Profit First Pt 4: The Behavioral Science of Profit First - And Why You Haven't Done it Yet
In the world of business finance, understanding the psychology behind money can be a game changer. On this episode, I explore the behavioral science that makes the Profit First method effective. If you’ve been hesitant to implement this system, this could be the push you need to transform your financial management.
Understanding Profit First Through Behavioral Psychology
Profit First isn’t just about numbers; it’s rooted in the realities of human behavior, especially under stress. The approach leverages several psychological phenomena to help business owners master their finances. I break down the six key psychological principles that make Profit First work so effective.
1. Parkinson's Law
Parkinson's Law states that expenses rise to meet available income. This concept, introduced by historian Cyril Northcote Parkinson, highlights how businesses tend to spend whatever budget they have. Just like in dieting, where larger plates lead to overeating, larger bank accounts can lead to overspending. Profit First counters this by dividing your income into smaller, manageable sub-accounts, making it feel like you have less money and helping you control your spending more effectively.
2. Mental Accounting
Developed by Nobel Prize-winning economist Richard Thaler, mental accounting refers to the way people categorize and treat money differently based on its source or label. For instance, money set aside for taxes is often seen as untouchable. Profit First utilizes this tendency by creating specific accounts for profits, taxes, and expenses, which helps ensure that you don’t dip into funds meant for essential obligations.
3. Loss Aversion
Loss aversion is a powerful psychological principle that suggests people prefer to avoid losses rather than acquiring equivalent gains. This principle is crucial in the Profit First system; when you set aside your profits, spending from that account feels like a loss, making you more protective of those funds. This emotional safeguard encourages better financial decisions.
4. Decision Fatigue Reduction
Decision fatigue can impair our ability to make sound choices as the day progresses. The Profit First system reduces the number of financial decisions you need to make by pre-allocating funds into specific accounts. This simplification helps maintain your financial discipline by cutting down on the mental energy required to manage money.
5. Immediate Feedback Loop
In behavioral science, immediate feedback is key to reinforcing positive behavior. Profit First provides quick visibility into your profits, allowing you to see financial results in real time rather than waiting until the end of the year. This immediate feedback creates a sense of achievement and motivates you to maintain healthy financial practices.
6. Scarcity and Constraints Drive Creativity
Creating financial constraints forces prioritization and efficiency. By limiting your spending to what’s available in your operating account, you’re compelled to focus on high-return investments rather than frivolous expenditures. This principle not only helps businesses save money but also encourages innovative thinking in resource allocation.
Conclusion: Key Takeaways
Implementing the Profit First system can revolutionize how you manage your business finances. By understanding the psychological principles behind it, you can harness your natural tendencies to create a more profitable and sustainable business. Remember, the goal is to create clear cash boundaries, reduce financial anxiety, and encourage better spending habits. If you’ve been hesitant to start, now is the time to take action. By setting up sub-accounts and prioritizing profit, you can transform your financial landscape.
Resources:
Book: Profit First - Transform Your Business from a Cash-Eating Monster to a Money-Making Machine by Mike Michalowicz
Connect with Darren Wurz:
Transcript:
Darren Wurz [00:00:00]:
Okay, so you've heard about Profit first, but have you been putting off actually doing it? Well, today's episode might be the final push you need to actually get started. The reason Profit first works has nothing to do with math. It works because it leverages how humans actually behave, especially under stress. Thanks for joining me today, friend. And if you're ready to master your money and your cash flow in your firm, you are in exactly the right place. Today we're talking about behavioral psychology and how it relates to cash flow and profit first. Well, what is behavioral psychology? You know, that's the weird things, the weird ways that our brain works, like mental accounting, which we'll get into. And these weird things, these weird phenomena are what makes Profit first work exceptionally well.
Darren Wurz [00:00:59]:
I'm also hoping that today this might be the push that you need, that you've been needing to finally get started. Maybe you haven't actually done profit first yet. You've been familiar with it. You know, you probably should do it, but you've been just putting it off. Maybe you because you don't quite understand it, or maybe you don't quite understand why you actually need it. Well, hopefully today is going to answer that question for you. Profit first harnesses your existing psychological wiring to make cash flow easier and to basically trick your brain into making better decisions. Better decisions that can actually make you more money than money that you could be bringing home to your family.
