more profit while using less time and money. (Shortform note: You might be wondering why working with less will help you be more creative. According to creativity coach Coleen Chandler, constraints like limited money spark creativity because they force us to approach problems in ways we aren’t used to, and being in new situations helps us think of new ideas.)
Michalowicz recommends three mindsets to accomplish this: Don’t just think small, solve a unique problem well, and push sales after you adopt an innovation. Let’s explore each mindset, as well as how they can lead to innovation.
Most ways you can innovate or improve your business come from questioning your assumptions about how your business has to run. These kinds of assumptions are in every part of a business: how your employees should do their work, how your product should be made, and how you should find new clients. By questioning each of your assumptions, you might find that one isn’t actually the best way to run your business, and that you can innovate on it to save money.
In other words, don’t just think about little ways to save a few dollars here and there—consider how you might change major parts of your business to increase profitability. Larger parts of your business rely on many more assumptions and will increase efficiency a lot more if innovated upon.
How to Come Up With Big Innovations
Coming up with large-scale innovation can be difficult, as it requires thinking creatively on-demand. In his book The Magic of Thinking Big, David J. Schwartz offers several concrete guidelines for finding large-scale innovations in your business.
Never assume the impossible: Schwartz explains that when you declare something is impossible, you’re focusing on the negative instead of the positive, which prevents you from being creative. When you believe you can do something, though, then he says that your brain will get to work thinking about different ways you could potentially accomplish that task.
Embrace different ideas: Don’t reject ideas simply because nobody has tried them before, or because they are “simply not the way things are done.” Instead, think to yourself about why that idea might work or might not work. Again, doing so will allow your mind to think about new ideas, rather than just getting stuck on negatives.
Ask questions and listen to others: Other people might have ideas that you wouldn’t otherwise think of. And even if those ideas ultimately don’t work, they will still take your brain in new directions, helping you be creative.
Look for new sources of stimulation: By varying up your routines and experiencing new things, your mind will become better at processing and coming up with new ideas. These new sources of stimulation should come outside of your business’s field, since you’ll find more ideas you haven’t previously experienced there.
Michalowicz says you should innovate your business to try and make it the best at solving a specific problem. This way, you’ll become the business that every client with that problem will want to buy from. He recommends you find the unique problem you can solve for your clients, and then focus your efforts on innovating that specific aspect of your business.
(Shortform note: Michalowicz suggests that once you find the unique problem your business solves, you should continue to build your business around solving that problem. However, business consultants Ken Blanchard and Sheldon Bowles argue in their business parable Raving Fans that the demands of your customers will change over time. Contrary to Michalowicz’s advice to build on one solution, they suggest you should be ready to alter your product or service to keep your customers satisfied.)
Michalowicz explains that the specific problem your business solves—and what your business specializes in—should align with your most profitable service or services. Specialization reduces the time and money spent on a given sale by narrowing your focus on fewer, more consistent tasks. Additionally, focusing on your most profitable services will help you keep your margins high.
Chances are, you’ll find that a vast majority of your profit comes from a small minority of your services. Find out which of your services generate the most profit and focus on innovating and improving your ability to offer them. If one of your services breaks even or is unprofitable, spend less time and money on it or cut it altogether.
(Shortform note: If you’re having trouble understanding how you might find your most profitable services, consider reframing it as the process of cutting services that are only useful in specific, exceptional circumstances. Often, companies will spend disproportionate amounts of money on offering complex and niche services just in case a client asks for them. These services are inefficient because they require extra specialization for something that doesn’t bring in a significant amount of revenue. To find your most profitable services, look for those that seem to be the most useful to and used by your clients.)
In addition to focusing on profitable services, Michalowicz emphasizes that you should pick and choose clients who are the easiest to work with and bring you the most profits. He cites a study that says that the top 25 percent of your clients will bring in 150 percent of your profit: The middle 50 percent merely break even, while the bottom 25 percent of your clients will actually cost you 50 percent of your profit. This is because the study also found an average business will be spending the same amount of resources on all of these groups, even if they generated much less revenue.
Because of this, you should specialize your business to focus on your most profitable clients. This will attract more clients like them, and you’ll naturally be inclined to better serve clients you get along with who are profitable for your business. If you have a client who isn’t working well with you and isn’t profitable, you should drop that client. It might go against your instincts to give up on a sale, but a bad client will slow you down, increase your expenses, and cause you stress, so dropping them is a smart financial decision. Your goal with the Profit First method isn’t to maximize sales (as doing so means taking on more expenses), but instead to maximize the profits from your sales.
