A few years ago I ran across a very interesting book, Profit First by Mike Michalowicz. The title immediately attracted my attention. At the time I was spending way too much time fighting with business owners who though fast growth was more important than sustainable profits. When I ran across Mike’s book I felt like I found an old friend who could explain why profit first was the way to go.
I met Mike at a conference recently and he graciously agreed to appear on this podcast and help us understand why profit first is really the most important thing, that is if you want to have a business that’s sustainable. Some of his ideas are ones you’ve probably not heard before. I’m going to ask that you suspend judgement and ask yourself whether there’s validity and if Mike’s ideas could be useful for you.
Some of the things we’ll talk about today are:
- Why profit first.
- Where putting money in different accounts makes really good sense.
- Start by paying yourself first (you’ve probably had that advice already.P
- Why grandma’s old system for managing personal finances makes sense for business owners.
- Why starving yourself for cash is actually a good thing for your business.
Narrator: Welcome to The Sustainable Business Radio Show podcast where you’ll learn not only how to create a sustainable business but you’ll also learn the secrets of creating extraordinary value within your business and your life. In the Sustainable Business, we focus on what it’s going to take for you to take your successful business and make it economically and personally successful.
Your host, Josh Patrick, is going to help us through finding great thought leaders as well as providing insights he’s learned through his 40 years of owning, running, planning and thinking about what it takes to make a successful business sustainable.
Josh: Hey, good morning today. How are all you folks? This is Josh Patrick and you’re at the Sustainable Business.
I’m really excited about our guest this morning. He’s Mike Michalowicz. Mike came to my attention through a book he wrote called Profit First and that’s what we’re going to talk about today. I found out he’s been an entrepreneur between three multimillion-dollar companies. He’s written a whole bunch of books which I’m sure he’ll talk about. He’s a former small business columnist for the Wall Street Journal. He’s been on MSNBC so he’s one of those guys who’s been around a lot. He has some really interesting things to say and instead of me talking about him, let’s bring him in and let him talk about it himself.
Hey, Mike. How are you today?
Mike: I’m doing well. Thanks for having me on your show.
Josh: Oh, it’s my pleasure. I’ve been really looking forward to this episode.
What do you mean by “profit first”?
Mike: What I mean is, most businesses – I think we’ve all been trained to put profit last which – we don’t use that term, we call it the bottom line or the year-end. But what I found is behaviorally, when people put things last, we play down in significance or even ignore it. One of the analogies is the kid you don’t want for the kickball team is the one picked last. Ironically, it was me in most cases. But the one you don’t want is picked last. Or if you come out of the hospital because of an illness and now you don’t make a statement saying, “I’m going to put my health last.” You should say it’s first. And so, it’s human nature to put last as insignificant or ignore but put first as the priority.
In the old business model, sales – expenses = profit. We’re saying profit comes last and sales and expenses come first. We sell and we spend. We sell and we spend. Most businesses I’ve studied, like upwards of 83% are in this trap, this cycle of selling so they can spend money to grow which means, sell more to spend money to grow, and they never post a profit. My argument is take your profit first. Sell because you have to. That’s how you make money. But then take your profit, that’s how you take money. So, sales – profit = expenses. Expenses are now the remainder. And if you take your profit first, you must find a way to run your business efficiently off of what’s left over.
Josh: Now, that’s s kind of very cool idea. So, when I read your book, you had recommended that private business owners open several accounts. Can you talk a bit about that?
Mike: This is grandma’s old envelope system. My mom did the same thing. And what my mom did is when she worked and, say, she got paid $100 for that week’s work, she would different envelopes set up at home. One was to pay for the rent of the apartment. Another one was for food. Perhaps, one was to give back to the community. She had maybe five or six envelopes.
