We’re talking about Profit First again this week, with a focus on those unexpected expenses that inevitably pop up in your construction business. Rob, Wade, and Stephen discuss the three steps you should take to address a cash flow shortage and how to prepare for similar situations in the future with the Profit First system.
Topics we cover in this episode include:
- How Profit First is an early warning system for cash flow issues
- How to address an unexpected expense in the short-term without wrecking your cash flow
- Defining the unexpected expense and whether you can avoid it in the future
- How to set yourself up to deal with unexpected expenses in the future
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[00:00:00] Rob Williams: Welcome to the Contractor Success Forum. Today, we’re talking about Profit First, one of our key tools that we use, and how to handle unexpected expenses.
Because here on the Contractor Success Forum, we discuss how to run a more profitable, successful construction business. And with us, we have Stephen Brown, McDaniel Whitley bonding and insurance agency, Wade Carpenter, Carpenter and Company, CPAs, and Rob Williams with IronGate Entrepreneurial Support Systems.
What I thought was so interesting in this topic is this actually didn’t come from Wade or me. It came from you, Stephen, the curiosity. And I’m glad! This is great.
Profit First Basics
[00:00:53] Stephen Brown: Well, okay. We talked about Profit First. Listeners, if you don’t know about Profit First, you might wanna listen to some other podcasts of ours, but Mike Michalowicz, who came up with this Profit First idea, is how we all kind of got together. And you guys are always explaining it to me and how it works. And I like it the more I hear about it.
And I’m saying, guys, I love the idea of how Profit First works. It’s very simple. It’s how you take income and you distribute it to pay for expenses, to take your profit and put it separately and then work backwards. It’s kinda like the analogy of how much extra toothpaste you can get out of your tube of toothpaste. I’m obsessed with it, guys. I never throw a toothpaste tube away till, I mean, there’s just nothing. There’s–
[00:01:43] Rob Williams: Yeah.
[00:01:43] Stephen Brown: And I guess it’s a scotch–
[00:01:45] Rob Williams: Parkinson’s Law.
[00:01:46] Stephen Brown: I don’t know but, so what do you do guys? When you’re running a Profit First system and you have unexpected expenses? I mean, I would think, well, you gotta borrow the money somewhere to pay for those expenses. Or you gotta borrow from another job, kind of– we use it in the bonding business of robbing Peter to pay Paul. When you start juggling those balls in the air, what do you do?
[00:02:08] Rob Williams: Well, first, let’s outline this a little bit for the guys that don’t know Profit First. Because the reason that Stephen is wondering about this is because we have different envelopes. Each different account, which is like an envelope. And you only spend from that envelope. So some of our guys, we’re speaking in code here, if they don’t understand that.
So just setting up the situation is, you’ve taken your payments and then you’ve allocated them into different percentages into different bank accounts. So what happens when you’ve got more money that you owe than is in the account? That’s the question, right?
[00:02:44] Stephen Brown: Yeah. And you have unexpected expenses. Well, it’s like, whoa. It’s every time you think you know every expense on a project, and every cost, then something new pops up.
How to avoid unexpected expenses wrecking your cash flow system
[00:02:56] Wade Carpenter: Yeah. So I guess where we’re going with this is, whether it’s unexpected or what it’s like, the goal of this is so we don’t wreck our cash flow system.
[00:03:06] Stephen Brown: Right.
[00:03:07] Wade Carpenter: And so I think we need to kind of break this down and me and Rob can kind address this as we go.
But number one, I think, how do we immediately deal with the cash flow shortage? Number two, we need to talk about why this occurred. And then step three is after we understand why it occurred, how can we deal with this in the future, so it doesn’t happen again? Because, too often, we see several reasons that people, they come up short, especially when they’re getting started with this. And how do we not wreck the system? Because I think me and Rob both can tell you the system absolutely works.
[00:03:42] Stephen Brown: Okay. So guys, if you have an unexpected expense and you pay it, then in the future, going forward, that particular unexpected expense is something that can be anticipated?
Define whether the expense is something you can anticipate in the future
[00:03:56] Wade Carpenter: That’s where we need to kind of talk about that. You know, why did this come up? So what are the reasons for it? Is it something that’s truly unexpected? Your truck broke down, or a major piece of equipment broke down and you had to fix it. You had some catastrophic event in your business, versus something like a worker’s comp audit.
