Profit First

Michalowicz proposes reversing the standard accounting formula. Instead of sales minus expenses equals profit, he argues small business owners should take profit first and operate on what remains, on the argument that expenses expand to consume whatever is available.

The mechanism is a set of bank accounts. Revenue arrives in an income account and is distributed on a fixed schedule, usually twice monthly, into separate accounts for profit, owner's compensation, tax and operating expenses, at predetermined percentages. The operating account is the only one the business spends from, which means the constraint is visible and enforced by the account balance rather than by discipline.

He gives target allocation percentages that vary by revenue level, and a method for moving from current allocations toward the targets gradually rather than immediately, since an immediate change would make the business insolvent. His argument for why this works is behavioural rather than financial. Parkinson's law means expenses expand to fill available funds, and the primacy effect means whatever is deducted first is treated as unavailable. Physically separating the money removes the decision.

He also covers the quarterly profit distribution, which he insists must actually be taken by the owner rather than reinvested, on the argument that a business that never distributes profit is not profitable in any meaningful sense. The method is a budgeting envelope system applied to a business, which is not novel. It fits small owner-operated businesses with simple cash flows and fits poorly where working capital cycles are long or where growth requires reinvestment. The insight that expenses expand to available funds is correct and the mechanism enforces it without requiring discipline.