Traditional Accounting is BROKEN - and can make you broke!

Entrepreneurship is hard, but the process can be simplified. You can achieve success faster, sooner, and easier. I'm Mike Michalowicz, and I'm on a mission to eradicate entrepreneurial poverty. My goal for this episode and every episode is to serve you on your journey. Let's start right now on entrepreneurship Simplified.

So here's how we started off. We're talking about the desert island.

Yes.

You go with Chris. You go with Krista.

Yeah.

And my argument for this is we already are established at living an extended period of time with a lot of face time with our spouse, but no one else.

And having expectations of each other.

And having expectations, knowing how to navigate that and the subtle cues that present themselves.

Yes, yes. Probably the safest for everybody.

That's the same as for everybody. Yeah. If I had to get stuck on a desert island without, like, my wife.

Yeah.

Um, I think I'd pick a Navy seal. And the reason?

March.

Now it's all about getting out.

Right.

And so I want someone, per him to know how to navigate the situation.

Exactly.

To fight wild boars.

Yeah. To tell you how to breathe for six hours through a straw. Who's. Who's going to teach you how to do that?

Exactly. Somebody I could drink for six hours. There you go. So what are we talking about today?

So, Mike, business author man, man who's written Profit first and all in and Clockwork and Pumpkin Plan and A School of Others, I need you today to tell us about Profit first, but let me start by reading you an email that we got. This is an email from James Frankham, and it says, dear Mike, although we never met in person, your book Profit first changed my life. Yes. I got your other books too, and they're doing a nice job, but that one major life changer. So the core methodology of Profit first is very similar to the envelope budgeting system. But why do you think something so simple, seemingly obvious, has been so effective?

Yeah, I feel blessed. And before I we start addressing that, I do want to recognize that we're in a brand new little studio set up for ourselves. This may be echoey, may not be perfect, but we're trying to get to perfect. So just.

We'll get there.

We'll get to our listeners, and I want to introduce you. You're Amy Cartelli and a longtime friend all the way back from the high school years. We are blessed to have you.

Thank you.

You really are the matriarch for our organization. So thank you for. For doing that.

Thank you for having me.

It's a joy. It's a joy work with you and our team. We have such a best team.

We do. We have the best team.

Extraordinary people.

You and Kelsey have done an amazing job of. Of finding the right spirits for this organization.

Different styles too. You know, we. Aaron is no bullshit. We have the job done.

Yeah.

Jenna is a connector and wants to socialize and it brings about this great balance.

Yes. Yeah.

Okay. So thanks for letting me do that little preamble.

Of course, of course.

This question, you know, why profit first and why is it kind of a hit?

Why is it a hit?

I believe the biggest facade in the world is the health of an organization. If you and I are small business owners, it is in our best interest to tell our clients everything's fine. Everybody's. Could you imagine? I'm your client. You come to say, mike, my business is struggling. I'm really dying, but I'm ready to serve you. Like, no, why don't we pass on this one? Right? It is in the best interest of a small business owner to present strength. And yet most business owners don't have strength. So here's the challenge that then presents itself. When I look around at all of my competitors, other entrepreneurs, and I ask them, how's business going? They fall into the routine. Fantastic. You know, we're crushing, you know, growing and so forth.

Right.

And therefore my perception is everyone else is doing well and. And I'm not. So then I buy into the game and say, well, I'm doing great. So it is the biggest misnomer that small business is fiscally healthy. The reality is, according to SPA research, and there was also research done by major US bank, 83% of small business globally is in a check to check survival. Almost every business is dying, right? Financially, and yet we can't admit that publicly. And so we live with it internally. And it becomes this insidious disease that just eats away us and we loathe ourselves. Why? Why am I the one who struggles? Why? Why can I not make it? Here's the reason most businesses struggle with profitability is because we're told to follow a complex, albeit logical, but complex system. And it's not human nature. It's not behavioral. It's logical. And humans are logical. We want to think we are, right? I ain't logical. I'm behavioral. And so are you.

Yeah.

What happens is when it comes to a decision that we make, it is inevitably any decision we make in life. It's inevitably based upon emotion and behavior. And then we backfill with logic. I want that nice car in the window, it looks really cool and sexy and I love to drive that. It's an emotional thing.

Yeah.

But then it backfills. Like, you know, if I have that nice car, people will think I'm successful.

Right. And that's good for business.

Success forgets success.

Right, right, right.

