We all want to run a profitable business. Yet most of us simply don’t. But before we go any further, let me explain what I mean by “profit”. In accounting, profit is the result of what’s left over after subtracting our expenses from our sales. If we have $500,000 in sales and $400,000 in expenses, our profit would be $100,000, or a profit “margin” (profit divided by sales) of 20%.
Accountants love this simple formula because it’s what they use to determine our tax liability. And because of this, they often think of profit as undesirable. Their job, after all, is to help us pay as little taxes as possible, so it makes sense that they would consider themselves successful by helping us run unprofitable companies. And to support their position, we often encourage them to help us find ways to spend our money simply to avoid taxes. After all, I haven’t met anyone yet that likes to pay taxes.
But wait, if we we want to run profitable businesses, then why do we allow our accountants to work so hard at making sure we don’t have a profit? Why do we heed their advice when they tell us to go buy this or that, prepay our rent, or invest in new equipment (we probably don’t need) before the end of the year just so we can “write it off” to save a few bucks in taxes? It’s because our objective as a business owner (being profitable) is often at odds with our accountant’s objective of paying as little taxes as possible (being unprofitable).
The kind of profit we want as business owners is better defined as “cash”. We want money. We want cold hard cash, the kind left over after we’ve paid all of our bills (and ourselves), deposited into our bank accounts in exchange for the hard work, effort and risk that we’ve taken to start, run and manage our businesses. And we want Uncle Sam to take not one cent more than his fair share.
When we think of profit in terms of the reward for having the entrepreneurial spirit, guts, drive and ambition to start and run our own business, and not simply what’s left at the end of our Income Statement, we begin to realize its importance. After all, we deserve it! Businesses that exist for more than a few years without rewarding the owner(s) often result in discontentment, frustration and resentment. This reward is what makes business ownership worth it, otherwise, we may as well work for someone else with a guaranteed salary and none of the stress, headaches or pressure of managing people, overhead and inventory.
This kind of profit is also what allows us to reinvest back into your business, pay cash for new equipment and hire better talent. But only if it’s done on our terms, in a well thought out manner, and part of a larger financial plan. Purchasing a new piece of technology, then becoming a slave to the payments for the next five years just to avoid taxes, is not a wise business strategy and often leads to more debt, poor cash flow and resentment.
Choosing Profit – Reengineering the Equation
Most (if not all) accountants use something called GAAP. GAAP stands for “Generally Accepted Accounting Principles” and is a set of financial guidelines, standards and rules with the purpose of providing consistency when analyzing a company’s financials. In its simplest form, the GAAP formula is:
Sales – Expenses = Profit
The problem with this formula is that profit comes last. It’s what’s left over only after we’ve subtracted all of our expenses from our sales. Unfortunately for most business, there often is nothing left. Most practice owners find a way to spend every last nickel operating the business. If the bank account has money in it, we falsely believe all is going well, so we find a way to spend it (that’s called “bank balance accounting”). Add to that our accountant’s attempts at minimizing our tax liability, the result is that there’s rarely anything left over at the end of the day (or year).
In his book Profit First, author Mike Michalowicz challenges us to think differently about profit. What if we instead choose to be profitable? What if we looked at profit not as what’s left over, but as an action? What if profit was a decision and not some random desire, wish, dream or hope? What if we re-engineered the formula and took our profit first!
Sales – Profit = Expenses
How can that be, you say? If we aren’t profitable now, how could we possibly cover our expenses if we take our profits first?
As it turns out, this strategy is nothing new. It’s grandma’s old tried and true envelope system of allocating a certain portion of our income into various envelopes of expenses. It’s the “pay yourself first method” often advocated by many financial advisors. It’s why 401-K plans work so well. When we pay ourselves first, we learn to live with what’s left over.
Parkinson’s Law, theorized by historian and author C. Northcote Parkinson, states that the demand for something expands to match its supply. It’s why when given a week to complete a task, we’ll take a week. If given a day to get it done, we’ll do it in a day. It’s why if we have $10 in our pocket, we’ll spend it, and if we have $20, that seems to get spent also.
When we intentionally make less available to run our businesses (i.e., operating expenses), we become more frugal and more innovative. We become more discriminating about our spending, and more innovative around problem solving. We change our behavior by learning to operate our businesses on less. The money doesn’t change, what changes is simply how we manage it. By taking our profit first, we force ourselves to reduce our operating expenses by being frugal and innovative, finding ways to get the job done with what we have by spending less and finding creative solutions to our challenges.
The Primacy Effect
By taking our profit first, we also place a greater sense of value on those profits. Studies have shown that items presented in a list are often given greater value the sooner they appear on that list (The Primacy Effect). If you’ve created a shopping list then realize that you left it at home only after you get to the grocery store, you’ll often recall the items first on that list. When we take our profits first, we place a greater sense of importance on profit, and place less emphasis and importance on our expenses. We become more focused on rewarding ourselves for our entrepreneurial spirit than ever before. And while our expenses remain important (we have to pay our bills, after all), our change in behavior results in our ability to run our businesses within our means, becoming more frugal and innovative along the way.
But What About The Taxes?
I don’t like paying taxes any more than the next guy. In fact, I generally hate paying taxes because of the waste that seems to occur by those spending the money
(congress). But taxes are necessary for our society to function properly. We need well maintained bridges and highways, emergency personnel, police, schools for our kids, a strong military and social services for the elderly and less fortunate. When considering all of the these benefits, I’ll gladly pay my fair share.
When we become more profitable, we will owe more in taxes. That’s just the way it is. But when given the choice, I would much rather have a large profit and pay my share of taxes than to have an unprofitable business with no tax bill. Would you rather have a $10,000 profit at the end of the year and owe $3000 in taxes (you get to keep $7000!), or have no profit and no tax bill? I’ll take the $7000 (in cash) any day. Sure, if you really need that new piece of technology (you probably don’t), and it improves your cash flow, efficiency and level of patient care, then it might make sense to make the investment and avoid the taxes.
But that’s rarely the case.
So instead of seeing your growing tax bill as a liability, see it as a measure of your continued success. See it as affirmation that you’re running a healthy, viable business with staying power and longevity.
Fortunately, becoming profitable doesn’t have to be a wish, hope or desire. We can choose today to become profitable. By simply reengineering the the GAAP formula, we can begin to reap the rewards of entrepreneurial risk. By taking our profit first, we change our behavior by becoming more frugal, innovative and creative about how we manage our business.