PDF Summary:Profit First, by Mike Michalowicz

Mike Michalowicz’s Profit First criticizes traditional business accounting methods by claiming that they are unintuitive, and that their unintuitive nature leads many entrepreneurs to failure. He then outlines an alternate accounting system, which he calls the Profit First method. In the Profit First method, a percentage of income is set aside as profit before any expenses are calculated. This method, he says, allows an entrepreneur to do their business accounting in a simple and intuitive way, and to increase their business’s profitability and stability.

In this guide, we’ll discuss Michalowicz’s criticisms of traditional accounting, as well as his own recommendations for how to set up Profit First accounting and use its guidelines to improve your business. We’ll also provide commentary explaining psychological and economic research related to Michalowicz’s claims, as well as practical advice on how to apply some of his broader recommendations.

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(Shortform note: Alternatively, if checking your financial documents is a task you have trouble with, you can work with a bookkeeper. The U.S. Small Business Administration recommends sending your financial information to a reliable bookkeeper once a week. They can compile your financial documents then answer any questions you have, so you can understand your financial situation each week. Michalowicz does disagree with this suggestion, though, arguing that even bookkeepers can misinterpret or fail to understand financial information.)

Step #2: Assessing Your Business’s Current Financial Health

Once you have your bank accounts set up, Michalowicz says it’s time to assess your business’s current financial health. He explains that you should find the percentage of your income you’re spending on each aspect of your business: profit, your personal salary, taxes, and expenses. Then, you can compare these to a healthy business’s percentages. The more similar they are, the healthier your business is. (Shortform note: While this section of the guide provides a simple way to assess your business’s financial health, it isn’t as comprehensive as what a skilled financial advisor can offer. Michalowicz himself mentions that you should work with your accounting team throughout the book, so don’t use this as a substitute for that kind of support.)

Using the Allocation Percentage Equation

To assess your business’s financial health, Michalowicz first outlines how to find what percentage of your income is allocated to each aspect of your business.

1. Find your total income from the last 12 months.
2. Now, add up all expenses spent on materials and subcontractors, and label these costs as (M).
3. Subtract your material and subcontractor costs (M) from your total income to find your adjusted revenue. Label this value as R.
4. Find how much money went into the following:
   1. Profit: Profit from the last year that you didn’t reinvest into your business.
   2. Salary: Your salary from last year.
   3. Taxes: How much of your business’s money you used to pay for taxes last year. If you use your business’s money to pay your personal taxes, include that amount here.
   4. Expenses: All expenses from the last 12 months minus your costs of goods sold.
5. Now, divide each of those values by your adjusted revenue to find what percentage is allocated to each.

Your Allocation Percentages Versus Healthy Allocation Percentages

Now, you can compare your percentages to Michalowicz’s in the table below for the appropriate adjusted revenue bracket. The closer your percentages are to those in the table, the healthier your business is financially.

Adjusted Revenue Bracket (R)	A = Profit Result	A = Owner’s Compensation Result	A = Taxes Result	A = Expenses Result
0 - 250k	5%	50%	15%	30%
250k - 500k	10%	35%	15%	40%
500k - 1m	15%	20%	15%	50%
1m - 5m	10%	10%	15%	65%
5m - 10m	15%	5%	15%	65%
10m - 50m	20%	0%	15%	65%

(Shortform note: Michalowicz acknowledges that these numbers aren’t industry specific, but keep in mind that depending on your industry some of these numbers might not be realistic for your business. Percentages can range wildly from industry to industry—for example, the advertising industry has an average profit percentage of 3.1 percent, while the video game industry has an average profit percentage above 29 percent. Depending on your industry, then, Michalowicz’s percentages might be too conservative or too optimistic.)

Finding Your Business’s Ideal Allocation Percentages

While the percentages Michalowicz gave in the previous section are a good general example of where a healthy business allocates its income, he also provides the following instructions for finding your own ideal allocation percentages. (Shortform note: Once you determine these ideal percentages, think of them as good initial goals for your business. They shouldn’t remain fixed forever—Michalowicz acknowledges that you’ll likely make adjustments over time to your ideal percentages based on your business’s needs and circumstances.)

