Every week as SmallBizLady, I conduct interviews with experts on my Twitter talk show #SmallBizChat. The show takes place every Wednesday on Twitter from 8-9pm ET. This is excerpted from my recent interview with @MikeMichalowicz. By his 35th birthday Mike Michalowicz had founded and sold two multi-million dollar companies. Confident that he had the formula to success, he became an angel investor… and proceeded to lose his entire fortune. Then he started all over again, with a new “profit first” formula. Michalowicz now operates his third million dollar venture, is a former small business columnist for The Wall Street Journal; the former MSNBC business make-over expert; is a keynote speaker on entrepreneurship; and is the author of Profit First, The Pumpkin Plan and The Toilet Paper Entrepreneur, which BusinessWeek deemed “the entrepreneur’s cult classic.” For more info, visit MikeMichalowicz.com
SmallBizLady: Why did you decide to write Profit First?
Mike Michalowicz: I wrote Profit First because the age old formula of Sales – Expenses = Profit wasn’t working for me. It makes logical sense, but in practice I found that I never had profit at the end of the day. My businesses always seemed to be check by check and I thought that I could simply grow my way to profit, but never did.
Then I tried a new formula of Sales – Profit = Expenses and have been profitable ever since. I taught other companies to do the same and it worked for them. That is when I knew I had to write a book to share the process with everyone I possibly could.
SmallBizLady: How has putting profit first and expenses last benefited your own business?
Mike Michalowicz: I always thought that I could run my business on the idea that I should sell as much as I could and spend as little as I could and that profit would “just happen.” It never did. I realized that I run my business by looking at my deposits (sales) and then paying my bills from what I deposit (expenses)… and always could justify spending/investing every penny I had. Profit was always put off to a future date, and that date never happened.
By taking my profit first, from every deposit, profit is now a habit, not a hopeful “one day” event.
SmallBizLady: Why can the GAAP accounting method be so problematic?
Mike Michalowicz: GAAP (Sales – Expenses = Profit) is logical. And that, ironically, is the trap. Logically, it works, but people aren’t logical. We are driven by emotion and habits. GAAP puts us in the habit of selling as much as we can and they paying expenses first. Expenses become a focus and for most businesses grow just as quickly as sales. Profit is a “left over” in the GAAP formula. It’s an after-thought.
As the experts say, we get what we focus on and GAAP has us focus on expenses. That’s the problem. We need to focus on profit and that is what Profit First does.
SmallBizLady: You call the GAAP model a “Frankenstein Formula.” Why is that?
Mike Michalowicz: GAAP purports that profit is a result of subtracting expenses from sales. Which, as I mentioned before makes complete logical sense, but in practice it creates “break-even” businesses. And break-even businesses are struggling business. When a business fails to make a profit, the entrepreneur’s natural response is to further grow sales. Because of the formula, the entrepreneur wrongly believes they must sell more and more so that at some point sales will surpass expenses resulting in profit.
What the entrepreneur doesn’t understand is that more sales require more expenses. And, that as they try to grow sales faster, the easiest way is to diversify their offering. They try to do more things for the captive (easy) clients. But this diversity in offering requires more expenses and dilutes the businesses ability to be efficient in any competency. So as the business sales grow, expenses climb at the same rate. The business becomes a Frankenstein-like monster… it consumes more and more of the entrepreneur’s energy, time and money. The entrepreneur serves the business – not the other way around. It is often by this point that entrepreneurs resent the business. The Frankenstein story becomes a real life experience.
The simple process of taking profit first automatically reduces the amount of money available for expenses. In turn the entrepreneur is forced to become more efficient, and to become efficient they must focus on serving a singular need to a singular market. In other words, it forces niche focus which in turn is the most effective way to spark growth.
SmallBizLady: How can the Profit First approach shift our planning and forecasting activities in a positive way?
Mike Michalowicz: Profit First will make us account for profits first. As a result, the remainder of our budget is for expenses. The expense budget gets squeezed down. This sounds like a subtle change from simply reducing expenses, but it is more than that… since the profit allotment is a fixed percentage. We take the profit first, and what remains is the ONLY money available for expenses. You must find a way to make it work with what is left over for expenses. Profit isn’t an option and it’s not a variable. It’s predetermined.
