{"id":65315,"date":"2022-04-22T18:44:33","date_gmt":"2022-04-22T22:44:33","guid":{"rendered":"https:\/\/www.shortform.com\/blog\/?p=65315"},"modified":"2022-05-02T09:37:51","modified_gmt":"2022-05-02T13:37:51","slug":"what-is-the-profit-first-method","status":"publish","type":"post","link":"https:\/\/www.shortform.com\/blog\/what-is-the-profit-first-method\/","title":{"rendered":"What Is the Profit First Method? Definition & Overview"},"content":{"rendered":"\n

What is the Profit First method<\/a>? In what way is the Profit First accounting system superior to traditional methods?<\/p>\n\n\n\n

Mike Michalowicz, a business makeover specialist and entrepreneur, believes that traditional accounting methods often fail in the long term because they prioritize the wrong things. The Profit First method is Michalowicz\u2019s alternative to traditional business accounting<\/a>. <\/p>\n\n\n\n

In this article, we\u2019ll explore the main principles of traditional accounting, Michalowicz\u2019s argument for why they don\u2019t work, and the main tenets of his Profit First accounting method. <\/p>\n\n\n\n\n\n\n\n

Traditional Business Accounting<\/strong><\/h2>\n\n\n\n

First, let\u2019s clarify what Michalowicz is referring to when he talks about traditional accounting. Specifically, he\u2019s referring to three main principles in his arguments, which he claims are the common wisdom of the business world.<\/p>\n\n\n\n

  1. Traditional business accounting recommends starting with income, subtracting all expenses, and labeling<\/a> the difference as profit. <\/li>
  2. Constantly look to grow your business and put growth as your first priority. <\/strong>Growth leads to an increase in your income as well as the overall value of your company in case another company wants to buy it. <\/li>
  3. Traditional accounting also advises that you consult financial documents like balance sheets or income statements regularly, so you know what\u2019s going on financially in your business at all times. <\/li><\/ol>\n\n\n\n

    The Danger of Traditional Accounting<\/strong><\/h3>\n\n\n\n

    While traditional principles work for some, they also lead many businesses to failure. Michalowicz argues that this high failure rate exists because traditional accounting principles clash with the way most people think and make decisions. <\/p>\n\n\n\n

    (Shortform note: Research supports Michalowicz\u2019s claim that traditional accounting methods can clash with the way people think. A study revealed that even professional accountants<\/em> still allow some of their personal, unconscious bias to get in the way of their logical, rational accounting work<\/a>, often turning out inaccurate results that favor their clients.)<\/p>\n\n\n\n

    Michalowicz identifies one major clash in particular: Entrepreneurs interpret the traditional principle that growth is success to mean they should reinvest all their money\u2014including their profits and personal funds<\/strong>\u2014back into their expenses. They think that this increase in expenses will be covered by the increased income from their larger business. However, reinvestment into growth makes a business unstable, as it creates high costs and eliminates cash on hand. This instability can make slow sales periods fatal for a business. <\/p>\n\n\n\n

    (Shortform note: Behavioral psychology studies on gambling support Michalowicz\u2019s claim that people naturally think continuing to put money into their business will eventually result in success. Studies suggest that while gambling, losing money makes us want to spend again, and makes us think that doing so will earn us rewards<\/a>. This research could be interpreted to suggest that if entrepreneurs are losing money growing their business, they will psychologically want to spend more money on growth to chase success<\/a>.)<\/p>\n\n\n\n

    Challenges in Addressing Instability<\/h3>\n\n\n\n

    The instability that comes from a rapidly growing business is also very difficult for most entrepreneurs to fix, <\/strong>says Michalowicz. He outlines three additional ways traditional principles clash with natural decision making<\/a> and explains how these clashes prevent entrepreneurs from stabilizing their businesses. <\/p>\n\n\n\n

    1)<\/strong> Many entrepreneurs become used to the extra expenses they reinvested their profits on, and don\u2019t want to get rid of them. They might have a hard time recognizing that they don\u2019t need the company car or office space they have grown accustomed to, for example. (Shortform note: Research on compulsive spenders supports Michalowicz\u2019s argument that people attach emotions to the things they buy, which makes cutting expenses<\/a> much more difficult. Studies suggest that people tend to believe that buying things will make them happier<\/a>, or compulsively buy as a way to try and cope with shame<\/a>.)<\/p>\n\n\n\n

    2)<\/strong> Financial documents are often complex and difficult to navigate, even for accountants. This can make it difficult for entrepreneurs to even recognize when their business is financially unstable. (Shortform note: Michalowicz\u2019s claim that small business entrepreneurs have trouble understanding their accounting is backed up by a recent survey, which found that 40 percent of small business owners would label themselves financially illiterate, and 66 percent wish they knew more about their finances.<\/a>)<\/p>\n\n\n\n

    3)<\/strong> Financial instability and uncertainty often lead entrepreneurs to make irrational or panicked decisions, which only put a business into further trouble. Often, these decisions involve looking for increased growth and sales even if they come with expenses or opportunity costs. (Shortform note: Psychological research supports Michalowicz\u2019s claim that as people lose money, they will make worse financial decisions. A study found that as gamblers lost money, they would be more likely to recklessly and impulsively spend more<\/a>, believing that doing so would earn them money back. The study suggests that this is because losing money is an emotional event, and so it doesn\u2019t encourage rational decision making<\/a>.)<\/p>\n\n\n\n