How to Focus on Profitable Clients
While Michalowicz recommends you focus more on profitable clients, you might be wondering what practical steps you can take to do so. The management consultancy Strategex, who conducted the client profitability study Michalowicz cites, recommends that you focus on profitable clients by taking practical steps in these two areas of your business:
Delivery: Strategex recommends that your business delivers services and products to profitable clients before anyone else. When you do this, your business will better satisfy its profitable clients and be more likely to keep them. This means it will take longer to deliver to less profitable clients since they’ll be a lower priority, but that’s acceptable—even if you lose them, it won’t be too harmful to your business.
- For example: A paint factory that receives a massive order for their typical products from a consistent client should focus on completing that order first before worrying about smaller or more specialized orders from other clients.
Sales: Strategex also recommends that you spend the majority of your sales time making calls to potential new clients that are profitable, and cut the time you spend calling less profitable clients to keep the overall hours spent on sales the same. This will make you more likely to get sales that will be profitable and benefit your business, while also spending less time trying to sell to unprofitable clients you don’t want anyway.
When you find an innovation or way to make your company more profitable, you should push sales hard right after. Implementing innovation to become more profitable will increase your margins, but only for a limited time. Eventually, your competitors will discover and implement your innovations, meaning you’ll have to lower your margins to stay competitive. To make the most profit, then, you should push sales while your margins are higher and push for innovation when they are lower.
Adding Extra Customers
You might be wondering how you can quickly increase your sales during these high-margin periods following new innovation. Business education professor Josh Kaufman offers several guidelines you can follow to make sure your marketing brings you additional customers in The Personal MBA.
Market to people already interested: Kaufman argues that advertising to people currently uninterested in your product isn’t effective, so your business shouldn’t bother trying to bring in that demographic. Instead, he says, target people who have already shown interest in your offer, or in an offer similar to it. Your marketing will have a higher chance of turning these people into your customers, because their existing interest means they’ll be more likely to pay attention to what you’re saying.
Keep it short: When marketing to these interested potential customers, Kaufman explains that your messaging to them should be short, so as not to lose anyone’s attention.
Use endorsements: Look for someone your potential customers like or trust, and have them endorse you. By doing so, your potential customers will associate (consciously or unconsciously) those positive feelings with your product or service being endorsed, which will make them more likely to become actual customers.
Keep it positive: Make sure your messaging emphasizes the benefits of your product or service. By doing so, your potential customers will start to feel like they are missing out if they don’t buy from you, which will convince many to become actual customers.
Using Michalowicz’s standards for cost cutting and improving efficiency, determine where and how you might be able to improve your business.
Add up the cost of all of your unnecessary expenses labeled “remove.” How much money will you save by cutting these?
Divide your adjusted revenue by your number of employees. How much revenue do you make per employee? Do you have employees who earn your business more or less revenue than that?
What is the unique problem your business solves for your clients? If there are several, list them all here.
List any products or services your business provides that do not help you solve this unique problem for your clients. Can you scale back or cut these? Explain your answer.
If you stick to the guidelines the Profit First method uses, you should have a relatively easy time maintaining stability and profitability in your business. However, Michalowicz notes that there are some common misunderstandings entrepreneurs have about the method, which can lead to mistakes in financial decision making. In this chapter, we’ll explain the three most common mistakes entrepreneurs make when using the Profit First method, the misunderstandings that cause them, and ways you can avoid making these mistakes yourself.
(Shortform note: When discussing potential mistakes, Michalowicz emphasizes that the biggest danger to your business once you’ve established the Profit First method is you returning to your own bad habits. If you do return to a bad habit, though, it’s important that you avoid shame—the feeling that you’re a failure, or that there’s something wrong with you. Research suggests that people who experience shame are more likely than those who don’t to indulge in their unwanted habits.)
The mistake: Cutting costs by reducing the quality of products or services. Doing so harms your business’s ability to make customers happy, which is one of an entrepreneur’s top priorities. This can occur when an entrepreneur misunderstands the Profit First method’s emphasis on cost cutting, and focuses on short-term savings over long-term efficiency.
While reducing the quality of your products or services saves money in the short term, it will ultimately harm you later on. Instead, cut expenses by finding ways to produce and deliver your products and services more efficiently, even if it might require a short-term expense.
How Customers Perceive Quality
Michalowicz’s argument that reductions in quality will decrease customer satisfaction seems like common sense. However, research indicates that the relationship between product quality and perceived quality isn’t as simple as you might think. Depending on the product, there can be a significant lag between when quality decreases and when consumers actually notice it decrease. This gap can be anywhere between a year to a decade, so keep in mind that your quality decreases or increases could take a long time to be reflected in customer satisfaction.