What was fascinating is when she went to go food shopping, she’d pick up the food envelope and she always had enough money. Now, I don’t mean she always had the same amount of money. She always had enough, meaning she worked with what was there. You see, sometimes, she was sick and didn’t work that week or didn’t work much. And instead of having $100 dispersed across these envelopes, she maybe had $30. And now the percentage going into the food envelope was a lot less. And then she would work with what was available. Conversely, sometimes, maybe she’d work over time to make more money in there. And it’d be, you know, a nice dinner. But whatever was in the envelope was the amount that she would work with.
Well, that system worked so effectively in our personal lives. I wish more people would do it. I do it. It works as effectively, if not better in our business lives.
As I was studying businesses and studying my own behavior, I noticed that – yes, I had a profit and loss statement. I had an expense sheet and a balance sheet. And yes, my accountants have been reading those documents, tie them all in together and you’ll know where you stand. And I didn’t do it, it was too complex. So, what I would do is I would log into my bank accounts – pretty much every day, see what the balance was and then based upon what was in my bank account, I would spend accordingly. If I had a lot of money come in there, I think my business is strong and healthy and I’d spend money because I could – to grow. And if there’s no money in there, I’d panic and do whatever it takes to make a quick sale. But by setting up these different envelopes – different bank accounts with distinct labels, one is for my tax reserves so I can pay my tax responsibilities. One is for my company’s profit, right? Profit first. One is for if I had a big business that runs or purchased a lot of materials. I may have a material purchasing account.
And now, in my business, when $100 comes in, I’ve pre-determined percentages for each account. I want my business to run at 20% profit, so I allocate 20% to profit. I want to take a certain degree to pay for myself so I allocate a percentage there. I know I need to buy materials and that’s 30% of my cost, so 30% goes there. Well, after all that, the leftover for operating expenses is like 15% so I don’t have $100 to run my business. I’ve $15 for my business.
By setting these different envelopes – these different accounts in your business, it gives us an immediately different perspective of what the money is available for because it’s been pre-allocated. In the old system, all the money went to one account and you had no idea, you just say, “Well, I have money in there, I can spend.” Now, you look at your operating expenses. You see how much you have and how much you can spend. You look at your materials account. You see what you can do to buy stuff. And you see how profitable you’ll be.
By pre-allocating your money to its purpose, prior to using it, we become very efficient running our business – very innovative. You’ve less money than you thought to run it, so you have to be innovative and you assure profitability because you’ve taken your profit first.
Josh: So, how many bank accounts would a typical business owner have?
Mike: I find that most businesses have five to maybe seven accounts. I’ll tell you what the core five are. Every business — and everyone listening in, if you do this system, I really encourage you to. The first account should be an income account and its sole purpose is to collect deposits. You don’t pay a single bill from there. I consider it like a Thanksgiving dinner where there’s the Turkey served on that beautiful tray and it’s put in the middle of the table. You don’t tell your friends and family, “Oh, just start eating off of that serving tray. Dive into that.” No, someone slices it up and allocates portions to each plate so everyone has something to eat. Well, that’s what an income account is. As money comes in, it simply accumulates your funds as it gets deposited. And then on a periodic basis—I usually do it twice a month, it’s what I recommend. On a periodic basis, you allocate out to the other four core accounts.
One is profit. One is owner’s pay. How owner’s pay and profit is different is owner’s pay is the salary of the owner. I found way too many owners will sacrifice themselves, not take pay, to ensure the business operates and continues along. They’ll do extraordinary things. They’ll make sure their number one employee is always cared for. If that person wants to go on vacation, they’ll make sure it happens. But the owner sacrifices themselves. Well, the problem is if the owner never pays himself, at a certain point they’re going to start to resent their business. So we need to receive pay. But additionally, we need to get into almost an expectancy, a consistency in our pay. When it’s very volatile all over the place, in our personal lives we start acting reactionary – kind of like I was explaining a business – lots deposits, spend more. Less deposits, spend less.
So, profit – owner’s pay. The third is tax, of the core four. Tax is the reserve for the tax liabilities of the company but also the tax liabilities of the business owners themselves. April 15th rolls around and business owners, inevitably, are panicked to pay the bill that’s come up. Well, we start our business for financial freedom, shouldn’t our business be reserving our taxes on our behalf in advance? That’s what that accountant does. And then the operating expense account.