1) Your ideal profit percentage: To find your business’s ideal profit percentage, look up the records of successful public companies in your industry similar to your business’s size, then divide their profit by their revenue for the past three to five years. The average of those results will give you a good idea of an ideal profit percentage.

(Shortform note: Michalowicz claims that when determining your profit percentage, you’re calculating money strictly for your personal use. This contrasts with Greg Crabtree’s Simple Numbers, Straight Talk, Big Profits!, which argues that a financially healthy business needs a minimum profit percentage of 10 percent (before taxes) reinvested into expenses. This is because of three extra costs Crabtree says are often ignored: Debt payments, interest on debts, and depreciation (reduction of value in an asset over time, like from equipment wearing down). Crabtree argues that reinvesting 10 percent profit is needed to cover these additional costs and break even.)

2) Your ideal salary percentage: To determine an appropriate salary for yourself, Michalowicz recommends you pay yourself the same amount you would pay an employee to do your work. Divide this salary by last year’s adjusted revenue for your ideal salary percentage.

(Shortform note: You might be wondering why Michalowicz's methods encourage you to determine for yourself a salary appropriate for an employee, rather than the elevated salary more typical of a CEO. Paypal founder Peter Thiel offers an explanation in Zero to One, where he outlines two reasons why a CEO should have a low salary. He argues that a CEO with low pay will work harder to help the business succeed, since they won’t just be getting paid for showing up. In addition, a CEO with low pay inspires other employees to work harder by showing their dedication to the company.)

3) Your ideal tax percentage: Michalowicz emphasizes here that your ideal tax percentage covers your business’s taxes and your personal income taxes. Find your ideal tax percentage by adding the amount you paid last year on your business and personal taxes together, then dividing that number by your adjusted revenue from the last year. (Shortform note: When Michalowicz refers to “your business’s taxes,” he can be referring to a number of possible taxes depending on what your business does and where it’s located. Be sure to check with an accountant or the IRS website for a list of taxes your business might have to pay.)

4) Your ideal expense percentage: To calculate your ideal expense percentage, subtract your profit, salary, and tax percentages from 100%. This is the “leftover” money you’ll use for expenses. (Shortform note: This ideal percentage is probably going to be a lot lower than your current one. To make sure you continue towards this goal and don’t give up, David Goggins recommends you visualize your success in Can’t Hurt Me. He says that when you visualize what succeeding will look like, you remind yourself what you’re working towards, and that it’s a worthy goal.)

Your First Year Using the Profit First Method

Once you’ve found your ideal percentages, Michalowicz says not to match them too quickly–if you allocate too much money away from expenses, you’ll often end up without enough money to keep your business running. Instead, gradually change how you spend your money. Michalowicz outlines three new financial habits for doing so. (Shortform note: When creating these new habits, try adding them onto your existing financial habits or routines. This way, it’ll be easier to stick with your new habits, according to James Clear in Atomic Habits. By connecting new habits to existing behaviors, following your existing behavior will remind you to follow your new habit as well.)

1) When you change your current percentages to meet your ideal percentages, start by only changing three percent. Subtract three percent from a percentage currently higher than its ideal, and add it to a percentage currently below its ideal. (Shortform note: Michalowicz claims that by making small changes, you’ll be more likely to stick with those changes. James Clear agrees and further explains why this is the case in Atomic Habits. He asserts that people have an easier time sticking with easier behaviors, and so smaller changes are better when forming new habits. In addition, by creating a smaller version of a habit, you can connect more behaviors to that existing habit, which makes it easier to stick to both.)

2) Allocate income to your bank accounts and pay your bills twice a month, so you can keep track of how much you spend and when you spend it. (Shortform note: If you have less money than you thought you would when paying your bills consistently, that could mean your business is experiencing cash flow issues. Often, businesses have cash “trapped” in inventory or in accounts receivable. They earn the revenue for their business to work in theory, but have trouble actually receiving this revenue as cash on hand. By maintaining the habit of allocating income and paying bills bimonthly, however, you’ll avoid being surprised by this issue again.)

