The Profit First Approach
If we take a look at human history, we can see that “business” has been a part of human societies (no matter how small they were in the old days), far longer than “paid jobs” have been. Wisdom, models, tips, tricks, plans, and ideas related to businesses are traced back to antiquity.
But the old world was isolated, and many great and unique business ideas didn’t see broad recognition and acceptance until communication and traveling tied the whole world together. Thanks to the internet, the world is now a global village. Many business ideas changed minds and adopted in other parts of the world.
It also means that business ideas and approaches to doing business have evolved. Not all are apt for every business, and some are more about how you can run a more fulfilling business than about running a more profitable business. That’s a subtle distinction that many small business owners fail to make.
The profit-first approach is straightforward at first glance.
The typical “profit” formula is:
Sales – Expense = Profit
It’s clear-cut, has been around for centuries, and it’s something that almost everyone understands. Your profit is what’s left from running your business. A great way to visualize this is by considering yourself and your business as two separate entities. Now think about sales as a pie. The business entity gets to eat first, and whatever is left is for you to eat. Sometimes, the business might be very generous and leave a massive portion for you to devour. But other times, it might hog almost all the pie down, and just leave some crumbs for you. (Or maybe you feel guilty about taking that generous slice of pie, and donate your portion back to the business because it’s begging for more!)
The profit-first approach is different. On the surface, it’s just arithmetic – an algebraic manipulation of the standard profit formula. But in essence, it’s so much more than that.
Sales – Profit = Expense
If we take the same analogy, where you and business are two different entities, you get the first crack at the pie. And that’s where all the difference comes in. Your profits are not left to the mercy of your business. Instead, your business gets to eat once you’ve taken your piece of the pie. (No more guilt!)
People who question the effectiveness of the profit-first approach claim that it’s not a realistic way of running a business. That claim is, up to an extent, correct. But running a business is more than just about profits and numbers; it’s about fulfillment and what you want from your company. And the fact is, even in the second scenario, the business entity gets most of the pie as it does in the first one. The only difference is control. The business entity is a mathematical beast and devours any numbers if you let it. In the typical cash-management approach, you do just that.
But in the profit-first approach, you tame the beast and teach it to learn to live on what’s available. The difference is that unlike the typical approach, you choose to trim your profits to keep the business well-fed in lean years and keep a decent portion for yourself when sales are good. Best to keep the business a lean machine and prevent it from overfeeding.
That’s where the profit-first approach’s nuance of money-planning comes in.
How Profit First Approach Helps Small Businesses
We won’t be discussing how the profit-first approach (as presented in the book “Profit First,” by Mike Michalowicz) exactly works, since we can’t do a better job of it, especially in a small article. But we will discuss what the implications are of taking on the profit-first approach of running your business and how it affects your life and your business’s profitability.
The profit-first approach entails creating small spending buckets, i.e., creating more business accounts (kind of like the cash envelope system for personal finances) and redirecting the funds to these separate accounts according to a rhythm. You might prefer the two-week frequency; others might fare better with a weekly schedule. Allocating to different buckets makes it easy to use the cash for its specific purpose.
The four standard buckets are profit, pay (yours), tax, and operating expenses. Now the profit bucket (no matter the size) comes first and is for a bonus, debt consolidation, or personal financial goals. Start with a small amount, compared to the other buckets, but just reversing the hierarchy gives you a powerful feeling that your business is working for you, rather than the other way around.
The owner’s pay comes second, and it’s where most business owners make one fundamental mistake: assuming the owner and business are the same. They believe the more money a business makes, the more they make. Even if that’s partly true, it creates a toxic habit of prioritizing reinvesting in business instead of getting compensated. This situation has a subtle psychological impact. Even if you’re doing it by choice, when you’re not paid enough for running your business (because you’re reinvesting part of your pay into the business), you’ll get resentful towards your own business. The need to be rewarded for an effort is embedded deep into the core of our humanity. Trying to fight it brings nothing but imbalance to your psychological relationship with your business, and resentment.
Shifting The Bottom Line
Now the two remaining buckets, i.e., tax and operational expenses, are just as important. How the profit-first approach helps small businesses (apart from its positive psychological impact) is that it makes you careful with your operational expenses. In the book, Mike Michalowicz gives a very relatable example of toothpaste. When you start using a fresh toothpaste tube, you are rather generous with it when it’s all full and fat. You spread a sizeable quantity on your brush, and even if a bit falls off, you don’t really care because you have a full tube at hand.
But when the same tube is ending, your behavior changes. Now you press the tube at a hundred different places, roll and squeeze it to get every last bit out of it. And you’re very careful with it. You only spread a measured amount on your brush, trying hard not to spill one bit.
That’s how you should use your operating expense portion of the earnings. Even if they are brutally frugal about personal expenses, many small business owners are very generous with operational costs. They believe that any money that’s going into a business is justified and that limiting it is equivalent to throttling your business’s growth prospects.
That’s exactly the thinking profit-first approach is effective against. Being as liberal as your business expenses as you are with a fresh tube of toothpaste is like spoiling a puppy. Instead, stick with a golden adage when it comes to business’s operating expenses: Give it everything it needs, but not everything it wants.
When you prioritize getting paid and profiting from business first, you will inevitably learn to take better control of your expenses. You will find ways to cut costs (reasonably) for expenses you never thought you could because you believed them to be core operating expenses. Trimming the fat is a faster road to profitability since it’s significantly easier to increase your net income by shifting your bottom line than increasing your sales.
Peace of Mind
Mental freedom is a more intangible benefit of the profit-first approach, but when you’ve spent a few years in business, this is the one you will appreciate the most. It also relates to profitability vs. fulfillment discrepancy. Some business owners have trouble splitting them apart, and they believe the more profitable their business is, the happier they would feel. But as it’s proven time and time again, it’s not true.
Instead, you need to think long and hard about what you want from your business. If the only thing you want from your business is money, then for you, fulfillment = profitability. Yet, that’s rarely the case. You might subconsciously be seeking other things, like creating a business from scratch and growing it. Or the feeling of success when you make a sale or claim a piece of the market. Your intentions might be more humanitarian deep down, and you want your products and services to impact your consumers or clients’ lives positively.
Identifying what you want from your business besides money, doesn’t just give you peace of mind, it also gives you fortitude. It helps you stick with your business and keep plowing ahead, even when life throws curveballs your way. And that’s imperative to succeed through tough times.
The profit-first approach offers a lot of tangible and intangible benefits to a small business. It might not be a perfect methodology or even an ideal formula for success, but it’s a powerful approach. Running a business is more than crunching numbers and crushing sales, and that’s something every business owner realizes sooner or later. The profit-first method teaches you the truth about business and fulfillment early by prioritizing your cut from your business’s sales over its operational needs. And that can have a powerful impact on how you see and run your business. How you budget, run operations, and grow your business. It also ensures that you don’t burn out trying to run a business that’s doomed to failure.
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