EP #139: Sales - Profit = Expenses - Mike Michalowicz (Entrepreneur, Author)

The business math equation S (sales) – E (expenses) = P (profit) has been widely accepted for years. However, entrepreneur and author Mike Michalowicz doesn't quite see it that way. "83% of small businesses in the US are surviving check to check, some of whom follow this model. From a behavioral perspective, what happens last matters least," Mike says, "Take your profit first and you will reverse engineer your profit forever." While some may scoff at this notion, in today's Paper Napkin Wisdom, he explains how a shift in thought process and subsequent actions can revolutionize small businesses forever. This concept is best compared to Parkinson's Law, which states that our behavior adjusts around the supply. Take toothpaste, for example. Upon purchasing a new tube of toothpaste, most people are less frugal with it than when they're on their last squeeze of the same tube. To apply this theory to business, Mike argues that if companies follow a different equation – S- P = E – they will reduce spending and maximize their bottom line. It's similar to a popular personal finance method – the 401k. By readjusting your spending based on what you're bringing in, it will increase your bottom line over time. Additionally, operating this way forces business owners to become radically innovative. One of the businesses Mike owns, a leather manufacturing company based out of St. Louis, was running into a problem. The equipment they needed to develop their product cost a whopping $40,000. Instead of making that investment, which would have greatly reduced their profit, they got crafty. After a few trips to Home Depot and some trial and error, they invented a molding mechanism that only costs around $200 to produce. "Our competitors were using the same [$40,000 machine], and our profit margins sky rocketed," he says. He urges that using this model forces businesses to think outside of the box. But in 2008, Mike would have probably initially scoffed at this advice. He had sold two companies and became an angel investor, which he recalls being a horrible experience. He hit rock bottom. "I was $50,000 in credit card debt, and I was driving a beat up Durango that only had two radio stations," he admits. Deciding that it was time for a change, he began reading The Richest Man in Babylon and similar books. A light bulb went off – he realized that while people had applied the "Pay Yourself First" mentality to personal finances, no one had taken that approach to business. He began to test the concept with his own business and the businesses of friends, and noticed he was on to something. So, how can a company go from their current approach to Mike's method? He suggests starting small -open a separate savings account and allocate 1% of every check into this separate account. "If you can run your business on $10,000, you can probably run it on $9,900. Set that extra $900 aside. While you may not amass a life changing sum of money, your mind set will definitely shift," he advises. After making these changes, Mike urges businesses to not reinvest that money into the business, "When it's not profitable, we will start to resent our business. Those distributions and profits help you celebrate your entrepreneurship and your innovation." Every quarter, he has a quarterly pause where he and his business partner discuss their successes from the month, along with any failures. This occurs after they both receive their quarterly distribution. While Mike doesn't reinvest his distributions into the company, he does ensure that he reinvests the profit into his employees. "It's very important that everyone has a vested interest in the success of the business," he says. While the profits may not be publicized, he does make sure to explain to each team member how they can benefit from being frugal with company funds. By combining a shift in mindset with a pivot from traditional methods, Mike's formula has led to profit increases for hundreds of businesses. What do you think of his method? Tweet us with your answers at @WiseNapkin.