How To Profit First | Advanced Techniques

Profit First — Advanced Techniques

When folks first join Weight Watchers, they set a goal of losing 10% of their body weight. Even if you weigh 300 pounds and have to lose another 150 to get down to your ideal weight for optimal health, you still only set a goal of losing 30 pounds. The strategy is to string together a series of small wins and build momentum, plain and simple; and it’s the reason why Weight Watchers has such an impressive success ratio compared to other diet programs. With 10% of your body weight kicked to the curb you can focus on the next 10%, and then the next until you get down to your ideal weight.

If on the other hand you focus on the target weight loss goal of 150 pounds from the get-go, you will likely become discouraged and give up; it takes a long time to lose an entire person! Massive goals feel exciting when you declare them, but can quickly become de-motivating factors because they seem so hard to reach and the chance to celebrate is so far off in the future.

You’ll see a lot of formerly overweight and obese people getting into running marathons and triathlons and other extreme endurance races and sports. Do they start this way right out of the gate? Heck, no. They start with a walk around the block. Then a longer walk. Then maybe a walk-run cycle. Then maybe they sign up for a 5K.

Small wins lead to big wins, and if you started implementing Profit First back in Chapter 3, you already know that. You lost your 10% and ran your first 5K. Now you’re ready to take on the advanced stuff . Like a dieter who recently completed a few small goals, your business is healthy enough to take on bigger challenges, now, much healthier than it was before you first cracked this book.

Here’s the deal: you are about to learn the Profit First equivalent of running your first marathon. You need to be in shape and all stretched out before you do it. So please do proceed with reading, but don’t implement this stuff until you have completed at least two full quarters with the core stuff you learned about Profit First. Are you making your biweekly allocations? Are you amassing some profit, no matter how small? Have you experienced a few profit distributions? Are you participating in some form of PAG? If you answered yes (a real yes) to all four, if you’ve mastered not breaking the rules, you’re good to put on your running shoes and move forward.

ADVANCED SIMPLIFICATION

A few years after implementing Profit First for myself, I realized that I could really take my money management to the next level if I tweaked my system further. The stuff I taught you in the beginning of this book was working well, but there were certain times I still needed to do the accounting work to understand the financial health of my business. Sometimes my deposits weren’t made as a result of sales; they were simply reimbursements for expenses. Other times, a client paid a wad of cash up front for work that I would do in dribs and drabs over the next year. Sometimes I needed to make big purchases, and I wanted to save for them. Mine wasn’t the only business that needed tweaks; everyone I consulted with needed them. So do you. And the process is simple. You need just a few more accounts.

While it may not seem like opening additional accounts simplifies anything, it absolutely does. Whenever you can get a clear, accurate picture of how much you have to spend on a specific aspect of your business, you will make better decisions and be less likely to commit to projects, vendors and expenditures that do not fall in line with the balances in those accounts. Likewise, if you know exactly how much cash is flowing into your business at any given time, you can make better decisions about where you need to focus your efforts.

You already have your four foundational Profit First accounts open—Profit, Operating Expenses, Owner’s Pay and Tax—plus your two no-temptation accounts that don’t get touched, the Profit and

Tax Accounts in a separate bank. Here are the additional accounts, contingent on your business needs, that I recommend you consider opening:

INCOME ACCOUNT

This is probably the most helpful and important account for advanced Profit First. I can’t imagine your business not benefiting from it. In this account, you collect all of your income deposits so that you can clearly see how much cash you collected between your 10th and 25th allocations. This will separate incoming from outgoing cash, both of which were being managed by the Operating Expenses Account in the simple version of Profit First.

An Income Account will give you an accurate picture of how much money you collected during any period of time. And the Operating Expenses Account will transition to only paying the expenses for operations, so you will have an accurate picture of how much money is flowing out of your business at any given time.

It’s critical that you adjust to your Real Revenue. If you have material and subcontractor costs, allocate these fixed amounts first, before you do the percentage allocations. Then, on the 10th and 25th of every month, allocate all remaining money in the Income Account to the other accounts: Profit, Owner’s Pay, Taxes and Operating Expenses. And possibly a few others suggested below.