There are also studies that suggest that consumers’ perception of quality is influenced by far more than the product itself. For example, one study indicates that consumers assume higher priced products are higher quality, even when that might not be the case. Because of the influence things like price have on perceived quality, it’s possible that a decrease in your product quality could be “covered up” by other factors, or that an increase in quality might not be noticed because of another factor like price.
The mistake: Using previous tax estimates to determine money needed for this year’s taxes. This will often lead to not having enough money to pay taxes. This mistake occurs when an entrepreneur using the Profit First method doesn’t recognize that as they increase their profit allocation percentage, they will have more taxable income and their taxes will increase.
To avoid this mistake, recalculate your tax liability every quarter, so that your estimates will accurately represent your newly increased profits and you can plan to allocate an appropriate amount of money to paying your taxes.
Keeping Profits High and Taxes Low
Michalowicz acknowledges that because his system will increase your profits, it will also increase the amount of taxes you’ll have to pay. However, there are a number of ways you can minimize your taxes, despite having more profits than before. There are three common methods for doing so:
Long-term capital gains: Long-term capital gains are defined as money made from selling any asset you’ve held for more than a year, and can include things like bonds, real estate, or cars. The United States taxes long-term capital gains at a flat rate, rather than at the rate appropriate for your overall income.
Appropriate expense deductions: As an entrepreneur, there are also a number of expenses you can classify as part of your business, making them tax-free. Examples of this include equipment for your home office, or even a portion of your home internet bill if you use the internet for business purposes. It also can include travel costs, business lunches, or even dry-cleaning bills on clothing you wear to client meetings.
Hiring a family member: In some circumstances, hiring a family member can reduce your tax liability on the money you pay them. Different taxes may or may not apply to certain family members, so be sure to consult an accountant or the IRS website.
The mistake: Increasing expenses or salary based on the income of an above-average month. Because the Profit First method is percentage-based, the amount of money going into your accounts will fluctuate as your income does. However, increasing your costs or salary in response to an above-average month will often leave you stuck with additional costs you can’t pay for when you hit a couple of low-income months.
To avoid this mistake, Michalowicz advises that you plan for below-average income months when calculating your expenses and salary. He recommends three methods for managing your accounting that allow you to do so.
Stay Optimistic, Stay Realistic
Michalowicz acknowledges that by planning for low-income months, you might have to temporarily suppress your entrepreneurial optimism and be pessimistic about your future. However, what he recommends can be seen as a form of optimism—specifically, what social psychologist Heidi Grant calls “realistic optimism.” Realistic optimism means thinking that you’ll succeed or things will go well, but recognizing that you’ll need to work hard to make that happen. This is in contrast to unrealistic optimism, which is the belief that you will succeed and have an easy time doing so—a belief that research suggests often correlates with failure.
Michalowicz’s guidelines in this section allow you to be realistically optimistic: By keeping leftover money in your salary account and basing your percentages on your low-income months, you’re being realistic by acknowledging that times might get tough at some points. However, by recommending you adjust your allocation percentages when your average income increases, Michalowicz is also recommending you stay optimistic. After all, this guideline involves making a plan for a future where your business finds more success.
Plan ahead to avoid making the common Profit First mistakes Michalowicz lists.
Return to your “keep, improve, remove” marked list of expenses, or just reflect on your current expenses if you haven’t yet made a list. Which expenses would lead to a reduction in the quality of your product or service if you were to spend less on them or cut them altogether? Label these expenses as “need.”
When was the last time you had your tax estimate calculated? How can you or your accountant ensure that finding this estimate becomes a consistent habit?
Find your lowest and highest income month from the last year. What’s the difference between the two? How would you manage your business differently during your lowest income month versus your highest income month?
Now that we’ve discussed how to set up the Profit First system for your business as well as the benefits it can provide, we’ll outline how you can further increase your financial stability by applying the Profit First method to your personal finances. To do so, you’ll use slightly altered versions of the Profit First instructions for businesses to: Set up bank accounts, manage your debts, and build your savings.
To be able to manage your personal finances through your bank accounts, Michalowicz recommends opening five:
Alternative Options for Personal Bank Accounting
Michalowicz isn’t too specific when talking about how you might allocate your personal income to these bank accounts. For more details on where to put specific portions of your income, you can look to Scott Pape’s The Barefoot Investor. While some of his recommendations are similar to Michalowicz’s, he also offers three specific guidelines for allocating your personal income:
Managing necessary expenses: Pape recommends you allocate 60 percent of your income to necessary expenses each month and work to keep your necessary expenses at or below that amount.
