This article is an excerpt from the Shortform book guide to "Profit First" by Mike Michalowicz. Shortform has the world's best summaries and analyses of books you should be reading.
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Are you still using traditional accounting methods in your business? Why don’t these methods lead to long-term success?
According to Mike Michalowicz, the author of Profit First, the traditional methods of business accounting don’t work in the long term. He says that the logic of traditional accounting clashes with the natural ways people think and make decisions.
Here are the four reasons why traditional accounting doesn’t work.
The Dangers of Traditional Accounting
While traditional methods certainly work for some, Michalowicz claims that those who do succeed do so more often out of luck or extraordinary circumstance rather than by simply working harder. He goes on to note that half of all businesses fail within their first five years, and eight out of 10 businesses overall end in failure—and the vast majority of those businesses used traditional accounting methods.
(Shortform note: Research indicates that many small business owners who have failed or are failing aren’t doing much accounting at all—whether that means not making a business plan or not understanding their finances. One could see this as supporting Michalowicz’s argument that traditional accounting scares away many entrepreneurs, who are unable to understand it. Alternatively, one could also argue that this means many failed businesses didn’t really use traditional accounting methods, because they hardly used any accounting methods at all.)
According to Michalowicz, the main cause of this high failure rate is the logic of traditional accounting clashing with the natural ways people think and make decisions. We’ll now examine the four main reasons Michalowicz identifies for why traditional principles and natural decision-making clash, as well as how those clashes lead to failure.
Reason #1: Business Owners Overemphasize Growth
Michalowicz explains that the biggest clash has to do with the traditional principle regarding growth. Because traditional accounting suggests that growth leads to success, many entrepreneurs interpret this principle to mean that they should constantly try to grow their business as much as possible, by any means necessary. This means reinvesting all the money they can—including their profits and personal funds—back into their expenses. They plan to cover their growth-driven increase in expenses with the increased income they predict that their larger, more expanded business will create.
However, this puts a business in a precarious position—when sales slow down, the business will have high costs and no cash available with which to pay them. Fluctuations in sales are inevitable, and overemphasizing growth makes slower periods potentially fatal for a business.
(Shortform note: Michalowicz argues that entrepreneurs believe that if they keep putting money into their business, they’ll eventually find success and make money back. His claim that this is the natural way people think is backed up by psychological research on the common phenomenon of “loss-chasing”: throwing good money after bad to try and recoup losses. Studies suggest that losing money makes us want to spend again and makes us think that doing so will earn us rewards. This research could be interpreted to suggest that if entrepreneurs are losing money growing their business, they will psychologically want to spend more money on growth.)
Reason #2: Expenses Are Painful to Reduce
Michalowicz explains that slow periods are particularly dangerous for unstable, growth-centric businesses because unlike income, expenses are often tied up in our lifestyles, agreements, contracts, and relationships with other people. This means that while increasing your expenses is easy, it can be difficult and painful to lower them quickly if necessary. This means that while increasing expenses to achieve constant growth, you put yourself in a position you can’t easily get out of if circumstances change.
- For example, an entrepreneur might get used to their company car and large office space that came from a few high income months. This means that when their income slows down, they will be reluctant to cut any of these new costs and look for other, less efficient ways to have more money on hand.
(Shortform note: Research on compulsive spenders supports Michalowicz’s argument that people attach emotions to the things they buy, which makes cutting expenses much more difficult. Studies suggest that people tend to believe that buying things will make them happier, or compulsively buy as a way to try and cope with shame. This indicates that our purchases are emotional events, and that we attach emotions to the things we buy—which would make getting rid of or cutting back on our purchases emotionally difficult, as Michalowicz suggests.)
Reason #3: Traditional Accounting Is Too Complex
If problems do arise for a business that uses traditional accounting, then it can be difficult to even recognize. This is, according to Michalowicz, because the principle of consistently checking financial documentation doesn’t work when those documents are too complicated to understand. Traditional accounting is very complex, involving a large amount of data and many different metrics and equations that can be used to interpret that data. Even if you hire an accountant, the vast number of possible documents, equations, and metrics they could use means that two accountants using traditional methods might end up with two different conclusions about a business’s financial health.
(Shortform note: Studies support Michalowicz’s argument that traditional accounting is too complex and that its complexity can even lead accountants to conflicting interpretations or blatant errors. One survey of 50 accountants interpreting the same tax information led to 50 different answers, while a later repeat of that survey resulted in no accountant submitting an error-free tax return.)
This can be a serious problem when it comes to understanding how much money you actually have available because traditional accounting will still show you’ve made a profit even when you’ve reinvested all of that money into your business. Most people define profit as cash on hand, though, so it’s easy to misunderstand how much money you have available and then spend money you don’t have.
- Let’s say in a given quarter, Steve the entrepreneur’s business has expenses of 100k and an income of 150k. Steve decides he’ll reinvest the extra money into his business. Despite this, traditional accounting would still say Steve made a 50k profit that quarter, even if none of that cash is available to him.
(Shortform note: Michalowicz’s claim that small business entrepreneurs have trouble understanding their accounting is backed up by a recent survey, which found that 40 percent of small business owners would label themselves financially illiterate, and 66 percent wish they knew more about their finances.)
Reason #4: Instability Leads to Panicked Decision-Making
The instability that comes from a rapidly growing business often leads to irrational and panicked financial decisions, says Michalowicz. When an entrepreneur reinvests all of their available money into expenses, they won’t have any cash on hand to stay open through a rough patch—their business will consistently be one bad month away from failure.
This instability, plus a growth-first mindset, leads many entrepreneurs to make panicked decisions—specifically, it leads entrepreneurs to seek any increase in income even if it comes with many more expenses or serious opportunity costs. Doing so will only increase instability, which will then inspire more panicked decisions in a vicious cycle.
- Example: Steve figures that since his financial troubles began when his income decreased, they’ll go away if his income increases. Steve decides he’ll start stocking sporting goods to bring in more customers and more income. Steve then has to buy new stock, teach his employees about it, and advertise his new goods. Steve’s income increases, but so do his expenses—his overall situation doesn’t change.
(Shortform note: Psychological research supports Michalowicz’s claim that as people lose money, they will make worse financial decisions. A study found that as gamblers lost money, they would be more likely to recklessly and impulsively spend more, believing that doing so would earn them money back. The study suggests that this is because losing money is an emotional event, and so it doesn’t encourage rational decision making. Financial loss (like from an unstable or failing business) is also an intensely emotional event, which based on this study could also lead entrepreneurs to more impulsive and reckless spending in a desperate attempt to earn money back.)
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Here's what you'll find in our full Profit First summary :
- Why traditional business accounting methods don't work
- How to use the Profit First method to increase your business’s profitability and stability
- How to assess your business's current financial health
