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How The Profit First Formula Can Keep Your Business Healthy

Recently, I was pleased to interview Mike Michalowicz, bestselling author of The Toilet Paper Entrepreneur and The Profit First Formula on my radio show The Goldstein On Gelt Show. Mike explained why putting profits first will help build up your business and how healthy lifestyle habits can also be translated into healthy business practices.

Read the transcript of the interview below, or listen to it here.

Douglas Goldstein: Your most recent book is called Profit First Formula. Can you tell us about its overall theme?

Michael Michalowicz: I believe that a lot of entrepreneurs get addicted to axioms, meaning that we perceive certain truths in business because they've always been this way. We used to believe that the world is flat. Everyone would say, "Keep your boat in the harbor. Don't go out too far, or you'll fall off the edge." In business, the formula for profit is sales - expenses = profit. That's the axiom that's out there, and it's wrong. Logically, it makes sense, but behaviorally it's totally wrong because what happens is we sell, we make our sales, the money comes into our bank account, and we then do the next step, which is to pay expenses. So we look at our bank account and pay expenses, depleting the account, and profit is the leftover. But what I suggest in Profit First is to simply flip the formula, so sales - profit = expenses. What happens in this scenario is that you sell as much as you can, as you always would, but you first subtract the predetermined percentage, 5, 10, or 15% of those sales stored away as profit. Now the remainder is for expenses, and it's a very minor shift, but the consequences are profound. By giving ourselves less money for expenses, by seeing less money in our bank account, behaviorally we adjust to make our business run more frugally. So it's a subtle change. It's the pay-yourself-first mentality that we apply in our personal life. Now we can now apply it to business.

Douglas Goldstein: I believe that managing a business is very much like managing your home finances, so do you think that the profit principle you're describing would also apply to someone's savings and personal finance?

Michael Michalowicz: Yes, no question about it. In fact, that's where I stole the concept from. It's the pay-yourself-first mentality. The reason why we are told to do it in our personal lives is so that our lifestyle will adjust to our net income. One of the greatest savings mechanisms of all time is the pay-yourself-first principle, and in the U.S., it is the 401(k), and every country has its own version of this. Basically the employer pays you your gross pay, say $1,000 for that period. Then they subtract out your tax liabilities and your retirement, your 401(k) first. Then we get paid the residual - maybe $600. Very quickly, we adjust our lifestyle to live off that residual check. That's the pay-yourself-first mentality applied to business. Behind the scenes, that retirement mind has been taken away very quickly and more people have achieved millions of savings through a 401(k) than any other mechanism. So this principle absolutely applies to our personal lifestyle, and what I just implore now is that we need to apply it as entrepreneurs to our own business too.

There was a study of U.S.-based businesses. There are 28 million small businesses in the U.S., and this is defined by having $25 million in revenue or less. Of these 28 million businesses, 22 million are running check by check. Income may be flowing into the business, but it's flowing out just as fast, and if they don't get another deposit in the next week or two it can literally put them out of business. So it's the natural tendency of entrepreneurs, and I believe all people, to expand our lifestyle to meet the money that's coming in. So instead of trying to willpower ourselves into savings, I'm suggesting that we should make it an automatic mechanism. Then our behavior becomes our best ally because it's an automatic mechanism. The savings might be taken away and put aside, but we now naturally adjust to the net income that we have. We still may live check by check, but because the money has been taken out in advance, the savings are growing behind the scenes.

Douglas Goldstein: Let's now go into your first book, The Toilet Paper Entrepreneur. You've got this philosophy there that it's better for someone to start a business with fewer resources. Why is that?

Michael Michalowicz: Because necessity is the mother of invention, and I see a lot of entrepreneurs going into business looking at the stories of Google or whoever the company is that got funded and became a success. There's now this belief that if I want to be successful, I need to accumulate a lot of money. But the funny thing about money, especially other people's money, is that it dumbs down our senses and when we have a problem or something is not working, money bridges over that problem and we can continue on with our business. The fact is that when we have no money, we are acutely aware of any mistake we make, or any problem we have in our business. It is painful to spend the last few dollars that I have and it's not working. So it actually makes our senses hypersensitive to challenges and allows us to adjust quickly. It makes us very aware of the ongoing action and activities in our business, but secondarily, when my competitor has thousands or millions of dollars in a similar situation but I have nothing, it forces me to find ways to get the same thing done without money. With the fewer resources that an entrepreneur has, the more innovative he becomes, and the most innovative entrepreneurs are ultimately the most successful.

Douglas Goldstein: We see this real problem with young people when they finish school, and then they expect to have money. They expect to go and get a high paying job, which they don't get, and they end up living in their parents' basement for years because they don't have the necessity to go elsewhere. The only mother they have around is their mom, cooking and doing their cleaning for them, so they don't get any better at handling money.

Michael Michalowicz: I'm a parent of three children, and one is actually going to college now. There is this protective mechanism of I want to support my kids, I want to give them the best life ever, but what I'm finding is that the best life ever is to allow them to face the challenges of life. Protect them, don't let it kill them, but let them get burned a little bit. Let them fight their own way because once you survive the struggles of life, you realized that there's an opportunity in the struggle. You're not the only one facing that problem. Everyone else is, but if you're the one willing to work through it and find the way around it, that will put you ahead.

Going back to business, it translates the same way. A business that gets funded, it's basically like it has a parent. A corporation or a wealthy angel investor comes in as a parent and gives money to this business, and the business says that everything is alright. But it isn't. You haven't lived yet. You know this. There are businesses out there that do this. They just constantly are trying to raise funds and they never get out of the coop. They never fly from the nest.

You mentioned that I was an angel investor. I call myself "the angel of death," because I was very bad at it. But I did learn one valuable lesson - that the more I funded a business, the more it became dependent and focused on getting more funds and the business was simply the business of raising money. It wasn't in the business of getting something done and impacting the world. Those are the worst investments out there.

Douglas Goldstein: In Profit First, you focus on four methods that are based on healthy lifestyle habits. I'd like you to summarize the four jRecentlyust to give us a sense of how you made that connection, and maybe give us something we can take away.

Michael Michalowicz: There are four healthy lifestyle habits. The first one is if you want to live a healthy lifestyle, get smaller plates for your house. This is a behavioral principle. The plate in the global diet has expanded. Around 200 years ago, plates were half the size they are today, and the natural tendency is to fill the plate and eat what's on it. So by reducing the plates, our behavior gets to continue to be the same but the guardrails are in place now to actually consume fewer calories. In business, most of us have one account or two accounts for our business. It's one big plate. I suggest that businesses have five or six accounts for different purposes, one for profit, one for paying the owners, one for expenses, one for tax liabilities, and by saving on different plates as money comes in, you allocate these plates and now you're consuming less. Instead of eating off one big tray and thinking it's all available for expenses, by dipping up to smaller plates, you know what's truly available for what purpose and you automatically become more prudent on how you use your money.

Second step is vegetables first. The sequence of how we eat our food is very important. If you eat your vegetables first, you get the nutrients you need right up front and you're likely to eat less later on. In business, the first thing we need to do is take our profit. It's the last thing we do. The nutrients come last. When money comes in, the first thing is allocate that money to your profit. Then with the rest, see what you can do and allocating it elsewhere because if you take care of your profit first, you're getting the most important nutrients your business can get.

Douglas Goldstein: How can people follow you and follow your work and get some of the great free resources that you offer?

Michael Michalowicz: Go to www.mikemichalowicz.com, I used to write for the Wall Street Journal. You can get free articles, and if you navigate the site, I blog every single day and I give free book downloads for all my books on my site, www.mikemichalowicz.com.