Well, a worker’s comp audit, yes, you may not have seen it coming, but maybe you should have, and there are ways to do that. A lot of times we’re getting started on Profit First and people try to take the percentages from the book. They start off too fast and realize pretty quick, well, I don’t have that much profit and we need to kind of work into it.
You know, are there annual payments that we forget about? And then they come around every year? It could be because of growth. It also could be because you took on a new debt and now you’ve got a new debt payment. One of the recent episodes, we talked about, we’re officially, I think, in a recession now. And so our podcast a few weeks ago about what happened with The Great Recession, this is where I think if you understand the reason, if we’re short, is it a constant problem? Or something where it’s systematic and we need to make some changes? Or is it something like seasonality? We need to recognize seasonality. So, is it just, we missed a customer payment that left you short?
So I’m throwing out all these reasons, but you know, that’s why I say we need to kind of figure out what happened at some point.
[00:05:22] Stephen Brown: And as an insurance agent, I’d also like to point out how many unexpected expenses might be covered by an insurance policy. And you can take that premium and build that into your overhead costs. So it’s not unexpected when you have a claim. Just like, our last podcast, I mentioned a project manager that was ordering materials for other jobs he was doing on the side.
Well, luckily, we had an employee dishonesty policy in place that reimbursed the contractor for that employee being dishonest. So.
How Profit First alerts you to issues early
[00:05:50] Rob Williams: I think the first point of this is that the alarm bell went off. And that’s the point? So it means let’s study it now. And it went off so much earlier than it would’ve gone off. It’s a leading indicator now, rather than a lagging indicator, because since you had those bank accounts done, it’s flagged so much earlier. If everything had been in the same account, it may be months or a year and a half before you even realized that you were over or under the budget.
So the fact that you run out of money in an account, it’s a great thing for Profit First, because it means you caught it. You would not have been alerted to that in a typical system with everything in one bank. So it worked.
Now the solutions from there, I think now you have to break down the situation. What is the goal of it? What is the point of your system? Are you looking for cost control? How much control do you want over that? Is it a do or die situation for your company? Are you gonna go out of business with that? And you may have some of your costs tighter, so you see that.
A lot of these controls, Stephen, when we set these things up, you have to figure out what the client wants or needs. Some of them don’t want that to happen. I get in there and man, they’re just really on the ball. They don’t have any junk, no expenses anywhere. And they just want a little bit of buffer, but they have some variances and they don’t want to catch those things.
But a lot of other ones will have something they’ll have in an account in the profit or something that they’ll pull that out from, or the owner. So there are a lot of different ways you can solve this. But the main thing is the light went off. The bell rang. You’re alerted. That’s the point.
Now getting to the solutions, Wade, there’s so many things we talked about. Line of credit, do you do that? To me, that’s sort of frustrating. It’s kind of dangerous because you just keep putting money in there if you have the line of credit to save it.
So where’s the system beyond there? The light goes off and maybe, especially just some owners that may be more advanced and they’re not there every day, you have to call the owner and at least alert the owner because they wouldn’t be aware of that without that. That’s one of the things I really like with one particular customer that I had. If they need owner to put money back in there, he knows.
Wade, I’m trying to separate these per situation. That’s my message, is you need to figure out the client and how this system needs to work beyond just the basics.
How to immediately deal with the cash flow shortage
[00:08:26] Wade Carpenter: Right. Well, so again, what is the immediate response we need to have? And typically what we’re talking about is we’re running short in our OPEX account. Or one of our operating. We don’t run short in our profit. Maybe we run short in our tax, the first year or something. But once we got that done you know, the owner’s comp.
Where to take money from to cover cash flow shortages
[00:08:46] Wade Carpenter: But what we’re usually talking about is we don’t have enough money in our OPEX to cover payroll or whatever. And so how do we address that? And this is where me and Rob may disagree or whatever. I don’t think there is a hard and fast rule where you take it from.
[00:08:59] Rob Williams: I agree. I agree.
[00:09:01] Wade Carpenter: And it’s gonna depend on the situation. I mean, do you go pulling it out of your profit account? Do you go pulling it out of your owner’s comp? Do you take it out of your tax account? Well, you’ve gotta remember if you stealing from your tax account, it’s not gonna be there. Do you go taking a permanent loan? Can you take it off a line of credit? Do you need to go raise outside capital?