So, again, five – income is the serving tray. Then you have owner’s pay, profit, tax and operating expenses. I think every business should have that. And some other businesses may have a few other accounts for their special needs.
Josh: So, what about an emergency fund, and money for growth – those sort of things?
Mike: Yeah. So, I categorize those differently – emergency fund and money for growth. So emergency fund, as profit accumulates in your business, we should extract it. I suggest quarterly. Like, every quarter, these large public companies announce, you know, Bloomberg Radio announces that Ford is taking another ¢20 a share. That’s the same time I suggest small businesses should be rewarding ourselves. As we’re recording this, we’re approaching quarter end and I already have a profit accumulation that’s sitting and waiting for disbursement.
Now, the thing is, I don’t think we should take all of it out so I suggest, in my book Profit First, that we take half of the money as a profit distribution on average and half stays in as a rainy day fund because emergencies do happen. One of my old business partners – we built a company together and then sold it, but prior to that he owned his own business and the roof literally collapsed. Thank God, no one was there when it happened but a snowstorm came through and the roof collapsed. The building was condemned. And they had to operate for six months without a building. Well, that emergency fund came in really handy. So, reserve a portion of your profits – 50% or perhaps a little bit more, as an emergency rainy day fund.
The second component is growth. This is the most important concept of Profit First. We have been, I believe, entrepreneurs, myself – everyone has been trained—well, there’s an axiom that says, “If you want to grow, it takes money to make money.” If you want to grow, you have to invest. And I think that, in the first blush, we all believe that but I want to propose something different. It’s called Parkinson’s Law. This is a behavioral theory.
And I believe, more growth actually happens when there’s less money. And I know, in the first blush, that sounds absurd but let me explain Parkinson’s Law. Parkinson’s Law states that the less available the supply of something is, the more innovative we become in our use of its supply. A classic example is toothpaste. If I’m using toothpaste from a tube and I notice that the toothpaste tube is almost empty, my behavior around that toothpaste changes – I use less of it, so I become more frugal. But more interestingly, I become innovative. I bend the tube over the corner of the sink. I squeeze it with everything I’ve got. I cut off the back side of the toothpaste tube to squeeze it out. So, when there’s less supply available, we become more innovative in extracting more value of what remained. So, by taking our profit first and having less money available for operating expenses, it actually facilitates growth because it forces us to be innovative.
I’ll give one more example. I’m a co-owner in a manufacturing business that manufactures leather products and we implemented profit first in this business. And what happened was, we realized very quickly, because we’re taking our profit first, there’s less money left for operating expenses, that we had to change or spend less to get the same results. Here’s one example, there’s these things called clicker presses. These are big, heavy presses that come down and mold or click out/cut out pieces of leather. They can cost upwards of $10,000, $20,000 to $50,000. Well now, as we take our profit first, there’s less money for operating expenses. We don’t have those funds to spend. We went to the local Home Depot and started to say, “Well, what can we kind of rig together on our own?” Well, we found a method. It’s not proprietary so I won’t say what it is. I’ll tell you what it’s not. We did test with microwave ovens – microwaving leather and we found that leather becomes very malleable. The secret is in super-heating so we found that there’s a technique you can make leather highly moldable, very quickly for literally about $150. The competitors are following the old axiom of “It takes money to make money.” This is how the industry operates, by clicker presses. Because we didn’t have the money, we had to become innovative. And now, our competition spends tens of thousands while we spend a few hundred bucks and we get the same—I would actually argue now, better results than the old method.
Josh: That’s an interesting idea. I never really thought about that. I used to be in the vending business and we used to go and buy 8-year-old bread trucks and rebuild them from the ground up. So, instead of spending $40,000 for a truck, we spent $15,000 on a truck.
Mike: Oh, I love that.
Josh: So, it took a while for our drivers to get used to them but eventually they did.