And so we actually backfill it to justify. Well, in our business, when we're not profitable, we try to go through the logical steps of reading the P L and doing your KPIs and all these things and it becomes overwhelmed. Yeah, this is too much. And then we get frustrated and say, I guess I just need to sell more. And so the result is I can't handle the detailed financials. I'm just going to try to sell my way out of this. Which if we're selling in a way that's not profitable, it actually is more damaging for a business. So profit first is so successful because it says, don't do that. Let's work with human behavior. Human behavior. The essence of it is this. When something comes, blast, it's insignificant. You love your family. Actually gets me excited and emotional and goosebumps. Because you talk about John Henry, you talk about Will, you talk about Chris. You have such an extraordinary family and you love upon them so much. I could never imagine Amy Cartelli coming here and saying, you know what? I'm going to start loving my family even more. And by doing that, I decided to put my family last.

Yeah, yeah, right, right. Makes no sense.

No, I. I put them first. I put Chris first. Like, you know, Chris had a challenge recently and you came right to us and said, how can we help Chris? It's minor and he'll navigate it, but you instantly put him first. That what comes first gets taken care of. And knowing Chris, not so well, but knowing Chris, when, when he wants something that becomes priority, he wakes up at 5 in the morning and he starts driving on it. What comes first gets done. Could you imagine Chris waking up and saying, no, forget that. I'll wait till the end of the day, maybe I'll take care of. And that's not Chris's nature.

No.

But also it doesn't serve people right. When something comes last, it gets ignored. When something comes first, it's prioritized and cared for. If your health matters, I put my health first. You never say I put it last. If problem first matters, we're told it comes last. Right now we call it the bottom line or year end. These are terms to say insignificant. And so for most business owners, we wait until the end of the year when the financial statements come and say, oh, there's no profit, maybe next year. Right. And I have a line for this. Profit is not an event, as in it's not an eventuality. Profit is not an event. Profit is a habit. We need to bake it to every transaction of your business. So Profit first is every time revenue comes in, take a percentage, hide away from your business and run your business off the remainder. And you're now guaranteeing profit because you've put it first.

Right.

That's why it works.

That's why why it works. Okay, but so back to gap. General Generally Accepted Accounting principles.

Yes, generally accepted.

Generally generally accepted.

It's kind, you know, like, it's kind of okay.

Yes.

So we're going to generally accept it.

And. And we're saying that Gap fails.

Yeah, yeah. I say GAB is crap. Imagine when Chris got his name, proposed to you and said, will you marry me? And you're like, generally accepted.

But this is a little unclear for me, Mike, as a person who is not yet owned running her own business. So you need Gap though, right? I mean, for your financial forms and your financial filings. That is how we. That is, that is the form which we follow. That is the format we follow.

Basically, the general standard. It is mandated for corporations of certain size. Small business does not need to adhere to it. But at the end of the day, for tax compliance, you do have to follow an instruction set so that the government can look at one consistent way of people spending taxes and make a determination what's due.

Okay, so as far as you're concerned, is that as good as it gets with it?

That's all this is worth. Okay, not worth. It's not valuable for the operations of the business. But there is compliance components. The beauty of Profit first is it is not an accounting system. People get confused about this. They say, you know, either going to do GAAP accounting, you know, or I'm going to do Profit first accounting. No, they're different. Prop first is a cash management system. Gap and there's other forms of accounting. Accrual accounting is a form of gap. And there's also what's called cash counting. Those are mechanisms for reporting. And there's value for the government, but it's also value for us in, in reading deeply into the business. Profit first, though, sits in front of it. I consider more of an umbrella.

Umbrella.

Yeah. Okay, so what happens is Prop first is you log into your bank account, you see money divided up proactively into different accounts for different purposes. I Call this a allocation. So every business consistently has a need for profitability. I want to give you an ultimate tip here. I'm going to ask you a question. Who do you think wants profit most for your business? And you can pick employees, owner, customers, vendors. Who wants profit most for your business?

I'd say the owner.

Yeah, that's what most people say. And I say that's actually not true. The person who wants you to be most profitable is your customer. Now here's what people say is like, my customers want to be profitable. They want the deal. This entry, could you imagine I'm your doctor and you have something that you're facing some issue and you come in and the doctor says, amy, I'm really struggling financially. I mean, I'm actually desperate. I am not profitable. I actually don't even know what to do if I'm going to be in business tomorrow, but I'm ready to do the procedure. Or Dr. Chu comes out and she says, amy, I'm highly profitable. The business I'm in is to serve exactly what your need is. And I make a lot of money doing this. I'm ready, I'm professional, I'm rehearsed in this. I'm going to crush it. And there is no rush because I got a lot of money. Which doctor do you choose?

Going with Dr. 2.

Dr. 2.

Dr. 2.