And that’s where I think the next part of it is. Steps defining why it happened will kind of help us address that. But the immediate need is sometimes, hey, where do we have it? Where can we borrow it from? And if it’s a temporary thing like a contractor or subcontract, whoever, owner didn’t pay you on time and it’s a temporary thing, the line of credit, if you’ve got it, that’s a great way to do it. If it’s a short term thing. But where people get in trouble is they go buying equipment and things like that off a line of credit or whatever. But, sometimes it’s gotta come from the profit or whatever. Rob, you want to comment on that?
[00:10:00] Rob Williams: Yeah on that, there’s actually two situations. One, this conversation is assuming you have the money somewhere else. So maybe it doesn’t get paid. And in the book, that’s sort of more the example, it’s more hard line. The hard line Profit first people say, you just don’t pay it. There’s no money there, you don’t pay it.
Well, a lot of people will not choose to not pay their payroll. That’s not their decision. They’ve got it somewhere else. So I tend to like, from my examples, to pull that from an owner’s account or somewhere where they feel it. A lot of times though, I’ve seen the easier route is to pull it out of the profit account in the middle of the quarter, but then you don’t have that profit there.
So I default to sort of the owner contribution or something. That’s what I actually see. And I’ve done that myself sometimes, you know, and I have not robbed it from another account. I put it there, but I know that’s there and that sort of has a lot more of the impact to make you wanna fix some things.
The trading between accounts, I see more of that in the beginning a lot of times when we run out because we just hadn’t gotten it right yet. There were a lot of expenses done in the books that come in when we set these numbers. If it’s a new person, they’re not, I don’t wanna say not right, but they’re not, well, they’re not right. So when we put them in there. So you take it from and do you have a buffer?
The other thing, some of the people just want the security of Profit First, not the cost control. They’re not in there. And so they want to build up a number of days of buffer. So the buffer is actually built into the expenses so they don’t run out of money. It doesn’t really control your costs as well, because they may be good at that. Some other system, they may not need that as much.
But that’s typically Stephen, where you get some unexpected expenses. There’s a longer customer that’s been there for a while. They’ve got that extra money already allocated. You have planned for unexpected expenses, because some of these companies often have unexpected expenses. So you just have a buffer.
[00:12:12] Wade Carpenter: If we can let’s hold that part to the last end, because that is definitely a way to address it.
Uncovering why the unexpected expense occured
[00:12:17] Wade Carpenter: But I think the next step needs to go saying, why did this happen? In construction we often see, you know, the trades that are working outside, or say, work with schools. They can be very seasonal. And how do we address seasonality in construction?
Well, number one, to find out, do you have it? And a lot of times, when you’re short on cash and you know the times they come in. But if you don’t know, just start taking a look of when cash came in over the last, say three years or whatever. Do you see normal dips and spikes in your cash, in your revenue coming in?
If we had more time, we could talk more about how to do that. But like Rob said, coming up with a seasonality account to address those things. Is it truly an emergency, like a one time thing? I mean, you can’t always predict all the emergencies. But as Rob said, we can create a vault account or whatever we want.
But the other thing is is it truly part of the recession, do we need to make some serious cuts? And that’s where again, carving into small plates, I think is one of the greatest things about Profit First, because you know, hey, I’m running short on something here because of that.
[00:13:30] Stephen Brown: Early warning system.
[00:13:32] Rob Williams: Yep. If you’ve got a tightly controlled company, somebody that really wants control, that can really be worth a lot of money to your bottom line. And one thing you said, Stephen is insurance policies. Typically I think the contractor wants to absorb a lot of those costs and not be paying an insurance company for that, but the opportunity cost of that insurance, that insurance may allow you to enforce these more strict, rigid, procedures because then you’ve got a reason that it happened. It really was an emergency, something like that, that would happen. And you make that claim because what’s the first thing that happens when something, not huge, happens? It’s like, do we turn that in? Do we pay that ourselves? What do we wanna do?
And the tighter that you go, yeah, you may not statistically think that money is worth that insurance policy. But when you look at the opportunity cost of having those tight controls in your company, that may be worth 10 times the cost of the insurance. So it’s all about your organization and your systems and your processes, and the goals and objectives that you’re trying to achieve.
So you got a different answer, with a lot of those things. I don’t mean to not give an answer, but the answer is, you need to solve it for that client. And it’s gonna be a different answer for each person that I know.
