The Real Formula for Profitability

profits chartWhile I have co-founded, built and sold two multi-million dollar technology service firms, I admit they were never truly profitable. Every increase in revenue seemed to be matched with an even greater increase in expenses. Every day I checked (and still do) my bank balances. As the balances would climb and fall, so would my confidence and my spending. I lavishly incurred new, unnecessary expenses when my bank account was fat. I panicked when it was thin.

This behavior, I have found, is not unique to me. In fact, of the hundreds of entrepreneurs and business owners I have asked, the vast majority also do “bank balance accounting.” It was with this realization that I started using a method for myself five years ago that I call “Profit First”.

The formula for profitability has been established for ages. Every business owner, CEO, freelancer and entrepreneur knows it. It is even supported – scratch that, mandated – by Generally Accepted Accounting Principles (GAAP), which is enforced by the SEC in the United States and the International Accounting Standards Board internationally.

GAAP’s fundamental formula for profit is simple:

Sales – Expenses = Profit

There is just one problem… this formula hurts profitability.

Logically, of course, the formula is sound. A business must first sell in order to generate inbound cash flow. Then the business deducts the expenses incurred to deliver its product or service and to run its operations. What remains is profit. Profit, effectively, is a leftover.

While the GAAP formula makes logical sense, it ignores the fact that it is managed by people. We are, first and foremost, emotional beings, prone to ignore (or even defy) logic.

Cyril Northcote Parkinson, in his famous bestseller Parkinson’s Law, proposed that “work expands so as to fill the time available for its completion.” His theory has been generalized to state “The demand upon a resource tends to expand to match the supply of the resource.”

Arguably, money is the ultimate resource. In GAAP’s “Sales – Expenses = Profit” formula, the business owner sees the cumulative deposits (resource) from sales and has a propensity to conclude that all the money is available for expenses (the demand expands to match the supply). The new equipment purchase is justified because the money is there. A new hire starts, because the money is there. Profit? It is an afterthought. Therefore, there rarely is any.

Now consider a new formula, where a business takes profit first:

Sales – Profit = Expenses

Mathematically the formula is identical to GAAP’s. But from the perspective of human behavior, the Profit First formula is radically different. In the Profit First formula a preset percentage of deposits generated through sales are first allocated to profit. The remainder is used to pay expenses.

In practice, as deposits from sales come in, a predetermined percentage – for example 15%, is immediately transferred to a separate profit account. The remainder is available for the business leader to use to run business as usual. The business owner will see his available cash (from which the profit has already been deducted) and make decisions accordingly. The owner might delay a new equipment purchase, or find a more cost effective alternative. The owner will not hire a new employee if the money is not there, and perhaps will conclude the hire was unnecessary in the first place.

I have posted a profit every quarter since I instituted Profit First five years ago. Every business I have invited to flip the GAAP formula, has also posted a profit or, unfortunately in some cases, decided to give up the system because it put “too much downward pressure on expenses.”

GAAP offers so much more in business insights than most entrepreneurs could imagine, but it does fall short on working with an entrepreneur’s “bank balance” habit. I have become an advocate for the Profit First approach to cash management, because of the one thing it does do extremely well. It works with the natural habits of business owners. And, it functions as a “plug-in” to all the GAAP accounting systems and processes I have in place. It doesn’t change GAAP, it simply sits on top.

Profit First has transformed my own businesses for the better (if you consider consistent profits, better). When Donna Leyens and I co-founded Provendus Group we instituted Profit First from day one. As a result, we were able to take profit out in our first year of operation, while at the same time maintaining a healthy cash flow and operating account balance. Admittedly, Profit First is not the panacea to all cash flow problems, but it surely makes profit a habit.

Written by:

Mike Michalowicz

4 replies
  1. Lisa Robbin Young
    Lisa Robbin Young says:

    Making profitability a habit, rather than a mandate that’s a result of afterthought, should be the primary driver of all business. I’ve been using Profit First for a few months now and we’re leaner, more profitable, and doing some pretty exciting things that weren’t possible before this handy habit-making snapshot came into my life.

  2. Debbie Horovitch
    Debbie Horovitch says:

    UPLEVEL SPARKLE: Who would ever think accounting could be so sexy?

    I had some severely screwed up money beliefs (but totally normal) when Mike started talking about Profit First in his earlier books, and it’s taken some time for me to become aware of those limiting beliefs and get to the point where I CAN psychically accept Profit First in my life.

    I started implementing Profit First with KNOWING who my perfect client is that I’ll put all my attention into serving (and they arrived the next week!), while the not-such-a-fit clients fell away. Then I went into major cost cutting, being especially ruthless on monthly subscriptions and recurring fees. Only Netflix has survived (I’ve canceled cable until I’ve finished writing my book).

    Then I set up my bank accounts and changed my thinking about FUTURE MONEY from “Do I have enough to make it to the next payday?” to “What future bills, debts, commitments are there (looming), that I can take care of in advance?”

    I suddenly, and oddly, have a little extra in every account and each bill that gets paid is being scrutinized and reconsidered each month, so I can eliminate future expenses (and create future profits!). I haven’t taken a profit distribution yet, but just being able to sleep at night with less stress about how to cover basic costs tomorrow is a dramatic improvement in my lifestyle… I’ve been able to lose weight, remove the constant distraction of money issues, and change who I am so that I’m the person READY for uplevel Sparkle!

    I’m so excited about what this can do for everyone in business!

    ~ Debbie

  3. Jason Spencer
    Jason Spencer says:

    I learned to use Profit First from Mike towards the end of last year. There’s no doubt in my mind that the system has more benefits that appear on the surface. Since implementing, I’ve not only had profit every quarter, but scraping for money in a pinch no longer happens. Furthermore, I was able to uncover all sorts of expenses that I could either systemize and reduce or (in most cases) remove altogether. In fact, once you grasp the initial concepts (not hard) you’ll wonder where this has been your entire life — and it is pretty darn easy!

  4. Eric Putnam
    Eric Putnam says:

    Great post Mike. Enjoyed implementing the principals from The Pumpkin Plan and watched you introduce Profit First online at Creative Live in the fall of 2013. The processes while simple are truly game changing for entrepreneurs like me who have been in the trenches for years. This is a “must read” for any one self employed!

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