It sounds like a reasonable idea—I’m going to grow my business by reinvesting my profits. But here’s another perspective. When you are starting your business, everything is tight, and you may have a “day job” to cover your personal expenses. Why not put that extra profit aside?
The downside to that plan is simply that you are building a business that may come to depend on always having the profits reinvested. If you are familiar with Profit First, you understand that Parkinson’s Law is at work in our everyday life. Simply stated, it means whatever resources are available to you, you will use them.
That means that you will have very little, if any, profits at the end of the day. If you do and you reinvest them in the business, your business will begin to operate with the expectation that those funds will always be available.
When the day comes that you decide to leave your day job and begin taking the profits out as salary or owner draw, you will find that you must completely change the way the business operates. You must cut expenses to ensure you have the money for your own pay or profit. You will find the unnecessary expenses, but what about all that time you’ve been paying for them? You could have been operating more frugally from the beginning. You could have been more innovative and more efficient. Why not start out that way?
When you set money aside for your profit and owner pay from the beginning, it sets up the right pressure on your business to operate efficiently. You will develop an innovative culture, looking for the best way to do something instead of just throwing money at the problem.
A common question that I get from clients and webinar attendees is, “Why can’t I just not pay myself in order to grow my business faster?” There are a couple of reasons why this is not a good idea.
First, you need to ensure that you create a business model that will pay you, even though you may still be working your day job. Even if you are willing to invest “sweat equity” in your business, your replacement, should you get “hit by a bus,” will not.
Successful businesses build a cost structure that they can sustain from the beginning.
Second, you will be learning a lot through these first few products, and oftentimes, a surplus of cash for a new business creates waste and inefficiencies. Take a little time to go slow and get it right. Then when you go fast later it will be quick and profitable.
We advise our clients to set that money aside in a bank account as if they were paying themselves. When the day arrives that you strike out on your own, you have some salary set aside to act as a buffer, should you have a lean month.
The business would have been setting this money aside routinely, so you can act confidently and not from a place of fear. You will learn to follow this model repeatedly and set aside the payroll funds before you bring on a new employee. When you hire, you have a buffer for them to help offset the training costs and the ramp-up to productivity.
There are many factors to consider before you begin to expand your product line. One, of course, is being able to afford the launch of that product.
From a financial perspective, I suggest that you begin planning for that next product right away. If you are selling your first product at a good gross margin (usually around 30% or more) and you are keeping your advertising and other operating expenses in check, then you should have cash to set aside for product development.
The Profit First cash flow strategy can be expanded upon to ensure that you’re planning for growth in your business and able to expand your brand appropriately.
Some of our Profit First clients plan to fund the next product by setting aside more inventory funds than are needed to simply replenish their existing product. They add 10-15% above the replenishment rates to grow the inventory bank account so that funds are available when they are ready to begin the development of their new product.
This strategy can work well if you keep track of those dollars and the growing amount you are earmarking for this purpose with each allocation. You can do this with a simple spreadsheet.
One downside to this type of approach is that it's easy to watch that bank balance grow and then when another use comes up, you reach into that account for the funds. In a flash, that money is spent. Only later do you realize that you did not reserve the funds as originally planned.
One common trap is inadvertently funding increased inventory buys of your existing products because of expected future demand for your busy season. It's great to set aside an additional percentage for sales growth, but just be clear that is a separate strategy from the funds you are earmarking for a new product.
A simple strategy that we recommend to clients to resolve this issue is to create a Product Development bank account. It can be a savings or a checking account. After you allocate to inventory in the typical Profit First manner, you'll then allocate to your profit, owner pay, taxes, operating expenses, and product development bank accounts
You can do a profit assessment on your business and then follow those percentages. The amount you want to raise for product development should be funded by a reduction in operating expenses. Don't cut your pay, profits, or taxes to fund product development. It is clearly an operating expense.
As you watch the product development bank account grow, you can simultaneously begin researching and planning your next product. However, make sure you don’t take your eye off the ball with your first product. As you create more complexity in your business, it’s easy for something to get lost in the shuffle.
If you are concerned that it’s taking too long to save up the funds for the second product, this is a red flag telling you that your margins may be slim, and your first product may not be a cash cow. Carefully consider your options in this situation. You may be able to increase prices or cut costs associated with manufacturing or advertising. Or maybe you should cut your losses and not reorder that product as your supply is depleted.
Finally, another common question is, “Can’t I borrow the money so I can scale quicker?” Debt can have a place in business, but often it’s misused. If you haven’t tested out your business model, additional funds may obscure an issue with pricing or sourcing. If those issues exist, then the gross margin may be too low to fund the interest on the loan.
It’s exciting as an entrepreneur to plan and dream about your businesses. Plans and dreams are really where it all starts. By taking the time to consider the financial implications before you expand your brand, you will have a better chance to make those dreams come true.
It may seem counterintuitive, but setting aside your profits does in fact allow you to build your business from a more solid base. It puts Parkinson’s Law on your side to grow organically.
If you need help getting your Amazon business where you'd like it to be in terms of profitability, check out my book, Profit First for Ecommerce Sellers. You can also sign up for the Profit First for Ecommerce Sellers Online Course. As a Mastery Level, Certified Profit First Professional and founder of bookskeep, I will explain why Profit First works so well for eCommerce businesses and the particular challenges for businesses that have physical products requiring inventory management.
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