Coral DarbyProfit First*
I found the financial assessment outlined in Profit First to be a crucial step in understanding the premise of the book. The author, Mike Michalowicz, emphasizes that this process is a quick and straightforward exercise that requires a full year of financial data. The ‘Instant Assessment’ involves analyzing real revenue (minus the cost of subcontractors and COGS), net profit, owner’s compensation, tax payments, and operating expenses. Surprisingly, our company emerged in a somewhat favorable position.
According to the formula, we need to reduce our operating expenses by around 10% to reach our target profit range. The author suggests setting aside profit first to achieve this goal more quickly. He recommends creating a new ‘profit’ account and allocating at least 1% of every payment to this account. Although I can list several reasons why we might not do it, as a service business that has experienced many ups and downs, we operate as efficiently as possible. We anticipate achieving our profitability goals by acquiring one larger client or two average-sized accounts, which we are currently working on. Despite being slightly overstaffed, we are still profitable. I am confident that this is a strong position for us as we pursue new clients.
I am enjoying reading Profit First, and as I delve deeper, I have more questions. For instance, how does the instant assessment account for business partners’ ownership compensation if we all own varying amounts of shares? Additionally, what kind of business pays over 100K in taxes? As an S corporation, we do not pay taxes from the company; we pay them through our individual taxes.
The most significant insight for me so far has been the recognition that cash accounting (rather than accrual) is crucial, especially if one is managing finances based on the bank balance. During a conversation with my accountant for my SME interview, she agreed that most companies make decisions based on the bank balance rather than the recommended P&L and balance sheet. The author claims that the only way to succeed with this bank balance approach is to plan and budget, accomplished by setting aside funds for profit, owner’s compensation, tax, and operating expenses. Then, you pay your bills from the operating expense bank balance. This seems to be sound advice.
One more thought on accrual accounting versus cash accounting: We have been paying out dividends and employee bonuses based on what has been promised and is recorded in our books. Unfortunately, at times, clients are unable to pay their bills, and with the accrual accounting method, we base dividend checks and bonuses on our receivables. This complicates matters and further emphasizes the case for cash accounting. However, the team has done the work regardless of when and if the payment arrives, which is challenging for me to grasp.
I would appreciate hearing your thoughts on what I’ll refer to as ‘bucket budgeting’ in the future and your experience with accrual versus cash accounting.
*Michalowicz, M. (2017). Profit First, Transform Your Business from a Cash-Eating Monster to a Money-Making Machine. Penguin Random House
Coral,
Thank you for sharing yet another great reflection this week! First off, I really love that this book and the process surrounding it focus on owner’s compensation (otherwise known as owner’s discretionary earnings). While many entrepreneurs tend to pour any profits back into the business, it is important that we remember many of us are in this for the financial freedom and security that running your own business can provide. Thus, we must always account for paying ourselves in a manner that meets the needs of our lifestyle and family. Interestingly, much the same as the book, one of the quickest ways to do this is by saving on operational expenses. Not surprisingly, I have found in my career that this can be one of the most challenging things for entrepreneurs to manage, as we are not inherently “operational” experts. Thus, we tend to provide the spark and manage things, but often leave the operational efficiency up to others. In my mind, it is critically important that owner’s understand the expense base of their business and manage it properly, as it can be the difference between red and black.
Your dilemma regarding your current staffing and expense position is an interesting one. I have had this challenge in the past as well and tend to believe in service businesses that a heightened focus on customer experience is warranted to achieve growth goals. However, I also believe we must ensure that overstaffing and service is actually impacting our overall customer experience and positioning us to genuinely grow (ie…are we using that extra staff to impact value for customers? Or are they simply performing basic duties that could be delegated across other staff?). This is similar to the old dilemma between boosting sales or reducing expenses and more and more companies are choosing the latter and running lean due to the challenges associated with banking on pipeline sales to close.
Finally, great insight on your books and bonus challenges. Interestingly, I have had similar discussions with my finance colleagues in the past and we’ve run into similar issues when customer payments are beyond terms (we already run on 90 terms for our large customers). Transparently, what we do to manage this is set back any bonus (or equity, though we don’t have this issue) payments to be settled 90-120 days post period. So, if bonus payments are technically due out at end of year, those will be paid out to employees at the end of March or April. Yes, we have done the work, but we are paid out as the company is paid out and this seems to be a reasonable compromise. I think it is fantastic that you have used equity in your business as a toolset to reward your employees and I wish more business owner’s did the same. It is a wonderful mechanism to garner “buy in” and loyalty. Overall, when it comes to managing supplemental pay, I have found its often best to be honest with employees about the challenges at hand and I suspect with your leadership and tight knit shop, you wouldn’t have any issues implementing something similar to the above. Great post this week!
Cheers,
Zane Breeding
Zane,
As always, thank you for your valuable feedback; I really appreciate it! Two points in your comments really stuck out to me—the first one being how important it is for entrepreneurs to be in the numbers, to understand the day-to-day operations, what they all cost, and what they generate. Knowledge is a potent tool. The second point is your feedback on the topic of supplemental pay. I understand why paying bonuses to staff once the organization is paid makes sense. It’s a smart fiscal practice I need to accept and implement. I agree; being honest and transparent with the team will go a long way. It’s so helpful for me to know how other companies manage this aspect of the business. Thanks again!
Coral,
I am enjoying your reflections about flipping the accounting equation. I love the idea of paying yourself first and then cautiously looking at your expenses or things that are not necessities more closely. When you start with the end game or end profit in mind every day, week, month, or year; it may cause you to think about transactions and the way you conduct business more seriously. Using this mindset and tools like the instant assessment are great concepts for new entrepreneurs to learn. It is also a good way for existing entrepreneurs to tweak weak spots.
It seems that you have assessed some vulnerabilities of being slightly overstaffed, but as you are actively pursuing clients; you will be in a great position to service those clients when you secure them. Customer service is always key, and companies usually suffer in this area when understaffed. As Zane pointed out, transparency, great leadership, and a clear picture of the company’s vision cause employees to be loyal in times of delay in bonuses, perks, etc. Great job!
Kind Regards,
Tonya T. Thomas
Hi Tonya,
Thank you so much for taking the time to read my post. I really appreciate it! I’m so glad you are enjoying my take on ‘flipping’ the accounting equation. This book is making me think about where I can trim expenses. I used to think, oh, it’s impossible; we are running as lean as we can, but I know that is not true—there’s always room to shave more!
Best,
Coral
Coral,
One thing that I have found my business doing, which again is much smaller, is that I have not taken a profit out of the company for salary. This tactic, due to the full-time nature of my other role has allowed me to create a “nest-egg” that could protect me, should I want to run this venture full-time.
As for the advice of your accountant I was told the same thing from mine, who cautioned me from always watching the bottom line, and running off of the budget. This tactic hasn’t been into play much due to the fact, profit never leaves, but I do see the benefit of this tactic.
Dear Coral
I’m happy that reading Profit First has been helpful for Darby Communications. The financial assessment outlined in the book sounds important for understanding the business’s financials and improving overall financial health. Expenses are hard to balance, but reducing operating expenses to meet target profits can be challenging. I think about it from my personal perspective of “needs” and “wants.” Do we need this to operate, or do we want it, and where can costs be reduced to remain on target?
I am not versed in owning a business with multiple owners, but maybe adjusting the instant assessment to reflect multiple ownerships with varying compensation could be an approach you take.
Thanks again for the great post, and I am excited to dive into the next!