This is understandable. Publishers tend to play it safe with tried-and-true subjects, and avoid number-crunching subject matter that puts most people to sleep.
But “Profit First” by Mike Michalowicz is not one of them.
In this article, I’ll uncover:
- What is Profit First?
- The principles of Profit First
- Parkinson’s Law and Behavioural Psychology in Accounting
- Turning theory into practice: Implementing the Profit First approach
- My personal take
What is Profit First?
Profit First is a book on budgeting, disguised as an ‘accounting hack’. Michalowicz serves up financial wisdom in a conversational tone, balanced with storytelling, analogies and behavioural psychology. It’s like a crash course for busy entrepreneurs who are running low on both time and patience for complex financial jargon. And it’s so engaging you’ll forget you’re actually learning important stuff.
My introduction to Profit First happened thanks to a client of mine, the one and only James Rose from Aktura Technology. Now, let me tell you, James is quite the busy bee:
- He’s rocking a website consultancy service.
- He’s deep into the world of software development.
- He’s got an ‘on-demand’ website support service going strong.
- And wait, there’s more – he’s the mastermind behind software gems like Chimp Rewriter, Silver Siphon, and Content Snare.
As I said, James is a busy man.
About a year back, James decided to adopt the principles of Profit First. How did we discover this? Well, it all started with a curious peek into his company’s Xero file – a bunch of new bank accounts popping up like rabbits in a magician’s hat. These accounts had some pretty interesting names, including:
- Money IN
- Owner’s Pay
- Operational Expenses
For the record, James had a total of 14 bank accounts frolicking around in his Xero file. It’s enough to make his accountant and bookkeeper exchange some serious “are you for real?” glances.
After discovering these newly established bank accounts, I decided to give James a call. I had to tell him that his accounting bill was going to increase due to all the extra reconciling work we had to do. (That was a joke.)
No, actually, I was curious to understand what he was doing with those bank accounts, and what they were designed to do.
The principles of Profit First
Now, let’s get into the principles behind Profit First. Get ready for a paradigm shift that flips traditional accounting onto its merry little head.
The traditional method of accounting, as we all know is:
Michalowicz’s methodology reverses this equation. He’s all about educating entrepreneurs to ‘put profit first’.
Now, I know what you might be thinking – “Wait, the math is still the same, isn’t it?” And technically, yeah, the numbers line up.
But here’s the magic: Michalowicz argues that this psychological flip has some serious benefits. See, traditional accounting wasn’t exactly built with humans in mind. It’s like a language spoken fluently by rational, number-crunching robots , aka accountants.
Traditional accounting has its fair share of letdowns, whether you’re an entrepreneur or just a regular human navigating this money maze.
Parkinson’s Law and Behavioural Psychology in Accounting
Ever heard of Parkinson’s Law? It’s the old adage that work magically stretches itself to fill up all the time we give it. This same concept often applies to our financial lives as well, where expenses rise to meet our income. In simpler terms: “The more we make, the less we keep.”
Now imagine flipping that accounting equation like a pancake at Sunday brunch. Suddenly, profit takes the centre stage, and the rest of the expenses line up obediently. This reframing forces us to think differently about our spending habits.
One example Michalowicz uses is toothpaste. You buy a new tube, and the temptation to squeeze out a toothpaste tower is almost irresistible. Big, fat generous gloops of minty freshness are applied to the toothbrush – and when that toothbrush meets the tap, it’s like half the toothpaste decides to take a swim down the drain.
And then you think, who cares? There’s plenty more in that tube, right?
Now, when that toothpaste is almost on empty, our behaviour is quite the opposite. Suddenly, we’re the thriftiest of thrifty. We work so hard to extract every little morsel of what’s left in the tube. We squeeze, we wring, and we coax out a tiny blob – a precious gem that’s treated like gold, carefully applied to our toothbrush.
In other words, we’re more frugal.
This is a living example of Parkinson’s Law in action.
If we are given 14 days to complete a project, guess how long it takes? Exactly 14 days.
By contrast, give us just one day to complete the same project, and bam, it’s done, often with even better results. It’s like our hidden superpower surfaces under pressure, and suddenly we’re capable of achieving more than we thought possible.
Michalowicz takes this magic principle and sprinkles it over your finances like confetti. Most business owners spend money left and right, then clutch whatever’s left as their “profit”. Now, Michalowicz steps in and says, “Hey, why not put your profit aside first?”