THE VAULT

The Vault is an ultra low-risk, interest-bearing account that you can use for short-term emergencies. At a certain point, leaving 50% in your Profit Account to act as a rainy day fund is not prudent since the money flow is a little unpredictable. A bad quarter won’t contribute much to the Profit Account. Then you take 50% out for a profit share, and now that Profit Account reserve might be too small for a big business. Every business should have a three-month reserve, meaning that, if not a single sale came in, all costs could still be covered for three months (a quarter). The question isn’t if you will have a dark day (your supplier goes out of business, your biggest client goes bankrupt, your best employees leave to start a direct competitor and your clients decide to go with them, etc.). The question is, when will your dark day come? The Vault is there for that.

When you set up The Vault, you must also establish certain rules for its use. What I mean is that, when you have a situation so dire that you need to access this money, you also have instructions written in advance on how to proceed. For example, if the money is pulled due to a drop in sales, you will pre-plan that, besides just trying to get more sales, you will also cut all the related costs in your business within two months if things haven’t improved. Few people have the discipline to think clearly or act appropriately in times of panic, and that’s why we document a simple set of instructions for ourselves in advance.

The idea behind The Vault and the entire Profit First system is that it puts your decisions well out in front of any money crisis. Your business dynamics may not, in fact, improve; but your decision-making will be much farther out in front of the actual financial impact. So the goal of The Vault is not to buy time; it may afford some time to address unexpected challenges, but it is really about forcing important decisions early, so your business doesn’t go into a cash crisis (you know, back to the Survival Trap).

STOCKING ACCOUNT

This is an account for big purchases and to fund stocking parts of your inventory. For example, remember my friend JB? His roof decking company, RoofDeck Solutions, Ltd., sells the materials contractors need to complete their projects. JB includes some basic nuts and bolts with each order, usually fifty or a hundred of each; yet his supplier requires a minimum order of ten thousand at a time, which costs JB roughly $5000. Each order will last JB ten months or longer, so he set up what he calls a “large purchase account” into which he allocates 1/20th (that’s $250 each time) of the funds he will need for the next big nuts and bolts purchase. Why 1/20th? Because he knows he’ll need the next order in ten months, and he is on the 10/25 Rhythm. Ten months, two times a month, equals twenty allocations before the next big purchase. By doing this, JB is able to chip away at the big bill before it happens. Then, when it’s time to cough up the $5000 for the next big nuts and bolts order, he’s ready. In the past, this bill caught him off guard and he had to scramble to cover it. Now, he barely feels the $250 he allocates to his Stocking Account twice a month.

PASS-THROUGH ACCOUNT

Some businesses receive income from customers that is not to be allocated for Profit or Owner’s Pay. Sometimes you may provide a service or a product to your customer at cost (or near cost), and other times you may be reimbursed for costs outright. For example, I travel a lot for my work and in almost every case my clients reimburse my travel costs. That income is not allocated to cover payroll or added to my Profit Account. It’s a pass-through and goes directly into this account, and then off to the corresponding vendor to pay the bill. If I have paid the bill in advance, the money is deposited into the Pass-Through Account and then transferred (on the 10th or 25th) to the Operating Expenses Account, from which I paid the initial bill. By the way, with all these advanced accounts, the nickname you give each is entirely up to you. I call this one my Reimbursement Account.

MATERIALS ACCOUNT

If most of your revenue (as indicated in the Instant Assessment) falls into top line revenue and does not flow through to Real Revenue, then most of your income is pass-through revenue and the core of your business is basically the management of that pass-through. If this is the case, set up a Materials Account for the money that is allocated specifically for purchase of materials. Do not allocate it for anything else. (Ever!) If for some reason there is money left over at the end of the quarter (in other words, you had a larger profit margin than you expected), you can move that balance to your Income Account (or Operating Expenses Account, if you aren’t doing advanced Profit First yet) and make the allocations accordingly. The Materials

Account functions in the same way the Pass-Through Account does, but it is broken out separately so that you know its exclusive purpose is for materials.

SUBCONTRACTOR/COMMISSION ACCOUNTS

If your business does not purchase materials, but uses contractors or people paid on commission instead, this is where you allocate the funds to pay these fine folks. Treat it just like the Materials Account, but apply it to contractors and commission-based team members.

