Author: Mike Mikalowitz
Profit First: Transform your business from a cash-eating monster to a money-making machine Mike Michalovicz 2014
How a piggy bank can change your life (Pay yourself first )
PProfit First : Mike Mikalowitz created his first business, a computer assembly company, “out of ambition and air” and, at age 24, was awarded the US Young Entrepreneur of the Year award. A few years later, he sold the business and launched a new company the next day. Two years later, he sold his stake in it for several million dollars.
After receiving the first check, he felt like the ruler of the world and began to overspend – he bought three expensive cars in one day, booked a luxurious tour to Hawaii for his family, and became a member of an elite club with huge membership fees. He then invested the proceeds from the sale of the company in 12 startups and waited for dividends. However, these businesses not only did not bring profit but also required constant investment. Within a year, all but one of the companies went under, and Mike found that he had spent all his savings on them. The last straw was a call from an accountant who said that Mike had back taxes.
Mike was shocked. He left his family without a livelihood, and in a year he turned from a millionaire into a bankrupt. He would have continued to feel sorry for himself if not for his nine-year-old daughter. She brought a piggy bank, which she was given at birth, and said: “Daddy, don’t worry, we have money.”
At that moment, Mike realized that the formula “Sales – Costs = Profit” does not make a person free and rich. We take out loans for business development, receive revenue, pay salaries to employees and invest the rest of the funds in the business. Often we see “live” money only when we sell a company if we are lucky and there are people who want to buy it.
Mike knew how to make money, knew how to spend it, but did not know how to save it. He created his new companies on the basis of a new principle: “Sales – Profit = Costs”. You need to take profits, and then think about how much money you can spend. This approach allows you to rationally conduct business without loans and “belt-tightening” in the hope of better times.
Financial problems: two reasons
We tend to think that big companies bring big profits. But there are not so many truly profitable companies. Most entrepreneurs barely cover costs, and some work for years in the red, accumulating debt.
Financial problems in business arise due to two opposite reasons:
• Bad sales. As long as the product sells somehow, you only have money for current expenses. But you hope that demand will rise. But instead of growth comes a recession, and you have nothing to pay the bills.
• Too good sales. You earn more and more, but your expenses also go up. You hire additional staff, and buy new equipment. Your personal needs also become different – a big house, a new car, a private school for children … It seems that this will always be the case. And here, as in the first case, there is a decline in sales. And you have no savings, and possibly debts – unpaid loans, taxes, salaries to employees.
If an entrepreneur does not have the right understanding of profit, any business, even the largest one, is just a house of cards.
Money comes to the bank account (salary, bill payment, fee), and we feel joy, we feel successful. And then we start spending money – we pay bills, we make purchases. The money is running out. We look at a zero balance, get stressed and rush to earn money in order to feel happy again for a while. Even if there is someone who is ready to buy our company, we continue to act according to the same pattern – we receive, we spend, and we end up with nothing.Pay yourself first
This behavior is common to all people – both entrepreneurs and employees. It is due to the effect of novelty – a psychological phenomenon due to which we perceive and remember the latest information.
If we continue to live check to check and stress to stress, there is little chance of getting out of debt, and not far from a heart attack. In addition, such behavior does not make us happier and does not bring us closer to the goal – the future we dream of. We often fall into the survival trap – we try to get out of the crisis at any cost – we sell low-quality goods and services; our clients are people who are unpleasant to us; we do what we are not interested in, instead of achieving mastery in our field and living the way we like.
Healthy food for business
The Profit First system (profit first) is simple and effective. All that is needed from you is full involvement and strict adherence to the rules.
Step 1. Draw a line in the sand as a sign that from this moment you begin to live differently. Promise yourself that you will run a profitable business. This is your main goal and everything else is secondary. Your business will be healthy today.
Step 2. Tell yourself that you will not scold yourself, complain and remember the past.
People who eat too much have health problems. Excessive consumption in a business also prevents it from functioning normally and making a profit.
In 2012, Coert van Ittersum and Brian Wansink published a study on the causes of excess weight in Americans. It turned out that from 1900 to 2012, the size of the average portion of an American increased by 23%, which leads to an increase in weight of 2.3 kg annually.Pay yourself first
To deal with the problem of overconsumption, you need to follow four simple principles of healthy eating that apply in business:
1. Use small plates. So you start a chain reaction – put less food on them, consume fewer calories, and do not gain (or lose) weight.