Darren Wurz [00:01:45]:
You may have been resisting because, you know, we all resist change. But when you actually put it into practice, you might find that everything gets easier. So let's talk about the real reasons that Profit first works and why it has nothing to do with accounting or math at all. Okay, so I'm going to give you six psychological phenomena or biases, perhaps, that impact our behavior and are the reasons why Profit first works really well. Okay, so the first one is called Parkinson's Law. And Mike Michalowicz talks about Parkinson's Law in his book Profit first, which you should definitely check out. Basically, profit Parkinson's Law is the idea that our expenses expand to match our available income or available cash. Now, this actually comes from a guy named Cyril Northcote Parkinson who was a British historian, and he introduced it in the 1950s in an essay that he wrote for the Economist.
Darren Wurz [00:02:55]:
Later he actually wrote a whole book on the topic. So what Searle was doing is that he was observing government bureaucracies and large institutions, and he noticed that these bureaucracies tended to grow even though the workload didn't. Staff created work for each other. And efficiency declined as resources increased. Hmm. I think we're pretty familiar with this in government. Government isn't known for being particularly efficient. Well, the rule is this.
Darren Wurz [00:03:30]:
And the rule he discovered is this. It's that if money is available, it gets spent. And this happens in governments. It happens in big businesses all over the world. You know, in your department, you have a budget, and if there's some money left over in that budget at the end of the year, you're going to spend it. Because if you don't spend it, the leadership is going to see that you maybe don't need quite as much money as they allocated to you. So Parkinson's Law is that rule. It's the rule that our expenses expand to fill the void.
Darren Wurz [00:04:07]:
If money's available, it gets spent. This explains why people spend raises quickly, businesses burn through increased revenue, and budgets get used up simply because they exist. Have you ever noticed that in your own life, right, when you get a raise or you get extra money, you tend to use it really fast? There's a similar concept in dieting. You might know this, but my husband is a physician associate, and in working with his patients, I always call them clients, but he calls them patients. You know, many of them are trying to lose weight, and one of the first things he recommends to them is using smaller plates. Only in America do we use the biggest, biggest plates ever, and we pile them high, full of food, right? And I don't know about you, but my mother taught me to clean my plate, and you better eat everything on it, because after all, there's starving children in some country across the world, right? And I think a lot of us were taught that, too. And so, you know, when we have a big plate, we fill it up and we're going to tend to eat everything on it. So a very similar way, a very simple way that you can force yourself to eat less and not even realize it, basically trick yourself into eating less is to use smaller plates.
Darren Wurz [00:05:25]:
And this is basically what profit first does by having your money flow into sub accounts. You know, one for profit, one for taxes, one for owner's comp, one for operating expenses. You're taking a big, large number, which is your big, you know, bank accounts, bank account balance number, and you're breaking it into smaller pieces. And so it seems like there's less money than there actually is. It's smaller plates. Applied to finance, there's a related phenomenon that we observe in the markets, and it's called the wealth effect. The wealth effect is a very confirmed and observable phenomenon that when the stock market goes up, people tend to spend more, even though they don't actually have more disposable income. It's because they feel like wealthier.
Darren Wurz [00:06:18]:
And the advice, you know, the opposite is true as well. When the markets go down, people feel poorer, and so they tend to spend less. And so one of the tricks in life is to make yourself feel poorer than you actually are. Yes, that is one way to help yourself spend less. So by removing profit from first, you are artificially constraining your spending. You're making yourself feel like you have less money. And I've often said this to clients, right? If you have one account that has $50,000 in it, you will feel a lot more wealthy than if you have five accounts with $10,000 in them each. It's just a very simple way of tricking your brain.
Darren Wurz [00:07:07]:
When we don't have these tricks, when we don't have these constraints, we tend to over hire, we tend to spend too much on software, we tend to justify inefficiencies, we tend to justify overspending. As I'm reinvesting in my firm. Well, when we have constraints, we force ourselves to adapt. And so Parkinson's law is simply that, giving us smaller plates. Okay. The second phenomenon is mental accounting. I mentioned this in the intro, and this might not sound very cool, but I'm going to tell you, it's pretty cool. Mental accounting is the tendency for people to treat money differently based on labels or where they got it from.