EMPLOYEE PAYROLL ACCOUNT

Employee pay is relatively predictable—full-timers are on salary and part-timers, for the most part, work an average number of hours per week. This means you can look at the cumulative gross pay for your employees plus the payroll taxes you’ll incur and allocate funds from your Income Account (if you use advanced Profit First) or Operating Expenses Account (if you use basic Profit First) to the Employee Payroll Account every 10th and 25th. If you use a payroll service, set them up to pull the payroll from this account (not your Operating Expenses Account).

MAJOR EQUIPMENT ACCOUNT

Similar to your Stocking Account, this account is for big purchases you may need to make farther down the road, such as new computers or a high-end 3-D printer. Estimate how much you might have to spend on future equipment purchases, divide it by the number of months you have to save up for it, divide that number by two and allocate that amount every 10th and 25th to accumulate enough money for that big purchase.

DRIP ACCOUNT

This account is for retainers, advance payments and pre-payments on work your company will complete over a long period of time and for which you have yet to expend resources. Say you get a big project (congratulations, by the way), and you receive $120,000 from the client

up front for work you will complete every month over the period of a year. That means that each month, you will really be earning $10,000. So when you get that check, put the $120,000 into the Drip Account and then automatically transfer $10,000 to the Income Account every month (or better yet, $5,000 every 10th and 25th). You don’t touch any of the balance in the Drip Account. You only make allocations when you drip a portion of the funds—in this case, the $10,000 each month—into the Income Account.

The Drip Account will help you manage the true cash flow of earned money, so that you can manage your expenses and costs. For example, the labor doing the work will be paid monthly. I helped implement a Drip Account with my friends at TravelQuest International in Prescott, Arizona. They provide their clientele with once-in-a-lifetime trips, from viewing solar eclipses from the best vantage points in the world, to visiting the South Pole to see the Aurora Australis, to experiencing zero gravity in outer space. People book these trips up to five years in advance, while the majority of the company’s expenses occur during the year of the event. Enter the Drip Account.

PETTY CASH ACCOUNT

Set up a bank account and get a debit card for petty cash purchases, such as client lunches. Then, allocate a regular dollar amount from your Operating Expenses Account to petty cash. Me? I allocate $100 every two weeks for myself, and also for a few employees who need it. The funds cover gifts, lunches and other small purchases. Sorry—if I’m buying, we likely aren’t having an eight-course meal. . . if it’s not in my Petty Cash Account, it ain’t in my budget.

SALES TAX ACCOUNT

If your business collects sales tax, every single, stinkin’ penny of the sales tax you collect is immediately allocated to this account. For example, if you sell something for $100 and sales tax is 5%, you will deposit $105 into your Income Account. First, transfer that $5 into your Sales Tax Account; then do your Profit First allocations with the remaining $100. Sales tax isn’t even legally your money; you are just acting as a collection agent for the government, so never, evertreat that money as income. Just bang people over the head for the sales tax and turn it over to the king (the government).

Figure 7 is my own account setup. The account numbers are made up, of course, and the balances are not my real numbers. But they do show a very typical breakout of the cash, and the names of the accounts are the real names I have assigned to my accounts. Next to each name, in parentheses, I put either the dollar amount or percentage that goes into each account at the allocation times (the 10th and 25th). You should do the same.

Looking at the numbers, I can see instantly where my business stands. I can run an Instant Assessment at any time. For the purposes of this example, I set my required personal monthly income at $10,000 per month. From there I can instantly calculate the total business income I need to make between every allocation period.

WRITE DOWN THE PROCESS

Create a single-page document that defines the function of each account. Explain what purpose each account serves, and the process you will follow. For example, document that, on the 10th and 25th of the month, all the money in your Income Account is distributed to the Profit, Owner’s Pay, Tax, and Operating Expenses Accounts based on the respective percentages. Then, the specific dollar amounts— $75 for Petty Cash and $1500 for Employee Pay—are transferred from the Operating Expenses Account into the respective accounts. Finally, the total money in Bank 1’s Profit and Tax Accounts are transferred to Bank 2.

This process is a system, so it needs to be documented. Your bookkeeper might have to take this over for you; otherwise, you might drink too much one night and forget the rules you set up for your accounts. Heck, you could end up allocating all of your money to your Erik Estrada Fan Club fund, a fan club of which you are the only member (even Erik dropped out).