Get four “small plates” – accounts to which you will transfer money after they have arrived in the main account:
• for profit;
• for your salary;
• for taxes;
• for operational activities.
Each account will receive a fixed percentage of the amount.Pay yourself first
2. Don’t eat everything at once. Start with vegetables. They are rich in vitamins and minerals. Leave the vegetables for later – there is a chance you won’t eat them.
Always transfer money in this sequence: profit – salary – taxes – operating activities.
What to do if there is not enough money on the last account? Take from other accounts? In no case. We need to cut costs. Only in this way will the business be healthy.Pay yourself first
3. Avoid temptations. When you are hungry, you want to quickly get enough by eating a high-calorie and harmful product. However, if there are no chips and cookies at home, you are unlikely to go to the store for them. You will have to eat healthy food.
Keep your income and taxes out of reach so you don’t get tempted to “borrow”. You do not need cards for these accounts.
It is optimal if you will not see them in online banking. Consult with a bank specialist on how to do this, or open two accounts in another bank, if there is a possibility of an interest-free transfer between banks.Pay yourself first
4. Set the mode. We overeat when we are hungry. If we eat a little at a certain time, we consume fewer calories.
Determine the days when you transfer money.
It is optimal if this happens twice a month, for example, on the 10th and 25th. So you will see not a single amount of income, but what has accumulated for half a month, and get a clear idea of how much money you have and what exactly you are spending it on.
This approach will save you from the survival trap.Pay yourself first
Business state analysis
Profit First will help you make your business profitable, no matter where you are. To begin with, it is important to understand the state of the company. To do this, complete the following table.
Table 1. Assessment of the state of the business
Column “Actual information (for 12 months)”
1. Fill in the “Turnover” cell. Data on the money received (for the full 12 months) can be taken from the accounting program.
2. If you manufacture goods or work in retail, enter the cost of materials or goods (for a full 12 months) in the “Materials” column.
3. If most of your work is done by contractors, enter in the Materials column the cost of the contracted work (for the full 12 months). If you have expenses for both materials and contractors (for example, when constructing a building), enter their amount in this column.
(!) The salary of employees is not fixed in the column “Materials”.
4. If you provide services, most of which are provided by your employees, put a dash in the “Materials” column.
5. Subtract from the data in the “Turnover” column the data from “Materials”. Enter the result in the column “Real revenue”. If there is a dash in the “Materials” column, copy the data from the “Turnover” column to the “Real revenue” column. This cell shows how much money the company is actually making.
You cannot influence the cost of the contractor’s work, the prices of materials, and the purchase prices of goods. But you can manage the amount from the “Real Revenue” yourself.
Many entrepreneurs cannot effectively manage money because they do not understand the difference between turnover and real revenue.
You have a real estate agency that receives $5 million a year into its accounts. Of these, you pay $4 million to agents (contractors). So you run a company with real revenue of $1 million a year.Pay yourself first
6. Now fill in the “Profit” column. This is money that lies untouched in the bank, some of which you will later pay to yourself and your partners.
(!) Profit is not a salary or a salary supplement.
7. Enter in the column “My salary” the amount of your monthly salary for 12 months. If you have partners, this column will contain the sum of all your salaries.
(!) Salary of employees is not included in the section “My salary”, it is included in the “Operating activity”.
8. In the “Taxes” column, enter the amount of taxes paid and the money reserved for paying taxes.
9. In the column “Operating activities” add all the expenses of the company for 12 months, excluding the amounts that are already entered in “Taxes”, “Materials”, and “My salary”.
10. Double-check the correctness of the calculations. Is it true that when adding the values from the columns “Taxes”, “Profit”, “My salary” and “Operating activities”, the sum from the column “Real revenue” is obtained? If not, correct the data and calculations.