    Core Tenets of the Profit First Method<\/strong><\/h2>\n\n\n\n

    Now that we\u2019ve shown how traditional accounting clashes with normal thinking and decision-making<\/a>, we\u2019ll outline Michalowicz\u2019s accounting system: the Profit First method. <\/p>\n\n\n\n

    What is the Profit First method? In this system, a percentage of income is taken as profit before<\/em> any expenses are paid. <\/strong>The Profit First method works on four main tenets, which allow an entrepreneur to avoid the challenges of traditional accounting by using the natural way they think to make healthy financial decisions. <\/p>\n\n\n\n

    Tenet #1: Limit Your Resources<\/h3>\n\n\n\n

    Michalowicz\u2019s first tenet is to allocate a specific percentage of your income for expenses (we\u2019ll discuss how to do this later on). By allocating only a percentage of your income to expenses, you\u2019ll force yourself to spend that money more efficiently. That\u2019s because of Parkinson\u2019s Law<\/a>: the theory that the more resources we have available, the more resources we will use. <\/strong>This theory works the other way as well: the fewer resources we have available, the fewer we\u2019ll need to use. <\/p>\n\n\n\n

    (Shortform note: Michalowicz\u2019s definition of Parkinson\u2019s law isn\u2019t quite accurate. Instead, it\u2019s a common misinterpretation of an essay on government bureaucracy<\/a> published by historian and author Cyril Northcote Parkinson. What Michalowicz (and many others) calls Parkinson\u2019s law is actually just the article\u2019s first sentence, which describes the \u201ccommonplace observation\u201d that people use all available time to complete work. Parkinson\u2019s actual law is an equation explained later in the article, which tries to predict bureaucratic growth. Because of this misinterpretation, keep in mind moving forward that this first tenet is founded not on behavioral psychology, but rather on a common-sense principle.)<\/p>\n\n\n\n

    Tenet #2: Order in Terms of Importance<\/h3>\n\n\n\n

    The next tenet Michalowicz outlines is to allocate your income in order of importance, starting with profit to emphasize that it\u2019s your first priority. This works due to what psychology calls the primacy effect<\/a>: When given multiple pieces of information, our natural tendency is to <\/strong>better remember and place more importance on the first one given to us.<\/p>\n\n\n\n

    (Shortform note: Michalowicz claims that you\u2019ll place the most focus and importance on whatever comes first. However, behavioral psychology suggests several other factors which might cause us to place more focus elsewhere in a list. Besides the primacy effect Michalowicz cites, there\u2019s also the recency effect, which says that we\u2019ll better remember and focus more on information given to us most recently<\/a>. Also, there\u2019s evidence that an item in a list emphasized more than others might also be better remembered, no matter where it is in the list<\/a>.)<\/p>\n\n\n\n

    Tenet #3: Removing Temptation<\/h3>\n\n\n\n

    For the third tenet, Michalowicz advises that you remove the temptation to reinvest money into growth by creating savings accounts for profit and other essentials, and making those accounts inconvenient to access<\/strong>. By making that money harder to access, you\u2019ll be less tempted to misuse it. (Shortform note: Michalowicz\u2019s suggestion of changing your circumstances<\/em> to avoid temptation may raise questions, as most people tend to think about temptation as an internal <\/em>struggle to maintain our willpower. However, studies show that changes in external circumstances can be an easier and more effective way to increase self-control<\/a>, supporting Michalowicz\u2019s tenet.)<\/p>\n\n\n\n

    Tenet #4: Keep Good Habits<\/h3>\n\n\n\n

    Finally, Michalowicz\u2019s fourth tenet is to make a habit<\/a> of dividing your income between profit and expenses and paying your bills consistently. By making a habit of dividing income amongst your business\u2019s bank accounts, you can recognize financial changes<\/strong> just by looking at their account balances. <\/strong>Then, you can react to those changes calmly because you\u2019ll have seen them coming. <\/p>\n\n\n\n

    (Shortform note: You might be wondering how good habits will help you react calmly to change. According to Chip and Dan Heath in The Power of Moments<\/em><\/a>, habits help us stay calm because they help us prepare responses to change ahead of time<\/a>. These prepared responses mean that when change does occur, we\u2019ll respond more calmly because we\u2019ll have already decided how to do so in advance and so won\u2019t be caught by surprise.)<\/p>\n","protected":false},"excerpt":{"rendered":"

    What is the Profit First method? In what way is the Profit First accounting system superior to traditional methods? Mike Michalowicz, a business makeover specialist and entrepreneur, believes that traditional accounting methods often fail in the long term because they prioritize the wrong things. The Profit First method is Michalowicz\u2019s alternative to traditional business accounting. In this article, we\u2019ll explore the main principles of traditional accounting, Michalowicz\u2019s argument for why they don\u2019t work, and the main tenets of his Profit First accounting method. <\/p>\n","protected":false},"author":8,"featured_media":65407,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[40,45,79],"tags":[610],"class_list":["post-65315","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-books","category-business","category-entrepreneurship","tag-profit-first","","tg-column-two"],"yoast_head":"\nWhat Is the Profit First Method? Definition & Overview - Shortform Books<\/title>\n<meta name=\"description\" content=\"The Profit First method is Mike Michalowicz\u2019s alternative to traditional business accounting. 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