PICK YOUR PAY TO FIND THE NECESSARY BUSINESS INCOME

The famed “monthly nut” is a horrible distraction. It’s up there with reruns of Jersey Shore. The monthly nut is a remnant of the GAAP mentality that simply tells us the number we need every month to keep the doors open. And that is nonsense. The “monthly nut” is a focus on—you guessed it—expenses, not profit. The concept of the monthly nut makes you focus on expenses and do everything you can to earn your “nut” with enough sales. In other words, it has us put costs first and makes the goal to cover expenses, not to improve profitability. Can you say “Survival Trap?” Good. I knew you could.

You get what you focus on, so stop focusing on expenses. Focus on profit and the expenses will be taken care of by default. Screw the “monthly nut.” Instead, focus on your Required Income For Allocation (RIFA). This is the money you need to deposit by the 10th and again on the 25th to have a healthy business, to pay the salary you want from your business and to take the profits you deserve. Period.

Take your monthly, required personal income and divide it by two, since you are getting paid twice a month. Then divide that number by the percentage being allocated in Owner’s Pay. Using the (made up) amounts on Figure 7, I would divide $5000 by 0.31. The result is just over $16,000 in business income, which means that by the 10th and 25th of every month I need to collect and deposit around $16,000 into the Income Account to cover it. It’s really that simple.

So when I look at my Income Account (above), I know instantly that I am currently falling short by $3000 and need to keep the sales moving. Every two weeks the Income Account drops to zero when it is allocated, and I need to rebuild it to $16,000 or more. Yes, there is a nice chunk of change in my Drip Account; but that money is for services I will render over another twelve months, so it will only account for about $1000 every allocation period. Using this system, my sales revenue minimum becomes very, very clear.

WHEN YOU HAVE MORE THAN ONE BUSINESS OWNER

Just one more point about Owner’s Pay: If you have a partner or multiple partners who are also getting paid, you need to add up the total income requirements for the company. So if you need $10,000 a month and your partner also needs $10,000, the total owner pay is $20,000 per month. Divide that number by two; then divide again, by 0.31, and you get an RIFA of more than $32,000.

You may also notice that the Profit (15%) Account with Bank 1 is at zero. That is because it is simply a holding tray for a day or two. Money gets allocated from the Income Account and goes to the Profit (15%) Account at Bank 1. Then, on the same day, I initiate a transfer to Bank 2, to pull the entire amount of money out of the Profit (15%) Account at Bank 1 and put it into the Profit Account at Bank 2. That is where the profit accumulates. And I can see, it looks as though I will have a really nice, $7000-plus profit celebration at the end of this quarter. It’s a simple calculation: $14,812.11 x 50%. Par-tay!

This same holding tray setup is in place for my Tax (15%) Account. Allocate and then remove the temptation immediately.

Also, you may notice that no bank summary “grand total” is shown in the table. The accounts aren’t all automatically added up to show a total combined balance. Many banks do this for your convenience, but I suggest that you disable the option (if you can). The grand total of all your accounts shows you all the money on one big plate again— exactly the thing we want to avoid. Looking at a grand total messes with your mind, so don’t do it.

THE PARETO OVERLAP

You may be familiar with the Pareto Principle, commonly known as the “80/20 rule.” For the history buffs: Vilfredo Federico Damasa Pareto was an Italian economist. While studying the distribution of wealth in Italy in the late 1800s, he discovered that 20% of the Italian population owned 80% of the land. Then he looked at his garden, and observed that 20% of the peapods contained 80% of the peas. Then he looked down at his feet, and exclaimed, “OMG—I own five pairs of clogs, yet I wear these super-fly boots 80% of the time!” And then, out of nowhere the theme song from The Twilight Zone started playing, thus marking the first time that music was associated with a slightly unsettling a-ha moment.

Okay, okay. I made up that last part, but you get my drift. Pareto’s pattern is everywhere. Eighty percent of the time you drive, you’re cruising down the same 20% of the roads you’ll travel in life. And, despite your love of the sale rack, you will still pull from the same 20% of the clothes hanging in your closet, 80% of the time. Chances are, you are wearing one of your fave pairs of pants or shoes right now, as you read this. You are, aren’t you? That’s Pareto’s rule at play in your own life. Cue Rod Serling and a smoldering Chesterfield cigarette.

