Profit First: How to Transform Your Business (Part 1)

Profit First: How to Transform Your Business

Raffingers are thrilled to announce that we recently became a Profit First Professional Firm. Right now, I imagine you are probably thinking ‘what this is and what it does it mean?’ so allow me to explain.

We were first introduced to the methodology called ‘Profit First’ written by Mike Michalowicz some time ago and we have been investing a lot of time learning about this intriguing and innovative system. If you are a business owner or entrepreneur, I would highly recommend reading the book (available on Amazon) as it really is an eye-opener.

I will be highlighting some key points of the system over the next few months so be sure to check in regularly for these.  

The concept of the system is based around why most businesses are not profitable and even as they grow, the additional growth is consumed without any significant improvement in the bottom line profit number – the system provides a way to transform this and ensure that growth brings bottom line profit and more importantly cash!

So, let’s initially examine some behaviour principles behind the methodology:

1. Parkinson’s Law; why your business is like a tube of toothpaste!

In 1955 a modern philosopher named C. Northcote Parkinson came up with the counterintuitive Parkinson’s Law; that the demand for something expands to match its supply. In economics this is called induced demand – it’s why expanding roads to reduce traffic never works in the long term because more drivers always show up in their cars to fill those extra lanes!

Similarly, if your client gives you a week to turn around a project, you’d likely take the whole week – but if they gave you just a day, you’ll make it happen in a day. The more we have of something the more we consume. A perfect example of this is to look at a tube of toothpaste.

How much toothpaste do you use when you have a brand-new tube? A big glob of it…You put a nice long bead on the brush; the paste falls off but hey it doesn’t matter because you have a full tube – so you put another big glob on the brush!

But when you open that cabinet drawer and find a near empty tube… oh how the game changes. It starts off with an insane amount of squeezing, twisting and turning. You reach for your toothbrush, momentarily releasing a little bit of your vice like grip on the tube, and with that the paste shoots back in the tube… but you carry on with the toothpaste extraction; biting down hard on the tube, one hand squeezing and twisting, while your other hand tries to get the brush bristles to scoop out toothpaste – you have victory! One droplet of toothpaste, just enough for that fresh mouth sensation.

Parkinson’s Law triggers two behaviours when supply is scant;

  • First you become frugal
  • Secondly you become extremely innovative

And if there is one thing that will forever change your relationship with money, it is understanding Parkinson’s Law. You need to make less money available to operate your business. You will then automatically run your business more frugally and will run your business far more innovatively.

If you first extract your profit and remove it from sight, you’ll be left with less on which to run your business. When less money is available to run your business, you will find ways to get the same or better results with less. By taking profit first you will be forced to think smarter and innovate more.

2. The Primacy Effect

The second behavioural principle you need to understand about yourself is called the Primary Effect – we place additional significance on whatever we encounter first.

When you follow the conventional accounting formula of Sales – Expenses = Profit, we are primed to focus on the first two words… Sales and Expenses and treat Profit as an afterthought, and we then behave accordingly. We sell as hard as we can, then use the money we collect to pay expenses. We stay stuck in the cycle of selling to pay bills, over and over again, wondering why we never see a profit!

When Profit comes first, it becomes the focus, and it’s never forgotten.

3. Remove Temptation: Once you take your Profit First, put it away

Use the force of “out of sight, out of mind”. As you generate profits, remove the money from your immediate access. If you don’t see it and you can’t immediately access it, you will find a way to work with what you have. Then, when the money is released to you, it will serve as a bonus.

4. Enforce a Rhythm

Enforcing a rhythm works with money too. When we get into a rhythm we don’t get into the reactive mode of crazy spending when we get large deposits and panicking in the face of big cash dips. Establishing a rhythm will be a great indicator of overall cash flow as you will see from bank balance movements the peaks and troughs and manage them accordingly.

The Alternative Accounting Formula

Using the above psychology, we can look at the Profit First formula:

            Sales – Profit = Expenses      

And here’s how the 4 principles above are applied, which works around 5 separate bank accounts (the foundational accounts) – INCOME ac; PROFIT ac; OWNERS COMP ac; TAX ac; OPEX (operating expenses) ac

  1. Use Small Plates – when money comes into your main INCOME ac, it acts as a serving tray for the other accounts. You periodically disperse all the money from the INCOME ac into different accounts based on predetermined percentages. Each of these accounts have a different objective
  2. Serve Sequentially – Always allocate money based on the percentages to the accounts first, rather than pay the bills first. The money moves from the INCOME ac to your PROFIT ac, OWNERS COMP, TAX and OPEX acs. Then you pay bills with what is available in the OPEX ac – with no exceptions. And if there isn’t enough in the OPEX ac to pay expenses, this means your business is telling you that you can’t afford those expenses and need to get rid of some
  3. Remove Temptation – Move your PROFIT ac and other “tempting” acs (TAX ac) out of arms reach. Make it difficult to access thereby removing the temptation to “borrow” from these accounts
  4. Enforce a Rhythm – do the allocations and payables twice a month (10th and 25th) so you get into a rhythm of allocating your income and paying bills so that you can see how the cash flows

The first step in this process is to carry out an Initial Profit Assessment which we will cover in the Part 2.

For now, take a small step in the right direction:

  • Open one new account – a PROFIT account with a separate Bank to your usual Bank and allocate just 2% of revenue (net of VAT) to this account based on the money coming into your main account during the month and do this on the 10th and 25th of the month.
  • Don’t touch it and treat it as “out of sight out of mind”.
  • This account can then be used later in the year (but only for limited purposes) – owners reward!

Please check in for later articles on the system.

If you would like further information or would like us to carry out an Initial Profit Assessment for you as the first step in implementing this system, please contact us.

Article by
Paul Dell

020 3146 1606
Partner

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