Mike: One of my first jobs was driving – not a bread truck but a large cargo van like that. It had the three on the tree which was actually a stick shift on the steering column.
Josh: That’s what I learned to drive on.
Mike: Oh my gosh.
Mike: I learned to drive a truck on that. And the owner of that business had the same concept – buy something that’s ten years old, save the money. Frugality brings about innovative thinking. That’s the argument here. If he had all the money in the world, he’d just buy the newest trucks and I suggest you might. I would do the same. So, frugality actually brings about innovation – a different perspective. And it spawns better and stronger and faster growth, in many cases.
Josh: That’s a great thing. So, everything you’re talking about brings something to my mind which is one of my favorite things in business is very simply – simplicity.
Josh: Would that be a fair statement?
Mike: Yes. Yes. So, I’m actually working on a thesis for a new book I’m writing and my argument is this, that every business is a manufacturer. And what I mean by that is, a service-based business – I don’t know, like a membership organization. We do have an end product, it’s an emotion or a feeling. If you’re an accountant, the end product – yes, you do the books and the taxes but the end product is confidence. It’s confidence that you’ve got your taxes correctly put together and you’re not going get audited. Or if you do, they will pass the audit. So, we are all manufacturers. And this points to simplicity. In that, a manufacturer will design a prototype. They’re making, say, mugs or something. They design the prototype, then they reverse engineer the way to get there and their objective is “How do you get there with the fewest steps possible and the fewest ingredients or materials?” because that’s where efficiency and cost savings are.
And I think we all have to look at the end product we’re delivering and say, “How do we get to the end product as simply as possible?” Now, I’m not saying you degrade the quality or that the product isn’t as functional but the steps to get there become more and more efficient – simplicity.
Josh: So, can you give us some examples of what we might do to simplify our businesses, compared to what the standard business education process would tell us we should do?
Mike: I’ll give you one step. I think you should start firing clients. We’re never told that – to fire clients. But I think we need to get rid of clients, not because they’re bad people but because they require variability from us.
Imagine this, you get the same customer, coming to you with the same problem every day. I mean, that’s a dream situation because it’s a great customer. They’re paying us well. It’s the same problem so that means it’s the same solution. We consistently do the same thing. It’s like Groundhog Day. It’s a beautiful circumstance because we can get really efficient at fixing that one problem.
Well, I suggest, let’s intentionally make that. So, reduce the variability in the types of clients you have so that you have a consistent group. This is the old “riches in the niches” concept. Identify a very specific niche of customers that need a very specific need.
Think of a heart surgeon versus a general practitioner. A general practitioner doctor can look at a skin rash, can diagnose a heart problem and can diagnose a cough, but if that cough turns out to be lung cancer, if that heart murmur turns out to be a valve defect, they now send you to the specialist. Now, the heart surgeon, she sits there and day after day does almost the identical surgery. She puts in a stent, opens some valves or something – does the same thing over and over. And we, the consumer, will pay an extraordinary fee for the heart surgeon because our life is on the line and we want to know that we’re getting the service from someone that has an extraordinary amount of experience in this.
The general practitioner, they can be on convenience. I’ll go to a general practitioner who’s in my neighborhood. But I’m not going to go across the city or across the country or across the world to find a general practitioner. Anyone can do that stuff. But the heart surgeon, I’ll travel anywhere in the globe to find the absolute best surgeon for my circumstance.
Our businesses have the same opportunity. Fire those clients that require variability, meaning you have to do one-off’s every single time because you’re a general practitioner now. Find that one type of customer that it’s repeated heart surgery, you’ll get paid a premium. But ironically, it’s more simple because you’re diagnosing and serving the exact same problem over and over again.
Josh: This kind of comes to one of my favorite topics, it’s because to run a successful business, you really need to become a nicheaholic. And by being a nicheaholic, less is more. You’ve just done a great job of explaining what “less is more” means. So, what steps would one have to take? I mean, it’s really kind of hard to say, “Okay, I’m going to fire clients. I’m only going to do one thing.” You have to go from where you are today to getting there some time in the future. What kind of steps would you recommend somebody takes to do that?