SmallBizLady: Can you share any success stories that illustrate the benefits of the “Profit First” approach?
Mike Michalowicz: I have received hundreds already… which has amazed me because the book isn’t out yet. One of my favorites was when I got a call from a couple who owns a movie theater in Wyoming. Amy and Adam heard about Profit First and implemented it. Within six months they not only where taking a consistent salary for themselves that was higher than they expected, they took enough money from their second profit distribution and took their family on a Disney vacation. This was the first vacation they had taken since starting the business ten years prior. The most amazing comment was when Adam said “Profit First has made one thing extremely clear to me… my business is here to serve me, not the other way around. Profit First has made it so clear and simple.”
SmallBizLady: You mention the concept of TAPs in your book. What are TAPs and why are they important?
Mike Michalowicz: TAPs stands for Target Allocation Percentages. It is the percentage of money that is allocated to the different bank accounts from the deposits generated by sales. The core accounts that every business should have is a Profit Account, a Tax Account, an Owner’s Pay Account and an Operating Expenses Account. Then on a periodic basis the money that has been deposited into the business gets distributed to these different accounts based upon the TAPs. I have found that, as a generalization, the ideal TAPs vary based on the size of the business. I have also found that a business should not necessarily start allocating the full TAP amounts right away. It can be too much of a shift for the company. A business just starting out with Profit First should define their TAPs but also realize that it is a target and not the starting point. Start smaller and build your way up over time.
SmallBizLady: Does the “Profit First” approach often have secondary—and unexpected benefits?
Mike Michalowicz: The secondary benefit that I am seeing over and over again is confidence. I think most entrepreneurs experience the tail wagging the dog. The business has become this monster and controls them. Once they implement Profit First they experience control again. They are back in the driver’s seat.
The process is simple that within a day people are up and running… but the key is sticking with it. It puts you in control, but it also forces the responsibility to make tough decisions.
SmallBizLady: Are there risks – such as that you might end up with not enough money to pay expenses if those don’t come first? How do you avoid that?
Mike Michalowicz: Funny enough, the “risk” of not having enough money to pay expenses, is one of the most important things you will experience with Profit First. When you don’t have enough money to pay your bills – that is your business screaming at you that your company is not in the position to incur those bills and you need to find a way to not incur those bills going forward.
There are a few risks though… one is going too big, too soon. I have seen people try to extract way too much profit from their business starting from day one and it cripples the business and then they revert back to the old, ineffective GAAP way. The key is to build a profit habit slowly.
The other risk is “borrowing” from yourself. I have seen businesses build up a profit reserve and then spend that money on expenses later on. That isn’t profit at all; it just is cloaking that money for expenses. When money is allocated to profit, it must always remain that way.
SmallBizLady: As entrepreneurs, why is it important to stay positive about our financial worth?
Mike Michalowicz: There is a saying that entrepreneurs have a parent/child relationship with their business. I disagree. I think we are Siamese twins. I really feel entrepreneurs and their businesses share a soul. When your financials get tight, so does your chest as stress settles in.
Our relationship with our financials is monumentally important. Strong numbers from a strong business gives us a way better feeling of self-worth than a weak business with weak numbers.
SmallBizLady: Is there an innate message in “Profit First” about how we run new businesses in general?
Mike Michalowicz: The innate message is this – be frugal but not cheap. In other words, we must build efficiencies throughout our business. And we do this by cutting unnecessary or low value costs, and squeeze all the juice out of our investments.
SmallBizLady: Are there any other tips for financial self-esteem that you can give to start-ups and developing businesses?
Mike Michalowicz: Start taking your profit first immediately. The thing you must remember is that profit is a habit, not an event. Start building your profit habit today. Start being profitable now, not some day in the future.
For more tips on how start or grow your small business subscribe to Melinda Emerson’s blog http://www.succeedasyourownboss.com.