Note: This Profit First summary is one of our longer and more in-depth summaries at over 5,000 words. You can buy this summary at leading stores, or check the price and reviews for the full book on Amazon.
The typical way to work out profit is pretty simple.
Sales – Expenses = Profits
While that formula is logically accurate, it doesn’t really take into account human nature. Most small business owners look at their bank balance and make decisions based on the amount they see. What this means, is that if you’re lucky enough to have some cash at the end, you turn a profit.
However, imagine a way that you could be guaranteed a profit every year.
In Profit First, we look at the following way to do your accounts:
Sales – Profit = Expenses
Basically, you take a predetermined percentage of profit from every sale first and then use only the remainder to pay for your expenses.
- Audible Audiobook
- Mike Michalowicz (Author) – Mike Michalowicz (Narrator)
- English (Publication Language)
- 07/11/2023 (Publication Date) – Penguin Audio (Publisher)
About the Author
Michael Michalowicz is an entrepreneur and used to write about small business in The Wall Street Journal.
By his 35th birthday, he had founded and sold two multi-million-dollar enterprises before losing everything by becoming an unsuccessful angel investor.
Michalowicz soon started his third enterprise and worked to build it into a million-dollar venture. He formerly was a business make-over expert on MSNBC and is now a popular keynote speaker on entrepreneurship.
Michalowicz is the author of three books including The Pumpkin Plan and The Toilet Paper Entrepreneur. He is a graduate of Virginia Tech.
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Michael Michalowicz: Profit First Summary
Make a stand
As any small business owner can tell you, it’s not how much turnover you produce that counts. It’s how much of that money you get to keep.
It is time to draw a line in the sand and declare that from now on, you will run an active business and make everything else small compared to that goal.
All businesses can and will be improved if it uses the Profit First system.
No matter who you are, sooner or later, almost every small business runs into cash flow problems.
Even if you bring in more sales, it won’t help you if your costs grow too. The real key to making your small business healthy is profit, not only growth.
Most small business owners end up using what can be termed ‘bank balance accounting.’
Does this sound familiar? You look at your bank balance each day and decide whether or not you are doing okay.
Psychologists call this the Recency Effect, and where you look at what you have in the present and make decisions based solely and solely on that information. It feels natural to look at what we have in the bank and use that to guide our thoughts and eventually, our actions.
Sadly, even though you may have good intentions, operating your business based on how much cash you have in the bank isn’t helpful.
You end up getting caught in a Survival Trap where you limp around from one emergency to the other.
Pure and simple, the Survival Trap arises whenever you justify making money at any cost – even if that means delaying the payment of taxes or suppliers for a time.
This sum looks simple and is unfortunately what trips business owners like you up.
Sales – Expenses = Profits
Let’s call the sum above GAAP (Generally Accepted Accounting Principles). GAAP teaches you to focus on sales and expenses before anything else. If you sell enough, the logic goes, everything else will take care of itself.
In practice, GAAP is a formula for failure when it comes to building a lucrative small business.
So, decide that starting today, you will run a profitable business and make everything else secondary to that goal. Make today the day you pledge to yourself that your business will focus first and foremost on profitability.
Set up Your Profit First System
The philosophy of Profit First is you set up a banking system that aligns with the way you think and operate.
We do this by arranging four separate accounts at your bank and then distributing your cashflows among those accounts carefully and effectively.
In practical terms, Profit First is all about making your business profit-ready and keeping it that way.
To use this system, you need to make it as easy as possible and avoid all temptation.
One industry which knows all about the challenges of human temptation is the weight loss industry.
If you examine most of the plans dieters are offered, they generally boil down to four core systems.
The core systems
1. Use smaller plates – so you will naturally take smaller portions. Small portions = less calories = weight loss.
2. Serve in a sequence – eat your vegetables first because they are full of nutrients. Fill up on veggies!
3. Remove any temptation – don’t have junk food handy or accessible.
4. Enforce a rhythm – don’t eat when you’re hungry because that will make you eat more. Rather, eat small servings often.
How Profit First is like weight loss
Profit First uses the same ideas from weight loss and uses them on your business’ finance:
1. Use small plates. Instead of having one bank account, Profit First suggests you have four accounts. Your funds get dispersed into all four: A profit account, an owner’s pay account, a tax account, and your current operating expenses account.
2. Serve in an order. Funds are always put into your profit account first. From there, pay your owner’s account and your tax account. What remains is your operating expenses.