Mike: I have very specific steps. And I’ve walked so many businesses through these now, so I’m very clear on the path – at least, from my perspective. The first stage is if you’re just in an early startup business, you actually do need to do everything for everybody because don’t know the one thing you do well yet. You may think you do but until you establish some clients who are just absolute raving fans, you aren’t there yet. I found the magic number, it’s somewhere between $250,000 to $1 million in revenue, which is most businesses out there. It’s still okay to be a generalist if you’re in that range. But then, once you find a proficiency – some service you’re doing that you can do proficiently and you’re generating a raving fan out of it, then I think you should start exploring a niche.
So, usually once a company is between $250,000 sub $1 million, we start testing the niche. And what that means is, identify who we think the industry is. Industries are the easiest niches to go after. They’re very well-documented, very clear who they are. So I could say, “I’m going to go after the dentists’ industry.” And start identifying how established that industry is. Now, here’s a couple of ways to do it. See if there’s associations, conferences and meet-ups. The reason it’s important, that means that industry is established enough that they are, on their own accord, gathering with each other to collect and share information. Also, you’ll find that when you go to these conferences or just look them up on the internet, you’ll see who the speakers are. Well, those are usually the influencers in the industry. And if you categorize yourself into one niche, serving dentists for example, you will be a subsequent authority just like those speakers are there. So then I study those speakers and those people that are attending those conferences to see how established they are. Are they only serving this niche? How are they serving this niche? Can they make a living doing this and in what way?
Now, of course, as a more of a traditional vendor, I simply look at the vendors that are appearing at this conference. Do they focus on this category exclusively? How are they doing? And so forth. Then I start marketing to it by—well, there’s many ways of marketing, but attending conferences is one way, by direct mailings, e-mail campaigns, ads but only to this niche.
And then I start to see if I can get some traction. Once I get those first two or three clients, then I look to start seeing, “Is there a singular service or a reduced service that I can offer consistently for all of them?”
If all of that stuff proves out, that’s when I start really pushing the niche. It’s only once I’m at that point do I consider firing clients. That’s the beautiful thing about niche testing. This early on, you can continue to serve other clients if they knock on your door and need your help, you can still work with them. You’re just testing the marketing effectiveness of this niche, then landing a few clients, before you ever consider firing a client.
Mike, unfortunately, we are out of time. But I know one thing for sure that some listeners are going to want to get in touch with you, buy your books or maybe have you come and speak at one of their meetings. How would they go about doing that?
Mike: The best way is mikemichalowicz.com. There’s a shortcut because I know that’s a doozy to spell. Go on Google, type in M-I-K-E and then M-I-C. It’ll drop down automatically the longest name you’ve seen in your life. The most Polish-sounding longest name you’ve seen in your life. That’s me. Pick that, it’ll bring you to mikemichalowicz.com. All my books are up there. Free chapters and stuff. But I will promise this to you, if you visit my website, you’ll find it to be the most different website you’ve ever visited – for sure.
Josh: We’ll take your word for that, Mike. Thanks so much for your time today.
For folks who’ve been listening, Profit First is a book you need to read. It’s going to challenge your assumptions about what you thought is true. And if you’ve been paying attention, you’ll notice that Mike does a really good job of challenging your assumptions on almost everything in your business. And in my opinion, that’s a great thing to do.
So Mike, thanks so much for your time today.
Mike: Thank you, Josh.
Narrator: You’ve been listening to The Sustainable Business Podcast where we ask the question, “What would it take for your business to still be around 100 years from now?” If you like what you’ve heard and want more information, please contact Josh Patrick at 802‑846‑1264 ext 2, or visit us on our website at www.askjoshpatrick.com, or you can send Josh an e-mail at firstname.lastname@example.org.
Thanks for listening. We hope to see you at The Sustainable Business in the near future.