11. Fill in each column of the column based on the actual revenue of your business. Take the data from table 2.
Table 2. Optimal distribution of real revenue depending on its value in US$
Your real income is $12,000 in 12 months? Use the data in column A. If the real revenue is $600,000, take the data in column C.Pay yourself first
(!) If taxes in your country are less than 15%, anyway, within 12 months, set aside 15% to the “Taxes” account. After paying taxes and fees, transfer the balance to the Profit account. If taxes are above 15%, reduce operating costs and increase the Taxes account. Subsequently, plan taxes with a small margin (+1%).
12. Transfer the data from the “Real revenue” column to the “Actual information (for 12 months)” column. Then successively multiply this amount by the percentages from the corresponding cell in the “PF%” column. As a result, you will receive the optimal amounts for each account.
See if this data is similar to the data in the “Actual information (for 12 months)” column.
13. Subtract from the amounts in the “Actual information (for 12 months)” column the amounts from the corresponding cells in the “PF%” column. In some columns, there will be a negative result. This means that there is not enough money in the corresponding accounts. In most cases, a negative result occurs in the cells “Taxes”, “Profit” and “My salary”.
14. In the lines “Profit”, “My salary”, “Taxes”, “Operating activities”, mark “increase” (if the result in the corresponding cell of the “Over/undershoot” column is negative) and “decrease” (if the result in the corresponding cell in column “Overrun/underrun” is positive).
(!) If you are just planning your own business, there is no need to wait 12 months to apply Profit First. You have the opportunity to build a profitable, healthy company from the ground up. Start distributing real revenue from the first month in this way: “Taxes” – 15%, “My salary” – 50%, “Operating activities” – 34%, “Profit” – 1%. Every quarter, make adjustments, gradually bringing the balance of funds in the accounts closer to the optimal indicators.
You don’t have to work for a business. The business must work for you.
Profit First helps you create your dream business – profitable and doesn’t require 24/7 work.
George Morales and José Payne created Specialized ECU Repair in 2007 with the dream of financial freedom and the ability to combine business with hobby. George was into freediving and José was into aeromodelling. For two years they worked tirelessly, but there was no extra money or free time. The partners were thinking about starting to increase their salaries little by little when they heard about Profit First. They immediately put the system into practice, and four years later, the company’s turnover exceeded economists’ forecasts, the number of employees tripled with modest operating costs, and profits were above optimal indicators. George and José receive high salaries and have time not only for work, but also for hobbies. The partners realized that high turnover is not an indicator of business success. They began to take profits and optimized operating expenses as much as possible during the first year of work under the Profit First system. How to do this, read below.Pay yourself first
The year with Profit First
After completing Table 1, you know what your target indicators are (columns “PF $” and “PF%”), and see what adjustments you need to make (“Over/Under”, “Output”). It’s time to act. Here is a plan for applying to Profit First for a year.
The first day
No need to wait for Monday, the beginning of the next month, or the new year. Implement Profit First right now.
1. Warn employees. First of all, tell your accountant about your plans. Be prepared for resistance. An accountant may claim that the Profit First system is useless and even harmful. You may need to change your accountant.
George and José reviewed the state of the business with the finance department. They reacted positively to Profit First and follow this system steadily.Pay yourself first
2. Get four accounts. You will distribute the real proceeds to these accounts. Name them Profits, Taxes, My Salary, and Operations.
3. Allocate revenue to accounts. At the initial stage, it is important to create and consolidate the habit of distributing revenue across accounts and start adjusting its ratio.
Look at what indicators need to be increased (the “increase” mark in the “Output” column in Table 1). Take the data from the corresponding cells in the “Actual information (for 12 months)” column in Table 1 and increase them by 1%.
Have you set aside 5% of your real income to pay taxes? Set aside 6%.
There was no profit? Set aside 1%.
Did you spend 20% on your salary? Spend 21%.Pay yourself first
4. We reduce operating costs. Where can I get money to increase the amount in my accounts? See how much money you have in your Operating Activities account (amount A). Then calculate the amount of debt – bills, employee salaries (sum B). Subtract the amount B from the amount A. From the remaining amount, transfer 1% of the real revenue to “Taxes”, “Profits” and “My salary”.
You received $10,000 in half a month.
They planned to transfer $5,000 to the Operations account. Do not hurry.
