Profit First: A New Spin on an Old Equation
by Cyndi Thomason, on January 4, 2019
It’s All About Inventory
In my work with Amazon.com and other eCommerce sellers, there are a couple of things that stand out when I begin reviewing a new client’s books. First, there are too many sellers relying on credit card debt or loans to pay for their inventory or operating expenses. I also see that many are not paying themselves on a regular basis. Some are even waiting until tax time to determine if they can take a paycheck. When I see this, I ask myself, “What is wrong with this picture?”
There are so many unknowns in business. Questions that need clear and decisive answers. As an eCommerce seller, the questions you ask typically center around your inventory. As you’re stocking up, you probably ask yourself things like, Is this the right inventory and will it be enough? What if I order too much? What will the storage fees cost if they don’t sell?
The 4th quarter is a critical time for profitability for most of you. It’s “make it or break it” time for the year. In early January you assess the last quarter, determining which products sold and which products bombed. That’s when the next round of questions come flooding in, How will I move the inventory that didn’t sell? Did we make money? Do I have enough to pay the debt for my product, plus pay taxes and pay myself?
How Profit First Leads to Profitability
Amazon and eCommerce retail is a particularly complicated business model because of 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 weather the storms and achieve their profit and growth goals.
Profit First, created by Mike Michalowicz, who is also the author of the book, Profit First, works with our existing behavior and provides a framework to manage financial activity in a manner that builds in profitability. This behavioral "law” is called Parkinson's Law. It was developed in the 1950's by C. Northcote Parkinson, a British Naval Historian. 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 any good or service. 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
Because of Parkinson's Law, the traditional business equation, Sales – Expenses = Profit is destined to leave you with little left over. The Profit First equation is Sales – Profit = Expenses. The math works either way. From a behavioral perspective, if you don’t take your profit first, there will be none left over, as your expenses will rise to meet your income. In contrast, if you do take your profit first, the funds left over for operating expenses will be less. This puts pressure on you to operate efficiently and frugally, and to be more innovative. If you’re not operating in this manner, you can bet that a competitor will be.
The Profit First 4-Step Process
Step 1 - Creating Multiple Bank Accounts sets you up for success by separating your cash into bank accounts created for specific purposes. Most businesses operate with a single business checking account for all business activity. For eCommerce sellers, I suggest starting with one checking account for inventory and another one for operating expenses. In addition, savings accounts are used for Profit, Owner Pay and Taxes.
Step 2 - Following a Prescribed Sequence creates a new behavior around the new bank accounts. As your Amazon or other income is deposited in your operating expense account, you will move the funds into the designated accounts based on a specific sequence. First, determine the cost of the products you just sold. Transfer that amount into your inventory account. This account will be used to pay for replenishment inventory. Your next step is to move 1 to 5%, whatever your cash flow allows, into the profit account. In this way you will be profitable with your next Amazon settlement. Finally, the remaining amount will stay in your operating expense account. Look at your expected expenses coming due before your next Amazon settlement and make sure you can cover them with the remaining funds. If not, you should look at what you can cut or reduce. Initially you may need to use a low percentage, 1 or 2%, for the Profit Allocation. Take note, if you cannot cover your operating expenses, it is a signal that you may be living beyond your means.
Step 3 - Removing Temptation is based on the realization that new behaviors are hard to learn and maintain. If a growing balance in your Profit Account is going to tempt you, then move that money to an account that is less accessible, like a savings account at another bank.
Step 4 - Implementing a Rhythm optimizes the time you will spend managing your funds. To truly understand the flow of cash, you should fund the accounts as prescribed in Step 2 every two weeks. Most Amazon sellers receive payouts biweekly, so this rhythm already exists. Fund your accounts following the sequence, then pay any bills due before the next payouts. If you’re using credit cards and auto withdrawals, look at the upcoming payments and ensure that you will have the funds needed.
This is a very abbreviated description of the Profit First process. You can follow this process for a few months 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 you begin to better understand your cash flow, especially as it relates to your inventory, you gain control of your operating expenses and can 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 this month on Amazon.com.