3) Take half of the money in your profit savings account for yourself at the start of each quarter as a reward for yourself, and to leave the rest of the money in the account as an emergency fund. (Shortform note: If you don’t want or don’t need all the profit for yourself, don’t automatically plan on reinvesting it into your business. Instead, consider giving some of the profit distributions to your employees by setting up a profit-sharing plan as part of their retirement fund. An estimated 19 to 23 percent of U.S. businesses do so.)

Part 3: Using the Profit First Method Long-Term

Once you’ve set up the Profit First method, you can start using it long-term to improve your financial stability and profitability. To do so, Michalowicz offers detailed instructions for improving your business by cutting expenses and increasing efficiency.

Cutting Expenses

Michalowicz explains that as you increase your profit percentage, you’ll need more money available for your profit allocation. However, he emphasizes that increasing your income is not how to get this additional money, because cutting expenses is a faster and easier way to make money available. Michalowicz recommends you cut costs by compiling a list of all expenses from the last year. Then, for each expense, ask yourself, “Is this necessary for keeping my business running or making customers happy?” If the answer is no, cut that cost. If the answer is yes, then consider ways you can accomplish the same thing in a cheaper way.

How Best to “Tidy Up” Your Expenses

If you’re having trouble finding unnecessary expenses, try using the practical techniques author Marie Kondo recommends for determining the things you do or do not need. Kondo offers these two guidelines in her book The Life Changing Magic of Tidying Up which can be particularly useful when cutting costs.

Discard in one go: When going through the process of getting rid of what you don’t need, Kondo recommends you get together everything you have and work through it all in one go. This doesn’t necessarily mean doing it all in one sitting, but rather working to power through everything whenever you can. When you declutter in one go, you keep up your momentum and don’t drag the process out. For your business, use all the time you have available to assemble your list of expenses and keep, improve, or remove them until you’ve reached your current goal.

Sort categorically: Kondo recommends that you sort by category when determining what to keep and what to get rid of. By doing this with your costs, you’ll have an easier time noticing which costs are redundant and cuttable.

• For example, when you sort your costs into categories you might realize how many online subscriptions you’re paying for, and then can cut those costs.

Focus On What’s Profitable

In addition to cutting expenses, Michalowicz also suggests you improve your business by specializing in whatever makes the most profit. He suggests two areas to consider when looking for profitability: services and clients.

Specialization in your most profitable services reduces the time and money spent on a given sale by narrowing your focus on fewer, more consistent tasks, and only providing these profitable services means every sale you make will have a high profit margin.

(Shortform note: If you’re having trouble understanding how to find your most profitable services, then consider reframing it as the process of cutting down on services that are only useful in specific circumstances. Often, companies will spend disproportionate amounts of money on offering complex and niche services just in case a client asks for them. These services are inefficient, because they require extra costs for something that doesn’t bring in a significant amount of revenue.)

Michalowicz also recommends you focus more on serving your most profitable clients—clients who consistently ask for your main product or service and aren’t difficult to work with. If you have any clients who are only interested in difficult to provide services or are difficult to work with, he says to drop those clients because they’ll reduce your profits.

How to Focus on Profitable Clients

While Michalowicz recommends you focus more on profitable clients, you might be wondering what practical steps you can take to do so. To focus on profitable clients, the management consultancy Strategex recommends taking practical steps in these two areas of your business:

• Delivery: Strategex recommends that your business delivers services and products to profitable clients before anyone else. When you do this, your business will better satisfy its profitable clients and be more likely to keep them. You will take longer to deliver to less profitable clients since they’ll be a lower priority, but even if they leave you, you won’t be losing much.

• Sales: Strategex also recommends that you spend the majority of your sales time making calls to potential new clients who are profitable, and cut the time you spend calling less profitable clients to keep the overall hours spent on sales the same. This will make you more likely to get sales that will be profitable and benefit your business, while cutting down time spent trying to sell to unprofitable clients.