Pareto’s Principle also applies to your clients, in that 20% of them yield 80% of your revenue. This is a foundational principle of the growth strategy I detailed in my book, The Pumpkin Plan. And it goes further—80% of your profit is derived from 20% of the products and/ or services you offer.

The key to this advanced strategy is to connect the two—your clients and your offering. Some of your top clients buy most of your profitable offerings; some of your top clients go for the offering with the lowest profit margin. Likewise, some of your weakest clients consistently purchase your profitable stuff and some are just weak all the way around, buying the same no-profit stuff over and over again.

Once you see the overlap, the decisions become very easy. Get rid of the “bad” clients who only want your least profitable products and services. You are losing money here, catering to clients or customers who are not a good fit for your company.

Find a new way to manage the weak clients who do buy your most profitable offerings. Often, “bad” clients can become better clients if you meet with them to set new expectations and methods of communication. Meet with your top clients who don’t buy profitable offerings, too. Find out how you can deliver profitable stuff to them.

When you focus on profit first, even when choosing the clients and customers you are willing to work with, you increase your profit dramatically. Not only do you save money by cutting expenses related to serving weak clients, who don’t buy profitable offerings; you also free up your time, energy and creativity to focus on the clients you love, who bring in the profit. Applied to your client base, the Pareto Principle is an advanced Profit First technique that does double duty— you save money and gain profit. Gotta love that!

And those beloved top clients, who routinely buy profitable offerings? You are going to rock their world. Get to know them better than they know themselves. These are the clients and customers you want to clone. Remember, profit is in productivity. Systematize the overlap of your best clients buying your most profitable offerings and watch your Profit Account grow by leaps and bounds.

EMPLOYEE FORMULA

There is a really simple formula for determining if you can afford a new hire—or if your business is currently understaffed or overstaffed. For each full-time employee, your company should generate Real Revenue of $150,000 to $250,000 (ideally more, but this is the minimum). So, if you want a million-dollar company, you know that you can afford four to six employees (including yourself). This is just a ballpark number; every business is unique. But do not use your super distinctive status as an excuse to hire more people.

Efficiency is always the goal. Always. Not hiring your husband’s cousin who is down on his luck and “could really use a job.” Not finding space for the brilliant kid who has a ton of great ideas you could use… someday. You’re a “bottom line” person now, remember? You flipped the formula. Now, you’re working the “Sales – Profit = Expenses” system. You’re taking profit first. And that’s why you’re forced to be careful with your expenses.

And remember—we’re talking about Real Revenue, not top line revenue. Subtract your Material and Subs cost before you divide by the magic number range to get to your ideal employee count.

Again, this is not an exact, perfect system, but it will give you a better and more realistic understanding of what it means to be over- or understaffed. The reason these numbers aren’t perfect is because labor costs vary tremendously. A guy cooking French fries at McDonalds will make much less than the lady who engineered the next generation smartphone. In this example, cheap labor is less costly but also has a smaller impact on revenue. The fry guy just facilitates that sale of fries, and the engineer creates an entirely new product and revenue stream.

Remember Greg Crabtree, the author of Simple Numbers, Straight Talk, Big Profits whom I met an entrepreneurial award event? I had a call with him one evening. After he poked fun at Virginia Tech (my alma mater) losing to Alabama (his alma mater) yet again, he shared another instant labor analysis he agreed to let me pass on to you.

According to Greg, your Real Revenue must be two-and-a-half times the total labor cost if you’re running a tech business. This is because the tech industry traditionally requires expensive labor (highly-trained people who have a big impact on revenue). If, on the other hand, you are in a “cheap labor” field, such as the fast food restaurant example I used above, your Real Revenue must be four times your total labor cost.

For example, let’s say you’re a manufacturer with $6,000,000 in Real Revenue. If you hire “cheap labor” (like assembly line personnel), you will divide $6,000,000 by four to get $1,500,000. This means that your total labor cost (the people on the floor and the folks in the office) should not exceed $1,500,000. And if you are a manufacturer with $6,000,000 in Real Revenue but use “expensive labor” (like scientists and engineers), divide the $ 6,000,000 in Real Revenue by two-and-a-half to get a total labor cost of $2,400,000.

