In July, Michael Michalowicz, who writes books about entrepreneurship (which I have heard are very good; “The Pumpkin Plan” is on my to-read list) wrote a blog post titled “Take Your Profit First, Always.”
The gist of the post is, instead of looking at profitability as “Income minus Expenses = Profit” you should flip the formula. “Income minus Profit = Expenses.”
Pay yourself first, then spend money on expenses. As the author says:
In practice, as deposits from sales come in a predetermined percentage, for example 15%, is immediately transferred to a separate profit account. The remainder is available for the business leader to run business as usual. The business owner will see his available cash (which has had the profit already deducted) and make decisions accordingly. The new equipment purchase may be delayed, or a more cost effective alternative may be found. A new hire won’t be made because the money is not there, and perhaps the entrepreneur will conclude was unnecessary in the first place.
As Mr. Michalowicz correctly points out, most of us who own businesses make decisions based on how much cash is in the bank today. By flipping the profitability formula, it forces the business owner to pay themselves first (or at the very least, to leave a reserve in the bank).
This is a great way to look at things. In fact, when I shared this article on Twitter, I stated that it was brilliant advice. But there are some cautions.
ONE: New businesses typically have legitimate expenses that are true business needs. You might have to accept a lower profit margin at first in order to get your business going. Note the key phrase is “true business needs.”
TWO: The real point of all this is: business owners need to put thought into major expenses. This means looking at the numbers and determining if you can really afford to hire an employee, or buy equipment, or upgrade software. Maybe it’s worth it to spend the money. Maybe it can wait. And maybe it’s not worth it at all.
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