The formula for profitability has been established for ages. Every business owner, CEO, freelancer, and entrepreneur knows it. It is even supported – scratch that, mandated – by Generally Accepted Accounting Principles (GAAP), which is enforced by the SEC in the United States and the International Accounting Standards Board internationally.
GAAP’s fundamental formula for profit is simple:
Sales – Expenses = Profit
There is just one problem… The formula hurts profitability.
Logically, of course, the formula is sound. A business must first sell in order to generate inbound cash flow. Then the business deducts the expenses utilized to deliver its product or service and to run its operations. What remains is profit. Profit, effectively, is a leftover.
While the GAAP formula makes logical sense, it ignores the fact that it is managed by people. We are, first and foremost, emotional beings, prone to ignore (or even defy) logic.
Cyril Northcote Parkinson, in his famous bestseller Parkinson’s Law, proposed that “work expands so as to fill the time available for its completion.” His theory has been generalized to state “The demand upon a resource tends to expand to match the supply of the resource.”
Arguably, money is the ultimate resource. In GAAP’s “Sales – Expenses = Profit” formula, the business owner sees the cumulative deposits (resource) from sales and has a propensity to conclude that all the money is available for expenses (the demand expands to match the supply). The new equipment purchase is justified because the money is there. A new hire starts, because the money is there. Profit? It is an afterthought. Therefore, there rarely is any.
Now consider a new formula, where a business takes profit first:
Sales – Profit = Expenses
Mathematically the formula is identical to GAAP’s. But from the perspective of human behavior, the Profit First formula is radically different. In the Profit First formula a pre-set percentage of deposits generated through sales are first allocated to profit. The remainder is used to pay expenses.
In practice, as deposits from sales come in a predetermined percentage, for example 15%, is immediately transferred to a separate profit account. The remainder is available for the business leader to run business as usual. The business owner will see his available cash (which has had the profit already deducted) and make decisions accordingly. The new equipment purchase may be delayed, or a more cost effective alternative may be found. A new hire won’t be made because the money is not there, and perhaps the entrepreneur will conclude was unnecessary in the first place.
While I have co-founded, built and sold two multi-million dollar technology service firms, admittedly they were never truly profitable. Every increase in revenue seemed to be matched with an even greater increase in expenses. Every day I checked (and still do) my bank balances. As the balances would climb and fall, so would my confidence and my spending. I lavishly incurred new, unnecessary expenses when my bank account was fat. I panicked when it was thin.
This behavior, I have found, is not unique to me. In fact, of the hundreds of entrepreneurs and business owners I have asked, the vast majority also do “bank balance accounting.” It was with this realization that I started doing Profit First for myself five years ago. That is when I applied the “pay yourself first” principle to the operations of my businesses. I became my own guinea pig for Profit First.
Every quarter since, I have posted a profit. Every business I have invited to flip the GAAP formula, has also posted a profit or, unfortunately in some cases, decided to give up the system because it put “too much downward pressure on expenses.”
GAAP offers so much more in business insights than most entrepreneurs could imagine, but it does fall short on working with an entrepreneurs “bank balance” habit. I have become an advocate for the Profit First approach to cash management, because of the one thing it does do extremely well. It works with the natural habit of business owners. And, it functions as a “plug-in” to all the GAAP accounting systems and processes I have in place. It doesn’t change GAAP, it simply sits on top.
Profit First has transformed my own businesses for the better (if you consider consistent profits, better). Admittedly, Profit First is not the panacea to all cash flow problems, but it surely makes profit a habit.
Mike Michalowicz is an entrepreneur, author, and speaker. He has written three books Profit First in 2014, The Pumpkin Plan in 2012, and The Toilet Paper Entrepreneur in 2008 and is the former host of “Business Rescue”, a segment on MSNBC’s Your Business.
The first 5 chapters of Profit First are available as a free download.