3. Remove temptation. To make it hard and painful to access some of your money, you should have your profit account and your tax account at another bank. That makes it harder to “borrow” from one account for another account, mainly if you restrict access.
4. Enforce a rhythm. With Profit First, you do your payables twice a month on the 10th and 25th of each month. You, therefore, see your cash accumulating and get a feel for where it really goes. You get into good habits rather than using a fly-by-the-seat-of-your-pants approach.
And that, in a nutshell, is the Profit First methodology. You manage your cash flows in a way which is conducive to paying yourself a profit first and foremost. Rather than being an afterthought, profit becomes the first thing you pay.
The four different bank accounts
Note especially that Profit First requires that you set up four different bank accounts:
- An operating expenses account – which will be the checking account you probably already have set up for your business
- A profit account
- Tax account
- An owner’s salary account.
It’s most helpful if you set up the tax and profit accounts at a bank other than the one you use for day-to-day operations at the present time. These can be savings accounts because they are merely holding bins for funds allocated to them. If you set them up so you can’t even view the balances online, then you have places where you can deposit funds and forget them. As strange as that may sound, having these accounts hidden from view will help your business become more profitable.
In addition to allocating funds to these four accounts, Profit First also makes you work systematically. On the 10th and 25th of each month, you:
- Pay your bills
- Move funds to the various accounts
- Get a feel for where your money really goes
Tracking your financial performance twice a month will be motivational. The other thing you should do every quarter is to pay yourself a dividend on the first day of each new quarter. You do that by taking 50 percent of the money in your profit account as your dividend. Leave the other half in your mind like a cash reserve.
As you get into the habit of taking a regular profit distribution, your thinking will change subtly. Celebrate. Spend that money on something you and your family will love. This is important because by doing that, you stop viewing your business as a cash-eating monster and instead view it as a cash generator which keeps giving to you and supporting you. Every quarter, you will fall more in love with your business if you follow the Profit First methodology.
After you’ve made a profit distribution, the balance of the funds in your profit account should accumulate until you have enough to cover three months of fixed expenses. Once you have that, start using these funds to make capital investments, which will boost your productivity.
The first obvious question in implementing Profit First is to figure out what your percentages should be for each of those accounts. The figures given are suggestions only – you have to decide for yourself what numbers make sense.
To decide what percentages you should shoot for, try this exercise:
1. First, figure out where you are right now. Enter your Top Line Revenue for the last twelve months, then deduct all payments for materials and subcontractors to end up with your Real Revenue figure.
2. Look at how Real Revenue is now distributed. You then enter your actual profit from the last twelve months, how much you paid yourself, how much tax you paid, and what your operating expenses were. Put the numbers down and then work backward to express them as percentages of your Real Revenue.
3. Compare your current distribution with the targets. The target percentages acknowledge that your allocation varies according to the stage of your enterprise’s growth. When you first start out, you are typically the only employee. As you grow and add employees, you will add systems and adjust your pay down as you become less an employee and more a shareholder. You will then likely add a management team as you grow bigger and make more from your profit distributions and less from being a hands-on employee. NOTE: The tax rate is indicative only. You may need to adjust up or down to match your actual tax rate.
4. Decide on what you need to fix. Comparing how you now allocate your real revenue with the target rates and decide on a fix moving forward. In this section, you write either “INCREASE” if you need to bump up this percentage or “DECREASE” if you need to lower your revenue allocation in this area.
Use Profit First to destroy debt and to optimize your business
Once you start to put your profit first, you’ll soon realize debt is the main challenge you face.
To remain profitable over the long haul, you have to destroy debt first and foremost in a savvy way. Once you have eliminated debt, you can then use Profit First style thinking to optimize and fine-tune your business so it will keep on generating profits in the future.
The key to successfully implementing Profit First is to string together a series of small steps in the right direction and then keep repeating them again and again. You don’t look at moving in one major overhaul but instead, make steady incremental changes.
Take your instant assessment of where you’re at right now as your starting point and start moving to where you want to be. For example, suppose your instant assessment looks like this at the moment:
Then your goals for the next quarter might be to:
- Increase profit by 3%.
- Decrease operating expenses by 5%.
- Increase owner’s salary by 2%.
At the end of the next quarter, you do another instant assessment. If you’ve achieved your goals, it will now look more like this:
Be comfortable making successive small steps heading in the right direction over a number of months rather than trying to make large, dramatic changes. Build momentum for change and keep moving forward.