[00:14:59] Stephen Brown: Okay, I’ll buy that.
[00:15:02] Rob Williams: But the big question is, is there even any money though? So is there money to pull it from somewhere?
[00:15:09] Wade Carpenter: Well, usually contractors are pretty resourceful and hopefully we don’t have to resort to these pay-by-the-day or pay-by-the-week loans where, they’re so incredibly expensive.
Long-term solutions for better cash flow
[00:15:19] Wade Carpenter: But, I guess going to the next part, Rob was going to, what’s the long term solution? And again, finding out why, is this like a recurring annual payment, or is it like a worker’s comp payment? A lot of times when I get a contractor started on Profit First, I’m like let’s make a list of your recurring expenses by the week or month or year, quarter. And some of them are annual.
And maybe we have them on a credit card and we don’t even think about it. You know, these, some of them are irregular, but these recurring expenses that you don’t see coming, well, if you had a quick system to say, I know I need to address this in September or whatever, then that’s one way to know that. As Rob said a little while ago, we need to build a vault account, or what I call a vault or rainy day fund.
[00:16:07] Rob Williams: Yep.
[00:16:07] Wade Carpenter: There are different ways to do that. And I don’t mean to keep going on these things, but you know, the seasonality, if you’re gonna be short in January through March, or whatever winter month, or whatever it is for you, when we determine what that seasonality is for you, a lot of times we’ll set up a seasonality account to where we drip some money in there as we go.
I just kinda led into the next one, the drip accounts. For me, I spend 20 something thousand at one point in May for tax software every year. So part of my Profit First is I have this drip account that I throw X percent in there to make sure it’s there at that point in, you know, after tax season that, I gotta make this huge outlay.
Any comments on that, Rob or Stephen?
[00:16:54] Rob Williams: I think the one great thing that you just pointed out is people get concerned they won’t have extra money for those expenses with Profit First, but the reason you do have money for those unexpected expenses is because you were on Profit First for a long time.
Not this week, but you’ve been on it for a long time. And you have put aside those funds into that vault account for contingencies that may happen, whether it’s a change in the economy or it’s a one time unexpected expense. You have set aside that money and you have had a system just like they compare it to the 401k. It’s an automatic system that has set aside that money that you’ve hopefully forgotten that you even have.
I love to hear these stories of the wives– maybe it’s not a wife, but somebody keeping the books and the owner has forgotten they even had this vault account. I think there’s one of the stories that it may be in the book. He says, oh my God, we’ve got this big expense, we’re out of business! And she says, what are you talking? I’ve got double that in the vault account over there. And he, what?! We have a vault account? What’s that? You, and it’s there because of Profit First. And so it allows you to be able to solve the problem. And the red flag does go off. So you have to consciously solve that problem and go get that money. So it makes you more in control of it, more deliberate.
[00:18:21] Stephen Brown: More proactive and not reactive.
[00:18:23] Rob Williams: Yeah.
[00:18:25] Stephen Brown: As you–
[00:18:25] Rob Williams: A good answer.
[00:18:26] Stephen Brown: You answered my questions. Great job. Thank you.
[00:18:29] Rob Williams: All right guys, Wade, what else you got,
[00:18:31] Wade Carpenter: man?
Well, just like I said, to wrap this up again, I love the system and exactly what you said when they discover– I’ve seen the same thing. I’ve had clients where, they forgot that they had this money set aside and it’s like Christmas to them. It’s like, hey we’re rescued here.
But you know, again, having the system in place when recession is hitting, that I think is one of the best ways to know that, hey, maybe we need– and I’m not trying to play doom and gloom here, but you know, if things start getting tighter, It’s a great way to know, hey, we need to make some changes. And Stephen, I don’t know if we actually addressed your question, but hope we gave some people some things to think about.
[00:19:11] Stephen Brown: You did. Thanks guys.
[00:19:13] Rob Williams: All right. Well, great. Well, this has been another very valuable episode of the Contractor Success Forum today. So let us know what your ideas are. What have you done out there? Let’s hear from all of our Profit First guys, how have you solved this? What’s the solution? What ideas did you think about during this conversation that can help us help our other clients?
You may have thought of something that we hadn’t thought of. Please share that with us. We wanna hear from you guys. Because together we can all be stronger and more profitable on the Contractor Success Forum. So come back and listen to our next episode.