Our customers don't say they want us to be profitable. They don't say, can you charge me more? How are your margins doing? They say, I want your undivided attention.

Right?

I want the best of your service. I want quality care. The only way to do that is by profitability. No profit stress, ineffective customer service. So the customer, the person who wants profitability most actually is your customer. We want it because of the effects it gives to life and the stability and sanity brings to us. So we're, we're close, number two. But I think our customers want it more. So that's something that we've got to digest.

That's really cool.

Now, when it comes back to this, this cash counting versus gaap, profit is, is a system where we pre allocate money to its intended use. So a natural tendency of most small business owners is to log into your bank account. Keep doing that. That's the best thing you can do.

Watch what's happening.

Yeah, yeah, you, you naturally do this. This is your natural behavior. Now we're going to have money allocated to different accounts before you spend it. So you know, oh, I have this much already available for profit. It's hidden Away. Oh, I have so much available to pay my future tax bill. The number one biggest bill associated with operating a business is that business owner is least prepared for is the tax bill. Your business can take care of it regardless of the formation of your business people. I have an S corp. Can't do it. Yes you can. Talk about first professional how to do what's called a reimbursement distribution. But you can do it now. You know what money is available. This is an old world system. So profit first is nothing new. I didn't like invent something and make it all from scratch. I looked at the history of financial education. It goes back to the Bible. It goes back to the Bible. The Bible has the pay yourself first principal in it. There's so many books on this. The richest man in Babylon think and grow rich. These are books from, you know, think Rich is 150 years old. Wow. It talks about the pay yourself first principal. It talks about. I was gonna say Cardoni. Partitioning. Partitioning money into different accounts.

Okay.

Their systems, the elbow system where people would get money and, and coins typically and put it into different little buckets before they spend it and then they'd open up. One bucket was for food. One was to. To. To buy account.

Account.

Yeah. Funny thing, buy account. And so you have the money pre allocated and now you know what you have to work with.

Okay.

It, it's the, it's the fundamental of human behavior now implemented where you naturally go at the bank.

Gotcha. Okay, well let's talk about the tenants of profit first. So we just covered pay yourself first.

Yeah.

Okay. The envelope system. So with regard to profit first, how many envelopes are we talking about?

So the pay yourself first principle, I just want to rewind to, that is we are allocating money toward profit first. There is an important reason behind this. You take care of the most important element first. We talked about it. When you wake up in the morning, the first thing you do, if exercise is important, you should exercise. Don't wait till the end of the day. By allocating money to a profit first, you're assuring profitability for your business. But secondly, it's called operant conditioning. If you do something that serves you and rewards you, it actually build momentum to sustain that. You are more likely to meditate if you meditate 30 days in a row on the 31st day than if you meditated sporadically whenever. So you want the repeated process. So Prop first is designed that we the owner do this allocation. When you take money as a posit and Put a portion into profit. You feel a reward, you transfer it over to, my gosh, I just got 10 more dollars just for me or whatever the number is. And you feel the reward, the benefit, so you're likely to repeat it. The envelope system, the core envelopes, to answer your question, there's five foundational ones. The main serving tray envelope, if you will, is income deposits come there. You never spend a dime from that, as my most business owners do, is money comes in your primary check and you spend it. No more money comes into income. It sits there.

Okay.

Second account is called profit. We just talked about that and we allocate money there first. It's all percentage based, so logically you can allocate any sequence, but behaviorally, always reward yourself first. The next core account is called owners compensation. If we walk down main street, boot in here.

Yeah.

Most of those business owners are making less money running their retail business than if they worked at McDonald's for, you know, a minimum wage. It is a sad state of affairs. They're working ridiculous hours. And you look at these stores, there's not many folks rolling in and they're sitting there waiting for opportunity. And it is stressful, it is painful. They're probably even putting money into it. So you, the business owner, need to be rewarded and paid accordingly. Now, the funny thing is not funny as an haha, but the ironic thing is all these businesses could be profitable, but what they're doing is money comes in that one bucket and they say, oh, I can buy more inventory. Oh, I can do this. And they keep on ignoring themselves. So we're going to stop that pattern and we're going to start rewarding the owner as a compensation for the work they do and every day in their stores. Different than profit. Profit. You start a business that can employ companies, that's a reward. You know, we started this business and we employ eight people here, right? The, the people that take the risk of starting get rewarded for supporting, supporting the economy.

Right.

The worker. The owners who also work in the business should be paid for the work they do. It's orange con.

Gotcha.

The next one's called tax. The biggest bill associated with operating business is tax. It shocks everyone every year. I used to, it used to knock me off my feet.

Such a horrible surprise.