It’s absolutely vital to have four different bank accounts set up rather than using one general bank account for everything. You must have a separate “Profit” account, “Tax” account and “Owner’s Salary” account. You have to transfer funds into those designated accounts on the days specified – the 10th and the 25th of each month.
Remember, you’re trying to get away from running your business on the basis of your account balance – bank balance accounting. The funds have to be moved to separate accounts or you won’t enjoy the benefits of Profit First.
And make it hard to access the funds in your profit account and tax account by having them at a separate bank. That helps remove the temptation to borrow from one account to meet a shortfall in another account. It’s only when you go to these lengths that Profit First will start to weave its magic in transforming your business from a cash eating monster to a money-maker.
How you can increase your profitability
Once you get Profit First working for you, there are now several things you can do to increase your ongoing profitability. Some suggestions:
Slice your expenses
Logically to grow your profit, you have to increase sales or to cut expenses. You should be working on both but building sales won’t happen overnight. You can, however, lower your expenses immediately by doing some simple things:
- For every expense, ask yourself: “Do we really need this?” You’ll be amazed at how often you buy things which aren’t of any value. Stop immediately.
- Look at any recurring bills you have and cancel the ones which you no longer use. There’s guaranteed to be some of those in the mix at present. Weed them out.
- Try and look for ways you can take more pleasure and enjoyment out of saving your money than you do spending your money. Give yourself a reward when you save money and whenever your profit percentage grows.
Get some emotional support
Join a group of like-minded people. You might set up an accountability group where you can gather with other business builders and celebrate the things you’re doing to save money. Come up with some fun (and ideally zany) things you can do to celebrate when you save money and then get busy having fun. Put on some loud music in the office and jump around if that gets you going. Do something memorable.
Go on a “debt freeze”
Look at all your expenditure over the past twelve months from all your business bank accounts. Excluding labor costs, payments to subcontractors and your salary, how much did you spend on other stuff?
Analyze that expenditure and highlight which expenses generated immediate revenue for you and which did not. Then commit to stop spending money on items which do not generate revenue from this point on. Freeze your debt and start working towards eliminating debt altogether.
Build a leaner team
The most expensive part of operating most businesses is labor. Evaluate your staff and ask:
- “Who are my A-players?”
- “Which roles absolutely need to stay in-house?”
- “Which roles do we no longer need to fill?”
- “Which roles could I be taking on personally?”
If you’re honest, you may well find you’re overstaffed for your present revenue level. Plan to layoff those who are not A-players or those who are filling roles you really should be outsourcing. This will be difficult and devastating but must be done to be profitable in the future.
By all means, talk to your attorney and comply with the relevant labor laws but go ahead and layoff the people you don’t need. Then explain to your remaining employees why you did what had to be done and how this action will impact the future viability of your enterprise.
Get hands-on in managing your funds
Call your bank and cancel all automatic withdrawals from all of your accounts. Also, call your credit card issuers and ask them to issue you with a new card with a new number. Tell all your vendors you will pay them each month by check on the 10th or the 25th of the month, whichever is most applicable.
Then wait and see who contacts you for new card details. If you’re like most people, you probably have recurring charges running in the background that you’ve forgotten all about. Get rid of them with immediate and permanent effect.
For all your monthly expenses which remain, see if you can renegotiate them downwards. Contact each vendor and ask what do you need to do to reduce your bill by 25% each month. See also whether other, cheaper alternatives have become available since last you looked at this.
Keep track of every expense you manage to end entirely, renegotiate downwards or replace with a cheaper alternative. This is hard and grinding work so take time to celebrate your victories along the way. Every dollar you don’t end up paying to someone else is another dollar you can put in your profit account. Enjoy.
Start a debt snowball
List all your debts, from smallest to largest regardless of interest rates. Pay the minimum on all these debts except for your smallest one. Then get to work and wipe out that first debt as fast as possible. Then you start paying off the second debt by adding the amount you were paying on the first debt – and so on.
A debt snowball creates momentum. You start small and build up to larger accomplishments over time. Just make sure you’re not adding any new debt as you work towards paying off all your existing debts.
Cutting expenses is vital for Profit First to work but the other way you can generate more profit is to build your efficiency. The three big ideas here are:
Achieve greater efficiency
Every week, focus on one part of your business and ask: “How can I get two times the results in this area with half the effort?” Don’t look for big leaps but first, try and make small gains which will add up.
Then once you’ve realized all those small gains, pause and look for any big and bold steps you can take to move forward. Ask:
- “How can I do this task significantly faster?”
- “What can I do differently but way better?”
- “What big steps forward can I take?”
