Profit First: A New Spin on an Old Equation
by Cyndi Thomason, on January 4, 2019
It’s All About Inventory
Working with Amazon.com and other eCommerce sellers, I typically encounter similar issues as I review a new client’s books. First, is the reliance on credit card debt or loans to pay for their inventory or operating expenses. In addition, many are not paying themselves on a regular basis. It’s not uncommon to hear that they don’t know if their business is profitable until tax time. I have to ask, “What is wrong with this picture?”
In business, there are so many unknowns. There are constant questions that need clear and decisive answers. The questions you ask as an eCommerce seller typically center around your inventory. When you’re stocking up, you probably mentally go through a list of questions, such as:
- Is this the right inventory?
- Will this order be enough? Or is this order too much?
- If they don’t sell, what will the cost be for storage?
It’s “make it or break it” during fourth quarter. Early January is the time to assess the last quarter. It’s a time to determine which products sold and which products are still sitting in the warehouse. That’s when the next round of questions has to be addressed:
- How will I move the inventory that didn’t sell?
- Did we make money?
- Do I have enough to pay the bills for my product, and taxes?
- Will there be anything left over to pay myself?
How Profit First Leads to Profitability
Amazon and eCommerce retail is a particularly complicated business model. This is due largely to inventory and the cash flow required to support it. Profit First is a cash management methodology that sets up any business for success. It works well for eCommerce sellers because it teaches them how to manage through the down times and achieve their profit and growth goals.
The creator of Profit First, Mike Michalowicz, who is also the author of the book, Profit First, works with our existing behavior, providing a framework to manage financial activity in a way that builds in profitability. This behavioral "law” is called Parkinson's Law, developed by C. Northcote Parkinson, a British Naval Historian in the 1950’s. Parkinson proved that the consumption of any resource will rise to meet the quantity of the resource available. This applies to time and money, or goods and services. In my new book, Profit First for Ecommerce Sellers, I take the Profit First methodology to the next level and customize it to address the unique needs of the eCommerce seller.
Embracing a New Equation
Following Parkinson's Law, the traditional business equation, Sales – Expenses = Profit is destined to leave little in the till, while the Profit First equation, Sales – Profit = Expenses, makes certain that doesn’t happen. From a behavioral perspective, if you don’t take your profit first, expect none will be left over, as your expenses will rise to meet your income. And if you do take your profit first, the funds left over for operating expenses will be less, which puts pressure on you to operate more efficiently and to be more innovative. If you’re not operating in this manner, expect that your competitor will be.
The Profit First 4-Step Process
- To Get Started: Open Multiple Bank Accounts. This sets you up for success by having an account for each specific purpose. Most businesses operate with one checking account for all types of business activity. For eCommerce sellers, I recommend starting with one checking account for inventory and another one for operating expenses. You will also need savings accounts for Profit, Owner Pay and Taxes.
- Follow a Prescribed Sequence. This creates a new behavior driven by the new bank accounts. As your Amazon or other income is deposited in your operating expense account, you will move those funds into the specific accounts based on a prescribed sequence. You must first determine the cost of the products sold. That amount should be transferred into your inventory account, which will be used to pay for replenishment inventory. Next you will move 1 to 5%, or as much your cash flow allows, into the profit account. Don’t skip this step. At a minimum, do the 1%. This way you will be profitable with your very next Amazon settlement, and each one after that. Keep the remaining amount in your operating expense account. You then need to look at your expected expenses that will come due before your next Amazon settlement. Make sure you can cover them with the remaining funds, and if you can’t, look at what you can cut or reduce. You may need to start with a low percentage, say 1 or 2%, for the Profit Allocation. It’s important to note that if you cannot cover your operating expenses, you may be living beyond your means.
- Remove Temptation if Necessary. New behaviors are hard to learn and maintain. If you’re tempted when you see the balance growing in your Profit Account, you need to move that money to an account that is less accessible, such as a savings or investment account at another bank. Out of sight, out of mind.
- Finally, Implement a Rhythm. This is an important step as you learn how to optimize the time you will spend managing your funds. You will begin to truly understand the flow of cash, as you fund your accounts every two weeks as described above. If you are an Amazon seller you probably already receive payouts biweekly, so this rhythm already exists. Follow the prescribed sequence to fund your various accounts, and then pay any bills due before the next payouts. Review any upcoming payments on credit cards and auto withdrawals to ensure that you will have those funds in the accounts when the draft hits the account.
This is a simplified description of the Profit First system. If you follow this process for a few months, you’ll begin to understand the cash rhythm of your business. Then you can streamline the process by using percentages so that the calculations are quickly done on a spreadsheet. As time goes on, you will have an even greater understanding your cash flow, especially as it relates to your inventory, and you’ll gain control of your operating expenses. The end reward? You will begin to pay yourself on a regular basis!
For a more in-depth detail of the Profit First method, customized specifically for eCommerce sellers, check out my new book, Profit First for Ecommerce Sellers, available on Amazon.com and on our website.