Yeah. The year ends and you're like, I still owe money. What the hell am I going to pay this? The business can pay your taxes and reserve it as you allocate this money out. The remainder goes to operating expenses to cover salaries for your colleagues. To cover the rent for the space we're in and so forth.

Right.

That money is, is a portion of the full deposit. And what it does is it shows you what is truly available to work with. That's the container you open and oh, I can afford that cow now or not.

Okay.

That's what OPEX is.

Okay.

It's always the last account to be funded. And it tells you what you must work with. Because if you want to be profitable, if you want to pay yourself, if you don't want to worry about taxes, this is what you must operate off. Okay. And it forces thinking. Thinking as opposed to reaction, like oh, I got money, let me just spend.

Gotcha.

Now you got to think with what you have. How am I going to make this work?

Yeah. And that ties in I guess with remove temptation.

Well, we know it kind of does. So here's the biggest thing I. I don't know if I ever told you. Sorry. I lived in Mountain lakes down the road from here and I used to in our basement we set up an office space. It was right next to the furnace was the only spot I had room. And I didn't have walls. So I took cardboard boxes to make little walls. It was funny, I'd be on a phone call with someone and the furnace would kick in and I'm like, hey, can I call you back in five minutes? If you're like, I know what's going on. So what I would do is say I, I can't live like this. What I need to do is I got a little money in my profit account, let me borrow from that. And the second you borrow, borrow, you're actually stealing from yourself. Yeah, we've all done that.

Yeah.

I remember I was reserving funds for my kids college education and said oh, we're still got the mortgage, let me borrow from that. And I never funded it back.

Right.

So we steal for ourselves.

Right.

But here's the funny thing. If I didn't have access that college education, I was still found a way to pay a mortgage. Maybe I worked a part time gig, maybe I would borrow money from my parents, but I had to, I don't know what it was, but we found an alternative path by removing profit from your business. And, and also the tax bill, we often steal from that because taxes aren't due daily, they're due usually quarterly.

Right.

If you hide and have no access to it, what happens is when you don't have enough money to pay your opex, you do find a way. Yeah, maybe you're incurring too many expenses or more often is maybe you don't price appropriately, that better margins, maybe there's efficiencies going on.

Gotcha.

And so it forces hard considerations. Right now there's an economic downturn as we're recording this. So these are indications of it. And what I'm so afraid of is most business, many business owners will say, well, I guess. I guess we can't be profitable at all and we're going to hunker down.

Yeah.

And my response is, no, you have to be profitable forever. What adjustments can you make now in this economy? It forces hard decisions today. If you're not taking your profit first, if all money's going to your operations, you won't feel the pain. Now, maybe six months from now, but six months from now, you're going to hit a wall and there's going to be not a dollar left anywhere. And then panic ensues.

Yeah.

So private first, by hiding and removing temptation to borrow, forces hard conversations, including one Kelsey I had literally yesterday around our business. But good conversations, healthy conversations, because we're six months to a year ahead of any.

Right. So you're staying in front of it.

Yeah, totally.

Yeah. Okay. And then finally, rhythm.

Rhythm.

Talk about rhythm.

Rhythm. Most business owners are reactionary. Old Town Deli down the street is funny. I was talking to them this last year right before the Super Bowls, about a month before. It's a house business. Like, I was pretty dry and things are not going so well. I went back in the week before the super bowl, so it's like two weeks later. So how business? It's amazing. It's the best year we're having. It's this kind of bipolar experience. If we have money, we feel great, and if there's no money, we feel desperate. It's kind of a binge, kind of starvation, gluttony kind of oscillation. So what we do in our business is we need to bring a consistency here. The reason we feel these kind of speak peaks and valleys is we log into our bank account every day. And every day we say, how much is here? How much can I spend or allocate around? We do this product first is we get into a rhythm. We use what called the 1025 BI weekly every two weeks. We let money accumulate. And then if it kind of flows through these different accounts and gets allocated by doing it bi weekly, you see money accumulating and depleting out. It also gives you an understanding. Over these two week periods of May, we do have a spike going on when you have a spike, there's more money than normal. Call your professional. I suggest a proffers professional. Call them and say, why is there more than usual? I want to sustain this.

Yeah.

And there'll be times when you look and there'll be less than usual. Call your professional and say, why is there less? What do I need to fix? So instead of every day just seeing what's there and reacting, we slow down the role to get into a risk.

So smart. So smart. Mike, thank you so much for that. That's fantastic.

Yeah, this has been fun. Did we cover the course of. I know we gotta wrap up.

We thinking about. Just real quick. When did you start?