Darren Wurz [00:07:54]:
We tend to categorize, label, and treat money differently depending on where it comes from, what it's labeled for, or how it is mentally assigned. And this comes from a behavioral economist named Richard Thaler. You may have heard of him. He's a Nobel Prize winner. Won the Nobel Prize in 2017. He wrote a book called Nudge. Maybe you're familiar with that one. Basically, his work, he showed that people create mental buckets for money and apply different rules to each bucket.
Darren Wurz [00:08:27]:
And in doing this, he was basically trying to prove that people don't behave rationally when it comes to their money. We actually behave irrationally. And mental accounting is one way that we behave quite irrationally. Because $1 over here is the same as $1 over there. But depending on where we got it from, we're going to treat it very differently. Here's an example. Found money versus earned money. We tend to treat found money a lot differently than we treat earned money.
Darren Wurz [00:08:58]:
If you find some money on the street or you win some money in a lottery winning or whatever, right? Or you get a random check in the mail that you weren't expecting. We're more likely to gamble, spend freely, or splurge with found money than we are with earned money. And so profit first basically leverages or harnesses this tendency that we have for our greater good. We're less likely to touch the money that's in the tax account because it's labeled tax. It's not supposed to be used for operating expenses. We're a lot less likely to invade the profit account to pay for operating expenses because it's there and it's labeled profit. So that is mental accounting. The third phenomena is loss aversion.
Darren Wurz [00:09:58]:
Loss aversion is the idea that we hate losing more than we love winning. Okay, so you might have to wrap your brain around this one a little bit. But behavioral economists have shown this in study after study. And actually we talked about this in the last book that we read, A Random Walk down Wall Street. In the world of investing, it's an observable and confirmed phenomenon that losses hurt about twice as much as gains feel good. Okay, now I know that's a tongue mouthful, so let me explain. The intensity of feeling is greater for a loss of the same magnitude than a gain of the same magnitude. So if you were to lose $100, the intensity of that feeling is far greater than if you were to gain $100.
Darren Wurz [00:10:50]:
We'd much prefer to not lose than to gain. Not losing feels a lot better. And loss aversion shows up in profit first, because once your profits, taxes, et cetera are set aside, spending it feels like a loss. And so your profits become emotionally protected. You don't want to spend from the profit account because I'm losing that profit. Right. Much easier to spend from the operating expenses account. The fourth behavioral psychological phenomenon that we see is decision fatigue reduction.
Darren Wurz [00:11:33]:
This one is fascinating. You know, decision fatigue is a real thing and you may be familiar with it. We can only make so many decisions in a day. This has been proven. And then the quality of our decisions starts to go down. This was discovered by a guy named Roy Baumeister. He was doing research on self control. He did a study in which parole in where he found that parole judges were significantly more likely to grant parole early in the day.
Darren Wurz [00:12:07]:
So if you ever, ever faced with parole, you want your hearing to be early in the day. As the day went on, the approval rates steadily dropped. Only after food breaks did the approval rates actually go up. Why is this? Because as time wore on, mental energy was depleted. As these Judges had to hear more and more cases and make more and more decisions. Their mental energy was actually depleted. Baumeister also found that decision making draws from the same limited pool of mental energy as self control. Ah, get that.
Darren Wurz [00:12:50]:
So too many decisions, less self control. Same thing with money, right? Too many financial decisions, less, less financial self control. Profit first reduces the need to make decisions by pre allocating money and simplifying financial decisions and therefore hopefully improving financial self control in a roundabout way. Fascinating stuff. Okay, number five. Number five is the immediate feedback loop. And this is a no brainer, right? We know this, you know this. Your brain responds better to short term feedback than to long abstract goals.
Darren Wurz [00:13:35]:
We all struggle with delayed gratification. You know, in the profit first system you get to see your profit now, not at the end of the year. That's what makes it so powerful. It's there, you have that immediate feedback loop, that immediate gratification. Traditional profit and losses are backwards looking and can feel punishing. Right at the end of the year you, or at the end of the quarter or whatever, you get your profit and loss and you didn't make it. You didn't get the profit that you wanted. You suck.