Managing unnecessary expenses: Pape recommends making separate bank accounts for unnecessary expenses—things like entertainment, pleasure, or hobbies. Specifically, he recommends you make a “Treat” account for day-to-day entertainment (like drinks with friends) as well as a “Happy” account you use to save for larger entertainment costs (like a vacation or new car). He recommends that you allocate 10 percent of your personal income to both of these accounts each month.
Managing debt and emergencies: For the last 20 percent of your income, Pape recommends allocating it towards paying off debt and maintaining an emergency fund—in Michalowicz’s system, this money would go towards your emergency and debt repayment accounts.
These are two extra guidelines Michalowicz offers for paying off personal debts like student loans, your mortgage, or credit card debt.
First, Michalowicz advises you pay your debts from smallest to largest just like you would for your business. In addition, focus on more immediate debts first before worrying about longer-term debt. Doing so helps to build your confidence before taking on larger, more intimidating debts.
(Shortform note: While Michalowicz only discusses how to pay down your debts, David Bach’s The Automatic Millionaire suggests methods that will ultimately reduce the amount you’ll have to pay overall. To do this, he advises you to negotiate with your credit card company for a lower interest rate, consolidate multiple debts into a single, low interest account, and automate your debt payments so you never miss them.)
Second, Michalowicz advises that while in debt, you should get rid of all of your credit cards except for one you use in case of emergencies. The number one priority when in debt is to avoid increasing your debt further, and getting rid of your credit cards will limit the ease with which you can do so. Set strict limits on when you can use your emergency credit card, and lower the card’s limit as you pay off its debt to keep yourself from getting into more debt should your spending discipline lapse.
(Shortform note: Getting rid of your credit cards as Michalowicz suggests will most likely lower your credit score, especially if they were accounts you’ve had open for a long time. This is because doing so can shorten your credit history, which is a component of your credit score. Michalowicz acknowledges this, but he argues that you shouldn’t worry about your credit score until you get out of debt. That being said, if you are looking for a loan in the near future and trust your spending discipline, then keeping your credit cards and not using them could be the financially healthier choice.)
Once your personal finances are stable, Michalowicz explains how you can save your money and earn more and more interest on it, as well as the benefits that those savings will offer you.
(Shortform note: While Michalowicz doesn’t specify how you should save your money, keep in mind that you have multiple options for how to earn on your savings beyond just keeping money in a bank account. Financial experts recommend you invest about 15 percent of your income. What you invest this money into depends on your financial goals and your risk tolerance, but it could include bank certificates of deposit, bonds, or stocks. That being said, this is a process best done with lots of research and help from financial advisors.)
To build up your personal savings, Michalowicz recommends you work to keep your personal costs at around the same level, even if your income increases. Doing this even just for a period of five years will allow you to put a significant amount of your money into your savings, which will start to earn you additional money through interest. Michalowicz outlines a few different ways for keeping your personal costs consistent:
(Shortform note: While Michalowicz offers practical advice for keeping your costs consistent, author J.L. Collins extends on this by recommending an overall change in how you think about money in The Simple Path to Wealth. He suggests thinking about money in terms of how much you’ll earn from saving or investing it, instead of what you can buy with it. This, he says, will allow you to better understand the opportunity costs of spending your savings—you’ll have an easier time recognizing the potential earnings you’re missing out on when you spend.)
The more money you’re earning from interest, the more financial freedom you’ll have in your personal life. You’ll find yourself having to say no to your dreams less often for financial reasons, and will have far less stress about your finances. As you get closer to financial freedom, Michalowicz says to be sure to treat yourself–you’ve earned it. (Shortform note: By reducing your stress levels, you’ll also likely be improving your physical health—research has linked high stress to increased risk of all kinds of physical ailments, including strokes, heart attacks, and chronic pain. When you’re healthier, you can enjoy your financial freedom even more.)
Using some of Michalowicz’s overall Profit First guidelines, perform an assessment of your personal finances and consider how you can keep your personal costs down.
Separate your monthly expenses into two lists: one for needs (basic food, housing, transportation, etc.) and one for wants (entertainment, eating out, hobbies, etc.).
Go through your “needs” list, and find the expenses you might be able to reduce by getting a better deal or finding a cheaper option. List them here and briefly describe how you could improve them.
Go through your “wants” list, and find expenses that don’t particularly bring your happiness or improve your quality of life. List them here and briefly describe how you can remove them.