MINI POWER TACTICS

Some advanced Profit First strategies require very little time and are super effective. I am constantly tweaking and improving my system, so if you want to know about my latest discoveries, and share yours, visit my blog at Mike Michalowicz.com. Here are my favorites (so far):

THE GOVERNMENT’S MONEY

It’s so easy to “borrow” from our Tax Account. (It’s really stealing, but you don’t need me to tell you that… oops. I just did.) The money is just sitting there, taunting us with all of those zeros we could put to good use. When we cave and pull from the Tax Account, we don’t feel the pain right away. But when tax time comes, we can get in really big trouble. Owing more taxes than we have money to pay means that, at a minimum, we’ll be paying interest and possibly penalties on the amount we owe.

A smart tactic is first to move this account to a third-party bank that you don’t see, and then change the name of the Tax Account to

“The Government’s Money.” Now, I suspect that, like me, you would be way more reluctant to “steal money from the government” than you would be to “borrow money from the Tax Account.”

HIDE ACCOUNTS

Following the “out of sight, out of mind” theory, you are less likely to justify transferring or withdrawing funds from your accounts if you can’t see them. Some banks allow you to “hide” accounts so that you can’t see them on first view when logging in to online banking. Try hiding all of your accounts except for the Operating Expenses Account. You can still do the disbursements and the entire Profit First system using this tactic; it just means that now you won’t consider the other accounts when making spending decisions.

OUTSIDE INCOME ACCOUNTS

Chances are that as your business matures, you will add a variety of other accounts that collect income. You may have a PayPal account to collect funds, or a wire account for international business or local transfers. The challenge with these accounts is, you might start to view them as “extra,” like your own additional petty cash fund. They’re not extra. They are part of your revenue, and you need to make sure that you protect and allocate the funds just as you would any deposit into your main bank account.

For this tactic, set up all your outside income accounts so that any income is transferred to your main Income Account on a daily basis. Some banks will let you set up an auto-transfer for the total balance in the outside account, which is ideal as long as you keep whatever minimum balance is required to avoid extraneous administration fees.

If you can’t do this automatically, simply transfer the money to your Income Account when you do your biweekly allocations. Just note that these transfers may take a few days, so you won’t instantly have the money in the Income Account and will have to wait until your next allocation period to move the money to all the individual accounts.

ACCOUNT SNAPSHOT

To keep track of your accounts, set up auto-notifications for your key accounts via email or text. Have the bank report the balances of your Income Account and Operating Expenses Account to you on the 10th (when all of your money has accumulated) and the 15th (when all of your money has been allocated and all checks have been mailed; and again on the 24th (accumulated) and the 30th (allocated). Set up a daily notification of the balance in your Petty Cash Account. Check the other accounts manually.

This quick report will ensure that you are acutely aware of how cash flows in (Income Account) and what is available to go out of your business (Operating Expenses Account) and out of your own spending allotment (Petty Cash).

BANK CHECKS

Until we see that a payment has cleared, we still think of the money is ours. And sometimes we forget we wrote the check. Hello, insufficient funds charges and a ticket straight to the ninth circle of hell. This technique changes that dynamic immediately. Rather than pay with checks you write by hand and mail (if you don’t lose the envelope on the floor of your car), pay with bank checks.

Also called “bank pay” or “bank payment processing,” bank checks are processed by your bank quickly. More importantly, the bank will pull the money for the checks you “write” immediately. This way, you know the money is gone forever as soon as you process a payment.

Yes, the bank makes money on “the float,” and you lose any interest you may have earned in the few days it would take your payment to be received and processed by vendors. But I say, “Who cares?” Here’s the dealio: If you manage hundreds of millions or billions by processing checks and transfers manually, it’s a good strategy to cling to your money for a few days because the interest earned on your operating capital in even just a few days is significant. But for most entrepreneurs, the interest earned in “the float” is embarrassingly negligible—usually around $5 per year, and you’ll spend more than that on postage, mailing out your payments! So let the bank do the dirty work, why don’t ya?
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