Darren Wurz [00:14:12]:
Well, profit first, unlike that, reinforces behavior more quickly by getting your profit faster by getting that feedback up front and helps create momentum. Okay, so immediate feedback loops we've gone through. So just to recap here, Parkinson's law, mental accounting, loss aversion, decision fatigue reduction, immediate feedback loops. And finally the last one is this. Constraint and scarcity drive creativity. So in the profit first system you are creating constraints and scarcity for yourself. We kind of mentioned this a little bit in the first one. Parkinson's law constraints force prioritization.
Darren Wurz [00:15:04]:
When you only have X amount of dollars, you have to prioritize where that money goes. You don't have unlimited resources now when you have a credit card and it can be very easy to feel like you have unlimited resources. But by constraining yourself by only looking at your OPEX account and only spending what's there, you are forcing yourself to prioritize. Instead of blowing tens of thousands of dollars on every marketing opportunity that comes your way, you are going to be forced to focus on those that have the highest roi. And that is going to make you more profitable. There are so many law firms right now, maybe you're one of them that are wasting money on low ROI activities. One of the beautiful things about Profit first is that it's going to force you to rethink all of those things. You're Forced to find efficiencies when money isn't unlimited.
Darren Wurz [00:16:08]:
And let's be real, money is always limited. Limited. But Profit first helps us realize that. And it also encourages us to pay attention to the numbers. To have an awareness of our spending. Scarcity forces us to make better decisions. So, my friend, those are all the reasons why Profit first is so effective. It has to do with tricking our brain.
Darren Wurz [00:16:37]:
We are not purely logical creatures. Our brains do weird things. And Profit first is a beautiful system because it capitalizes on those weird things that our brains do. When you actually implement Profit first, and I'm not saying you have to do it or you have to do exactly the same system. You gotta find the system that's right for you. But the basic idea is this. You need a structure for your cash flow that's going to help you create. Create clear cash boundaries, reduce your financial anxiety.
Darren Wurz [00:17:11]:
You're not going to have those looming tax bills because you're going to have tax money in your tax account. You're going to have immediate visibility into your profit. It's going to help you improve your spending discipline, organize your finances, and most of all, smooth out volatile cash flow. That's the beauty of the percentages. That's when I first found Profit first and I saw the basic concept is allocating money into sub accounts based on percentages instead of dollar amounts. Oh, wow, what a beautiful way to do it. So simple, but makes so much sense. Friend, if you've been dragging your feet on Profit first, but you know you need a better system.
Darren Wurz [00:17:58]:
Today's the day. So here's what I want you to do. I want you to take that first. You don't have to do it exactly how the official system is, but start by setting up those sub accounts for yourself. When you get clear about cash flow, everything changes. I've seen it with clients that we've worked with. There's some kind of weird magic to it. I don't know.
Darren Wurz [00:18:22]:
All of a sudden everything starts improving. But I strongly suspect it has a lot to do with the way our brains operate. Profit first works with the way that our brains are naturally wired. And, you know, profitability and cash flow is a big part of the work that we do here at the Lawyer Millionaire in helping law firm owners grow stronger businesses so that they can grow their personal wealth and achieve their lifelong dreams and goals. Because that's what it's all about, isn't it? So, my friend, let me ask you, when are you going to start prioritizing profit? When are you going to start taking home the money that you deserve, the money that you need to take home to take care of your family, to send your kids to college, to take your spouse on that dream vacation, to finally do that home renovation, or to finally get your retirement accounts growing. If you are ready to put a stake in the ground and get your financial house in order and make this the most profitable year yet, schedule an intro call with me and we'll show you the whole system. The link is in the show notes. And by the way, if you're not yet a part of the lawyer millionaire community, what are you waiting for? Join us to get access to a distinguished network of law firm owners, monthly masterclasses, free resources and more.
Darren Wurz [00:19:55]:
It's completely free and the link is in the show notes. Well, that's it for today, friend. And remember, if your law firm isn't building you wealth, joy and freedom, what the hell are you doing? Can I get an amen? I'll see you next time.