Every week, focus on a different aspect of your business and challenge yourself to get two times the results for half the effort and expense. Be willing to shoot for the stars and go after some significant gains. You may or may not achieve that but if you do, it can be a game-changer.
Sell more productively
Selling productively generally requires that you figure out how to sell smarter. Learn what works for you and then embed that into a system which you use and which you can teach others. You then get busy fine-tuning and improving your sales system progressively over time.
To sell productively also means you become very good at what you do and focus on that. It’s easy to get sidetracked on tangents if you’re not careful. Put an effective sales system in place and make maximum use of it.
Duplicate your best clients
If you really want to get serious about boosting your profits, plan on firing your worst clients and then looking for ways to clone your best and most profitable clients.
The 80/20 or “Pareto Principle” applies just as validly to your customer base as it does in every other part of your business. Twenty percent of your customers will generate eighty percent of your profits. If you can get rid of your worst clients and clone your best clients, it stands to reason your profits will increase.
So how do you clone your best clients? Look for customers who have similar needs and behaviors to your best clients. Then become super-efficient at serving those specific needs. If you excel at doing this, your existing customers will bring their friends to you as well. Love your best clients and become passionate about serving them and your marketing will become automatic and effective.
Integrate some advanced techniques into your Profit First system
Once you get the basics down, you’ll find Profit First provides a good framework for taking your company to the next level.
There are numerous advanced tactics or strategies which can be added into your Profit First system. Profit First is a robust framework for growth for companies of any size and shape.
There are loads of ways you can build on the basic Profit First framework. Some suggestions:
Accountability Groups
To give your self-discipline a regular boost, join or start an accountability group. This is a group of like-minded peers who meet regularly to report to each other and to swap ideas. Just the mere fact you know you will have to report what’s happening to your friends will increase the odds that you follow through and do what you say.
Profit Pods
A profit pod is where you teach others the Profit First principles and then help them apply them. You form a group of people who are going through the same transformation and then get busy providing hands-on help to each other. The idea here is you always learn more by teaching the principles than you ever do by living them. Profit pods are also a good way to give something back.
You can start a profit pod with you and one other person if you want to. Pick someone who wants to be running and owning a healthy and profitable business just as much as you do. You then become champions for each other and build on the positives. It makes sense to hold meetings of your profit pod on the 11th and 26th of each month so you can report on your profit status and discuss any problems which have arisen. Choose a partner who will push and prod you into acting on Profit First rather than merely having good intentions.
Add more specific purpose bank accounts
The essence of Profit First is you use multiple bank accounts to manage your money better. You do that by opening three additional accounts to supplement your main operating expenses account. On the 10th and 25th of each month, you then transfer funds into the specifically designated accounts.
That works well for most situations but if you really want to take your money management to the next level, you should consider opening more accounts into which funds can be deposited. Some suggestions:
- Set up an income account
In this account, you collect all of the income deposits so you can see clearly how much cash you collect before you make your 10th and 25th allocations. Separating income from outgoings in your operating expenses account gives you a clearer picture of how much money is flowing into and out of your business at any given time. If you do this, your operating expenses account will then detail just your outgoings.
- Set up a “Vault” account
The Vault is an account which holds funds you can use for short-term emergencies. Eventually, you want to have enough money in your Vault account to meet three months of fixed expenses. The Vault should be interest-bearing and ultra low-risk. A document that you will use the Vault only in the event of no or low sales and that you will also move to cut your fixed costs in the event you have to use these funds.
- Set up a stocking or “Large Purchase” account
If you periodically make big purchases of inventory or stock, you deposit money into this account every month so the funds are available when required. That way you chip away at a big bill before it arrives.
- Establish a “Pass-Through” account
If you provide a service or product to your customer at cost or get reimbursed for your expenses outright, then this account will separate that expenditure from your business income. It handles funds which come into your business as reimbursements rather than as earned income.
- Set up a materials account
If the majority of your income gets spent on materials and subcontractors, then it is helpful to set up a materials account. This is where you gather the money which will be paid to suppliers so you don’t spend it yourself.
- Have a separate employee payroll account
If you have one of these, you take funds from your income account or general operating expenses account and use it for your employee payroll. Again, this assists you to manage cash flow because it clearly and concisely designates where those funds will be applied.
- Set up a major equipment purchase account
Similar to your stocking account, if you’re planning to make a major purchase this account can be used to track your progress. Allocate money to this account every 10th and 25th and you will accumulate funds to make that big purchase.
