A few months ago, I wrote a post titled, “What Profit First Is and How it Helps Businesses Succeed” (I’m not great at short titles).
In it, I defined Profit first as:
…a simple, yet very effective approach to finances that works with human psychology to create profitable, sustainable businesses.
Today, let’s dive deeper into what we mean by “human psychology” in the context of your finances.
Parkinson’s Law
This is the psychological principle that underlies Profit First. To understand it, let’s talk toothpaste.
Mike Michaelowicz, the author of Profit First, uses an analogy to explain Parkinson’s Law. It goes something like this:
When you first buy a tube of toothpaste, you squeeze out great globs from the full tube, often losing half of it down the drain. This doesn’t worry you too much, because there’s lots more where that came from.
But as you get nearer to the end of your tube, your habits change. You pinch and squeeze every last bit, getting a full tooth-brushing in with only a fraction of the toothpaste.
As a mom with as many as 7 kids in the house at any given time, I can tell you I’m really good at rolling up that tube to squeeze out every last drop.
It’s a great analogy because everyone can relate to it. It illustrates the principle behind Parkinson’s Law:
“Work expands to fill the time available to completion” [source]
If my kid has a week to finish his homework, it takes him a week (or more likely, the last day of that week).
You know how it goes. There are a ton of examples from daily life.
Now let’s show how it connects to your business finances.
The Profit First Formula
The age old accounting formula looks like this:
Sales – Expenses = Profit
We take what we earn, pay our expenses, and the leftover is our profit. Seems pretty straightforward, right?
Well, easy to understand maybe, but for some reason those profits never seem to materialize for many business owners. Recognizing this, Michalowicz reversed the formula to look like this:
Sales – Profit = Expenses
Why?
Mathematically, the result is the same.
But psychologically, they have very different results.
To understand this, let’s go back to toothpaste.
Simple Financial Habits for Profit
How do you know how much profit you have?
Most business owners look at their bank accounts. If there is a lot in there, they make decisions differently (like the full tube of toothpaste).
If it’s looking lean, they may rethink capital purchases, dividend payouts, or going on that 2 week conference/vacation.
The problem with the bank account as a cash flow indicator is that it isn’t accurate. Some of that money may be earmarked for expenses that haven’t been paid yet, or plans that you have in the works, or, I don’t know, payroll?
Cash Flow Statements
The most accurate picture of your cash flow position comes from your cash flow statement. But when do you take the time to generate and review that report?
Most of us… not so much.
And even if you do, deep-seeded psychology might not register that all that money in your account isn’t yours to spend (or that all that toothpaste down the drain costs you money.)
This is where the Profit First system comes into play.
By reversing the accounting formula, profit is removed from the revenue first and the leftovers are used to cover expenses.
This equates to removing some of the toothpaste from the tube to use later. That sounds a little tedious. Thankfully, it’s easier with money.
The #1 Profit First Habit
To accomplish this (and trick your lizard brain), Michaelowicz recommends opening a separate bank account for your profits.
Once revenues come in, you immediately allocate a percentage to the profit account and transfer it over. The leftover money is available to pay expenses and operate your business. The idea being, a smaller tube of toothpaste will make you think twice before spending anything.
And it works.
The Profit First system extends to setting aside tax dollars, your owner’s pay, operating expenses, and revenue.
If you’re interested in learning more, get the first 2 Profit First chapters on me.
You won’t regret it.
Jenn
P.S. Looking to work with a bookkeeper who can help you keep more of your profits? (And who doesn’t mind reconciling the extra accounts!) Book your complimentary Profit First Blueprint here.
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