Book Review 12: Profit First

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Profit First by Michael Michalowicz is the Total Money Makeover for business. Fundamentally, it flips traditional profit accounting on its head. I agree with the author, Mike, that GAAP accounting is shit and rarely provides any insights into business health. He notes that even Enron reported GAAP profits right before it went bankrupt. There’s big money being made by big accounting firms, and that’s probably what props up the overall complexity. It is what it is, and we can do better.

What does it mean to put profit first in business, and how powerful can that be? First, let’s reframe the definition of profit with Mike’s help. Most folks would agree that to find profit, you take a business’ revenue and subtract expenses. Profit = (Revenue – Expenses).

Sure, that’s true. But that frames things in a way that isn’t conducive to optimal decision making. It positions profit as a question – is there profit? Do the math and find out – calculate revenue. Then, calculate expenses. Find the result, and then you’ll know if there is (or likely isn’t) a profit.

This frame reminds me of my SaaS sales days at Sumo.com. My mentor/manager Anton taught me, if you don’t have to ask the question, or you don’t want the answer, don’t frame it as a question! Let’s say one of my sales prospects said on Monday they’d buy on Tuesday at 10am. Tuesday morning, I’d say “Hey [prospect], see you at 10am to process the sale!”. I do not give them an out and ask “Hey [prospect], 10am still work for us to complete this sale?”. They’re more likely to see the loophole, make an excuse, and shirk the sale. Don’t let them! Don’t ask, tell.

So, don’t ask your business for a profit, tell it you have one. The profit equation then changes to…

Revenue (known) – Profit (known) = Expenses (unknown).

So the question you ask of your business is: how much can it afford to spend? Mike gives us a really nice framework to build in a known amount of profit and expenses, as seen below.

Whatever you’re making in terms of revenue, you deduct these %’s top-down. First, profit. Second, owner’s pay. Third, tax. Finally, Opex. These %’s above are called Target Allocation Percentages or TAPs. With Opex at 30% of total revenue, you’ll probably be way over this number at first. Most entrepreneurs like me look at this and think – dang, I need to make more revenue to cover my expenses! WRONG. I need to cut expenses to an appropriate size to match my business size. Focus on efficiency, everywhere you can. Cut, cut, cut.

FWIW, I think Mike goes a little overboard about negotiating every contract, buying everything used, etc… He’s not a software entrepreneur and I think taking the 80/20 here is much more useful. Negotiate the 20% of vendors that make up 80% of your expenses and then just send it with the rest. Time = money.

[Sidebar: I sometimes get confused between books like this and Total Money Makeover which appear to contradict Naval’s advice on wealth. He says to set an aspirational hourly rate and pretend it’s real. Base your behavior on the idea that you make $5,000 per hour. This suggests to me that cutting so many expenses is a waste of time. Are these compatible? Maybe you guys can tell me!]

The setup here is a framework for the treatment of a given dollar, no matter how many you’re making. If you’re not extremely careful, Parkinson’s Law creeps in. Whatever time allotted to a project, that’s the time it takes to complete. Whatever money a business makes, that’s how much money it costs to run. I’ve done it, we’ve probably all done it. We need to play offense against this tendency before it creeps in by automating profit.

To build this framework out, it’s important to establish a bank account per function. First, at one bank, create-

Income (Checking)
Owner’s Pay (Checking)
Operating Expenses (Checking)

Next, at another bank, create-

Profit (Savings)
Tax (Savings)

The cadence is simple – you reconcile income, owner’s pay, and opex bi-monthly, and profit/tax quarterly. Mike recommends doing the bi-monthly shoring up on the 10th and 25th, which I wholeheartedly agree with. Your money should be well settled on those dates before you begin shuffling.

You build a natural moat around your profit and taxes by making them savings accounts at a different bank and don’t give them much thought. Where you focus your energy matters, and in this case it’s on Income and Opex, both entirely under your control.

One question I’ve never dealt with well is how exactly to pay myself in a way that made taxes easy. I’m an owner, and I want to live a badass life thanks to my business. Mike suggests that each quarter, you should take out 50% of the profit account as a disbursement and enjoy it. It’s not for “plowback” or “re-investing” in the business. In doing so, you build a nest egg of 50% of profit, but like a true owner, get something on top of your salary.

The last rule I’ll leave you with is how to scale your team, since I also sucked at this when I ran my business. In order to hire a full-time employee, your business should have 150-250k in real revenue. In tech it’s probably slightly higher, since labor is expensive. But this is a good rule of thumb, employees should 2.5-3x their cost in value.

That’s it, that’s the system and how to run it. Sure, it gets more complicated, but you’re not here for that. Build profit into your business first, and figure out expenses second. If you can’t reduce expenses that leave you with a profit, then should you even be in business at all? You’d be better off as an employee of a healthy business with a chance to make more than mere salary. Scale or adjust your TAPs to your business and growth goals.

Lastly, be accountable to your system. I’m looking for a profitability partner, so if anyone wants to run this system on their business too, I’m all ears. Let’s share and grow together.

Team Wealth, out!