- Use a drip account
If you get prepaid for a major project, you deposit the funds into your drip account. Then each month, you transfer the appropriate amount into your income or operating expenses account. The drip account helps you manage the true cash flow of earned money into your business.
- Set up a petty cash account
Allocating a set monthly amount into a petty cash account will also help you track and manage how much you’re spending on small-ticket items.
- Open a sales tax account
If you collect sales tax, you’ve got to be very careful about turning it over to the government in a timely fashion. If you have an account into which you deposit the sales tax whenever you make a sale, that will ensure those funds are paid as required. You avoid the situation where you treat those funds as if they were your own.
Don’t obsess over your “monthly nut” Instead, pick your pay and work towards that
Sometimes small business owners get stressed over their “monthly nut” – the amount of money they need to bring in each month to keep the doors open. That’s a distraction because it makes you focus on expenses, not profit.
Profit First suggests if you focus on making a profit, your expenses will be taken care of by default. Concentrate on how much money you need to be depositing twice each month (on the 10th and 25th) to have a very healthy profit account surplus. Decide how you will deliver that much value to present and future customers. That is worthy of your complete attention.
Keep working the Pareto Principle
You’re already aware that 20 percent of your customers will generate 80 percent of your revenue. You’re already trying to fire your worst clients and clone your best clients to take advantage of that. Don’t forget that 80 percent of your profit will be derived from 20 percent of the products or services you offer as well.
When you connect the two, you will realize some of your top clients buy most of your profitable offerings while others go for those which are least profitable. Equally, a few of your bad clients will already be buying your most profitable offerings.
See what you can do to get those bad clients to buy more. At the same time, also see what it will take to get your best customers to buy more profitable stuff. Focus on profits first and foremost at all times and let that imperative guide your actions.
Lock in your lifestyle
Many entrepreneurs and small business owners ramp up their living costs as their profits increase. This is unhelpful if you genuinely want financial freedom. Instead, promise yourself you will lock in your lifestyle for the next five years so all the extra profit you earn can go towards achieving financial freedom.
To build as big a gap as possible between what you earn and what you spend, try these ideas:
- Whenever you want to do something, pause and look for whether there are any free alternatives available.
- Never buy any toys (like cars or houses) new when you can get the same benefit by buying used. (They will be used as soon as you buy them anyway.)
- Never pay full price for anything.
- Always negotiate and seek cheaper options or alternatives.
- Delay any major purchase until you have written down ten alternatives to making the purchase and have thought each one through.
In other words, live frugally and don’t pose as a big spender. Every time your income increases, commit to spending half of that increase (or less) and putting the rest back into savings. The faster you can grow your savings, the quicker you become financially independent.
Don’t forget to teach your kids to think Profit First
Everyone wants their kids to be successful in life.
One of the best things you can do to help your children have a bright future is to teach them to always take their profits first and then adjust their expenses to match what’s left.
A good way to do that is to get them into good habits early on. Give each of your kids five mailing envelopes and have them label each one this way:
- Envelope #1 is for the “Big Dream.” This should be to buy something big, like a horse. Have them stash 25%of their chore money or gifts into this envelope.
- Envelope #2 is for “Family Support.” Have each kid pay something every week to contribute, even if it’s just $5 a week. They need to get used to this.
- Envelope #3 is for “Impact”. Have your kids put 5 percent to 10 percent of their income into this envelope to give to a charity of their choice or to start their own business.
- Envelope #4 is “The Vault.” Have your kids sock away 10 percent of their funds for a rainy day fund. You hope they will never need this but it teaches them to prepare well.
- Envelope #5 is their “Mad Money.” They can use this to buy whatever they want and have fun.
If your children learn to always allocate their money to the different envelopes before doing anything else, they will be forming good habits which will serve them well for their entire lives and careers. It will also prepare them for the realities of the world.
Operating Expenses Account
- 15% PROFIT ACCOUNT
- 25% OWNER’S SALARY
- 15% TAX ACCOUNT
- 45% OF OPERATING EXPENSES
Our thoughts on Profit First
My Personal Takeaway
What I love about Profit First is how simple the system can be.
Obviously, the concept is straightforward, but having the ability to automate your accounts takes all the extra steps out of having to move cash around constantly.
The book is a little hard to implement from day one when you’re more than likely investing more than you’re getting in return. However, once you have some cash flow, you’re set.
Put it into action
Start by leaving even the smallest amount of profit. Even if all you can spare is 1%, then that is better than nothing. You’ll find that you can chip away at the profit you take ver time and increase it.
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