Nathan Sykes

March 11, 2021

Revenue - Profit = Expenses

Mike Michalowicz is one of my favorite business authors. He approaches entrepreneurship in a way that makes sense to people like you and me, drawing stories and inspiration from small business owners around the country. He's one of the rare people in business who talks more about his mistakes, his ego, and his losses than he does about his success.

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I'm sure he wouldn't mind me using this file photo of him. Man, I'm not great at copyright compliance.

One of the books that he wrote, and by far his best-selling, is Profit First: Transform Your Business from a Cash-Eating Monster to a Money-Making Machine*. It's the first accounting/finance book I've ever purchased that's actually pleasurable to read, and it goes against most everything you've ever been taught before about how to keep track of your company's money.

GAAP (Generally Accepted Accounting Principles) are what most businesses on Planet Earth use. That's why they're called generally accepted! Bookkeepers and accountants can move from client to client, knowing that their books retain, more-or-less, the same structure.

But you and I are not bookkeepers or accountants. We're business owners. We were never trained in GAAP! For the most part, we employ a significantly simpler accounting method called "How-much-money-is-in-the-bank?". It's a very intuitive strategy - if there's a lot of money in the bank, you expand! If there's not a lot of money in the bank, you make collection calls and work until there is a lot of money in the bank. Repeat steps one and two until you hit it big, and, at the end of the year, hire an accountant to sort through the mess.

That's more-or-less how it was when Howdy Interactive was a marketing agency. We'd expand when we had money, and stay stable/contract when we didn't. But when we had to shift over to private equity, I knew that couldn't fly. We needed to put a system into place that would account for our spending, taxes, profit shares, and still put us in a position of growth.

Profit First is that system. Instead of GAAP, where the standard financial equation is Revenue - Expenses = Profit, the Profit First methodology flips it on its head, and makes the financial equation Revenue - Profit = Expenses. For every incoming transaction, a set percentage of it is automatically deducted and shifted away into other bank accounts. These accounts account for profit, taxes on that profit, owner's compensation, and a reserve fund - automatically. You run your company using the remaining funds.

Don't have enough money to cover all of your expenses? Too bad. That means it's time to downsize! A point that's heavily made in the book to justify this philosophy is the introduction of Parkinson's law!

"Work expands so as to fill the time available for its completion"

Think back to your academic days in high school or college (or if you're currently in school, think back recently) - it shows Parkinson's law at play. If you remembered you have an essay due tomorrow, you bet that you're going to be focused on that essay and have it done. But if you get assigned an essay that's due in two weeks, it will most likely take you the entire two weeks to turn in the paper.

Parkinson's law doesn't just apply to time, thought that was its original intention. It can also apply to finance. If you are flush with cash every month, you don't mind spending a premium on the tools and expenses that you need to run your business. That is what's eating up your potential profit. If you remove the money from your operating expenses account before you can even consider it, it'll force you to be significantly more conservative with your expenses and cut the low hanging fruit, leaving you the ability to be permanently profitable.




*=You guessed it, that's an affiliate link. Now instead of Amazon keeping the entire $18.26 USD it's listed for, I get $0.82 of it! What fun!