Calculate your debt. Suppose it is $3000. There are $2000 left. From this amount, you need to subtract 3% of real revenue ($10,000 3% = $300) and distribute them to the accounts “Taxes”, “Profit” and “My salary” – $ 100 additional for each account.Pay yourself first
But where to get the missing money for operating activities? You can increase sales, but this is not a quick process. It is better to optimize future expenses.
To get started, cut costs by at least 10%:
• Reduce anything that doesn’t contribute to business efficiency and/or make your customers happier.
• Discuss any cost cuts other than employee salaries.
When big expenses come up, George and José ask themselves, “Do we really need to spend this money?” If they understand that spending will negatively impact annual profits, they refrain from spending.Pay yourself first
Allocate revenue to accounts twice a month. Let it accumulate on the “Operating Activities” account, and on the 10th and 25th of each month (you can set your own dates) or a day or two earlier, if these dates fall on weekends and holidays, you need to pay bills and transfer the established percentage on the accounts “Taxes”, “Profit” and “My salary”.
(!) If you don’t have enough money to pay your bills, you’re running a business beyond your means. We urgently need to rethink our spending.
Once a quarter
Divide the year into four parts – they must match the quarters of the fiscal year in the country where you do business (In Russia – January 1 – March 31, etc.).
1. Distribute the profit on the first day of the new quarter. You give half of the profit to the owner or distribute it among several owners depending on their share in the business. Leave the other half on your account.
(!) Never invest your profits in a business. The company must develop at the expense of operating expenses.
George and Jose know a lot about pleasure. In the four years of using Profit First, they have traveled to many different places. They gave themselves and their loved ones travel-cruises and trips to Europe and Bermuda.Pay yourself first
2. Optimize revenue distribution. Quarterly bring profits, taxes, and owner’s salary closer to optimal indicators. To do this, reduce operating costs by at least 3%.
3. Submit quarterly tax returns and pay them on time. Taxes are a priority for any business. If you go to jail for not paying taxes, you won’t be able to run a business.
End of fiscal year
It’s time to analyze the results of using Profit First and pay the bills. The company should enter the new financial year with a positive balance.
1. Settle all tax issues. Check if you have enough money for this.
• If you don’t have much money, you’ve been saving too little of your earnings. Lack of money for taxes is the case when you need to take money from the Profit account. Starting next month, the percentage of real revenue that goes to pay taxes should be increased to the optimal one at the expense of profit. You will work on increasing profits next year.
• If there is money left in the account after paying taxes, transfer it to the Profit account.
2. Pay a bonus to the owners of the company. Distribute 50% of the amount in the Profit account according to the share of each.
3. Stock up for a rainy day. In case of difficulties, it will become your own bank. The optimal amount in the fund covers all business expenses during the quarter if there are problems with sales.
4. Invest in business development. If you have money left after paying bonuses and creating a reserve for a rainy day, you can think about how to use them to increase profits later.
(!) Optimal profit indicators are not the limit. Once you’ve reached these milestones across all accounts, continue to reduce your operating costs while increasing your profit percentage.
Top 10 Thoughts
1. The formula “Sales – Costs = Profit” is outdated. You can become free and rich using a different formula – “Sales – Profit = Costs.”
2. For a healthy business, you need to follow the principles of healthy eating.
3. Real revenue is the amount you can manage.
4. The Profit First system begins with an analysis of the distribution of real revenue – for taxes, salaries of owners, operating activities, and profits.
5. Then you need to determine the optimal indicators for the distribution of real revenue and understand whether to increase or decrease this or that item of expenditure and by how much.
6. The Profit First system needs to be implemented today by notifying employees about changes and opening different accounts – “Taxes”, “Profit”, “My salary”, “Operating activities”.
7. Optimal distribution of revenue and making all payments (salary, payment of bills) twice a month on certain days.
8. Revenue should be adjusted gradually: once a quarter, reduce operating expenses and allocate an additional 3% to accounts that require an increase.
9. If at the end of the financial year there is not enough money to pay taxes, you need to take them from the Profit account. Starting next month, you need to increase deductions to the “Taxes” account at the expense of “Profits”, and increase profits during the second year.
10. Half of the profits must be distributed among the owners, the rest should be set aside for a rainy day and sent to business development, which will contribute to profit growth.