Suddenly, the remaining cash has a mission – it’s earmarked for expenses, and every spending decision gets a serious dose of scrutiny.
Turning theory into practice: How to implement the Profit First approach
Let’s break it down into practical steps. The heart of the idea is this: instead of nibbling at the bottom line, start by taking a tiny slice off the top. Share some with your future self, stash some in savings, and squirrel away a bit for a rainy day.
Here’s how it works: the system involves transferring designated percentages of your cash deposits into various bank accounts. It’s like playing a financial game of chess where every move counts.
If you’re curious, there’s an entire training academy out there for bookkeepers and accountants who want to help their clients adopt the ‘Profit First’ routine. Though I can’t spill the beans on every detail, I’ve pieced together a set of instructions based on my interactions with my client James and my own take on the system.
Step 1: Build Your Banking Arsenal
Team up with your bank to set up new bank accounts tailor-made for your business. These accounts can wear whatever names you fancy in your accounting system:
- Profit: Hello, savings account!
- Owner’s Pay: Another savings account, this time for you.
- Tax: You guessed it, yet another savings account, this time for taxes.
- Operating: Transaction account for everyday expenses
- Revenue: Transaction account where all your sales deposits hang out.
Make sure your accounting system has those proforma invoice templates ready. They’ll guide those sales deposits right into your “Revenue” account.
Step 2: Determine your TAP
This bit is the most subjective piece of the system. Your Target Allocation Percentages (TAP) are the magic numbers that determine how much goes into each spending account. These amounts usually get dictated by a handy lookup table, often tied to your revenue.
Here’s a lookup table for reference — look for the “Instant Assessment” and see FIGURE 1 on Page 2. Note: This table is based on the USA tax system. Your percentages may vary depending on tax jurisdiction.
Here’s an Aussie excel template fo the TAP system.
Step 3: Show Me the Money (Transfer it, Actually)
Let’s talk about payday – or in this case, pay-fortnight. Get into this spreadsheet and plug in the total deposited funds in “Cell C5.”. Then, start transferring the dollar values into each respective bank account. It’s like giving your money its marching orders for the next period.
But here’s the kicker: it’s important to be disciplined with your spending from each account. Otherwise, it defeats the purpose and you’ve just created a lot of admin with no benefit.
The bank accounts should be used as followed:
- Profit account: A cosy spot for your profit to pile up.
- Owner’s Pay: Your personal wage goes here.
- Tax: This one’s for taxes – the inevitable but important part.
- Operating: Day-to-day expenses have a home here.
- Revenue: Only income deposits allowed in this club.
My personal take
While I haven’t personally integrated Profit First into my own business (we have our own rational robot system in place), I’ve been all ears to James, who can’t stop singing its praises.
From a technical perspective, I do see limitations in the system. The key challenge? Nailing that sweet spot for your TAP percentage – making sure it’s both realistic and doable. But let me be clear – I’m waving my endorsement flag high. Anything that helps people understand their finances is a win in my book.
I should disclose that the Profit First system does not replace the need for accounting. It doesn’t replace the need to understand your financial performance, decipher those levers that can boost your financial game, or hold the secret to unlocking all your money mysteries. It’s purely for cash flow management.
I’d give this two thumbs up to fellow business owners and entrepreneurs who feel like cash flow is their personal enigma, who grapple with the ABCs of accounting, and who could use a dash of spending discipline (which, let’s face it, includes pretty much everyone).
Don’t forget the personal touch
This system isn’t confined to business territory alone. You can take its principles and apply them to your personal life too. Just swap out those tax and profit accounts for a savings account and a house deposit / investment account, and voila – you’re all set for the personal finance version of Profit First.
Hungry for more?
If you’re eager to dive into the full book, grab your copy here.
If you can’t be bothered with the full book, don’t sweat it. Just follow the advice I’ve dished out above.
If even that seems like too much effort (hey, we’ve all been there), just do this:
Set up at least two bank accounts.
- The first one handles transactions, juggling revenue and daily expenses.
- The second is your super-secret stash for Superannuation and taxes — GST and PAYG. When the month turns over, send all those liabilities right into this account. And here’s the golden rule: hands off! This neat trick will save you a mountain of stress when BAS time rolls around.
If the idea of doing this stuff on your own gives you a major case of “nah, not today” vibes, then reach out to SBO Financial. We’ll sort you out in no time.