Pf I started? Yeah, Great question. And maybe it's a great way to wrap up. I started it 15 years ago now. I've had 58, 59 consecutive quarters of profit distributions and we're gonna have one for a company this quarter too.

Great even.

We're going through economic changes in the economy. We're going to have a profit.

Fantastic.

The first one I ever took, I'll never Forget, it was 15 years ago and I had $8 in there to be distributed because I just started the profit first system. I went to the bank and I said, like to withdraw $8 please. And they said, how do you want it? I said, as many bills as you can make. I went to, I think it was a Starbucks, plopped it down and said, like a cup of coffee. Which way? At Starbucks you can't get a cup of coffee for $8. But whatever, barely. I plop it down. I said, give me everything you got. Which was a small cup of coffee. That cup of coffee chills. It was still the best cup of coffee in my life. I didn't use a credit card. It wasn't an expense. My companies have said, thank you for running a healthy business.

Right.

The profit has increased over time and I think for many businesses you'll see it continue to increase over time. But that, that quarterly, every 90 days, we do the profit distribution. That quarterly reward is an acknowledgment of the risk we've taken. But it also shows the power of a healthy company. So I will do this the rest of my life. But God, that one 15 years ago was just so remarkable.

Tremendous. Yeah, tremendous.

That's awesome.

All right. I think we're good with profit first.

Okay.

But I wanted to ask you about this.

Keep a say that microphone.

Yeah, sorry.

You can hold the paper if you need it.

I wanted to ask you this. There was that news article I think Kelsey pulled this one up. A friend you can wear around your neck. This is Avi Schiffman introduces a new AI wearable called the Friend, a pendant sized AI chatbot that offers companionship through text message and push notifications on a paired phone. So you wear this pendant around your neck and like, you push it and it texts you whenever it wants to reply to you. And I was like, well, you know, that's kind of cool for somebody who's really lonely. But then I watched the little video of how it works and I had such a sad, sunken feeling. Like, think of all the people out there wanting to connect and they're not.

Connecting because some dude in Japan who married his pillow. Did you hear about this? No. This is like a few years back. But the headline news is guy marries pillow.

What the heck?

But there is a decline from what I'm reading in the tactile human experience. People are becoming more isolated. And this isn't just Japan. This is a U.S. it's an international phenomenon.

Yeah.

And we are becoming more and more of a lonely species.

I feel that. I totally feel that.

You said something yesterday as I was walking out and I looked back, go, hey, how's the podcast gonna go today? Could you check with your dad? Now your dad's past.

Yeah.

But you feel this.

I feel like he's talking to me through head nods. Just through heads on. I don't get his voice. I don't get his voice, but I get these really comical head nods.

Or no, he said yes.

Yeah.

You're gonna have some tech issues, but you're gonna kick butt. But I was thinking on the way I was walking, I was like, gosh, isn't that so interesting? In a. With AI now there, you can recreate past love. Oh, my God.

Yeah. Yeah.

And with AI, you can actually have an image of them. You can talk with them, and it's only advancing in with VR virtual reality, you can immerse with them. And my thought is, are we entering a path where we can have forms of therapy, of completing a conversation that we needed to, but we didn't opportunity? Or are we going down a path of there is no loss? And. And that we have this artificial sense of.

Yeah. An artificial experience.

We need. We need those experiences. That's the life journey.

Yes. I was saying that too.

Try to mollify this. And it's constant comfort.

Yeah. Yeah.

An experience of conflict. In the gym, they say if you want to gain, you have to go through the pain.

Yeah.

If you want to go through life's journey. To see the highs, you're gonna have.

To feel the lows. There's gotta be the yin and the yang.

There's got to be like, this is scaring.

Yeah.

We're. We're at a big risk of trying to never feel pain. I think that's danger.

I think you nailed it. I think you nailed it.

Okay.

All right, my friend.

Maybe this is a joy. As always, thanks for asking these questions, um, and for letting me to share these thoughts.

Thank you for breaking down entrepreneurship and simplifying it for us.

There you go. There you go. So, hey, if you're a listener, thank you for joining us. I do have a big ask for you. Would you be willing to subscribe? And the reason I ask is that way you'll never miss an episode. My goal, my commitment is to drive your business forward, to make it easier and more accessible. And it serves us. The more subscriptions, the more the word spread. I know it takes 60 seconds or so to do it, but that's my big ask for you, and I'm looking forward to seeing you. Next week on Entrepreneurship simplified. What are we going to talk about next week?

We're going to break down profit first a little bit more into Mount Implementation.

Oh, good. So how do you now you know the prop first kind of principles. How do you do it for. We'll see you next week.

Bye.