The Danger of Mental Accounting

One of the easiest ways to make your business look more profitable than it actually is is to start mentally separating your money into different categories.

“This is normal revenue. That expense was a one-time thing. That money is already set aside, so it doesn't really count. That expense doesn't belong to this program.”

These are all examples of mental accounting.

And before I make this sound like a terrible financial habit that only other people have, let me be clear:

We all do this.

In fact, some amount of mental accounting is necessary. The problem isn't mental accounting itself. The problem comes in when the way we mentally categorize money starts overriding the actual financial reality of the business.

We all mentally account.

Mental accounting is the tendency to treat money differently depending on where it came from, what we're using it for, or how we perceive it. It's the age-old “cash isn't real” philosophy. 

There's a great Freakonomics Radio episode about personal finance where they talk with Yale finance professor James Choi about the difference between economic theory and the way real people actually manage money.

If we followed purely rational economic models, we might think about every dollar as part of one giant pool of money and make every spending decision based on the mathematical value of that dollar. That same economic model would suggest that we also never save a dime in the name of maximizing utility (economics lingo for happiness)!

But that's not how real people operate. We put vacation money in a separate savings account. We mentally treat a tax refund as “extra money,” even though technically it was already our money. We might have an emergency fund that we don't consider available to spend.

And there are entire financial systems and strategies built around this concept. In Profit First, Mike Michalowicz recommends setting up separate bank accounts for different purposes (profit, taxes, operating expenses, etc). The idea is that physically separating the money changes how you think about it and helps you make better financial decisions.

That's mental accounting, and it can be incredibly useful.

If putting your tax money in a separate account keeps you from accidentally spending it, that's a good thing. If separating your profit helps you actually take profit instead of spending every dollar the business earns, that's a good thing too. So I'm not arguing that we should eliminate mental accounting.

I'm arguing that we need to recognize when we're doing it and make sure it doesn't cause us to lose sight of reality.

Yes, I've done this too!

A few years ago, Seth and I made a fairly significant investment in our business to get help fixing our sales process.

We worked with Motion Mentors, and the investment was specifically intended to help us improve how we generated and converted leads.

We knew it was a large expense. We also knew it wasn't something we were planning to pay every month or every year. And if everything went according to plan, we expected the investment to pay for itself within a few months. So what did I do?

I excluded it from our internal financial reports.

Obviously, it was included in the reports we gave our tax advisors. I'm talking about the financial reports we used internally to evaluate how the business was performing.

I mentally categorized it as a “one-time investment” rather than a normal business expense. And honestly, everything worked out great. The investment helped us improve our sales process, and we were able to move past the expense.

But looking back, this was a very clear example of mental accounting. I knew better. I knew the expense was real. I knew the money had actually left our bank account. But because I expected the expense to pay for itself, I mentally put it in a separate bucket.

The reason I'm okay admitting that is because I did it once. I knew I was doing it. I knew it wasn't technically the right way to look at our finances. And I continued to have a complete understanding of what the actual numbers were. That's very different from allowing mental accounting to become a pattern.

When every program looks profitable

I saw another version of this when I first started doing the finances for Swift.

One of the first things I wanted to understand was which programs were actually profitable. So I started pulling together the revenue and expenses associated with each program.

I would take all of the expenses that could be directly tied to a program (things like instructor wages and other program-specific costs) and compare them to the revenue that program generated.

And guess what? Every program looked profitable. Except it wasn't the whole picture. There were a lot of expenses that couldn't be easily tied to one specific program (rent, software, insurance, utilities, administrative labor, marketing, equipment, etc). If I looked at each program in isolation, those expenses didn't really “belong” to any of the programs, but the business still had to pay them. So I started pushing back on our program profitability calculations.

I had to make the argument that we needed to include these expenses somehow.

Because if a program generates $50,000 in revenue and has $30,000 of directly attributable expenses, it isn't necessarily a $20,000 profit center. Maybe it also requires $15,000 of overhead to support it.

Now we're looking at something very different. This is another form of mental accounting.

We were mentally separating the expenses that were directly connected to a program from the expenses that weren't.

And if we only looked at the first category, everything looked great.

Once we included the full cost of operating the business, suddenly nothing was as profitable as it initially appeared. In the past, when we didn't include overhead expenses, we were operating off the assumption that if we got our overhead costs down, we would “be fine.” But the reality was that we were already spending as little money as possible on operating expenses. 

That was a really important turning point for us. Once we started including those expenses in our program profitability reporting, we could actually see where the problems were. Maybe a program needed a price increase. Maybe we needed to change staffing. Maybe we needed to improve enrollment. Maybe a program simply wasn't financially viable in its current form.

We couldn't make those decisions until we were looking at the actual all-encompassing profit margins of the program.

The expenses didn't suddenly appear when we added them to the report. They were there the entire time.

We had just mentally put them in a different bucket.

When “one-time” expenses become a pattern

This is where mental accounting can become particularly dangerous. Imagine your business spends $8,000 replacing a heater. It wasn't in the budget, you weren't expecting it, and you don't expect to spend $8,000 on a heater every year. It would be reasonable to say, “This was an unusual expense.”

The problem comes when you start doing this with everything that makes your finances look worse. 

The heater was a one-time expense. Then an expensive piece of equipment breaks, that's a one-time expense. Then you need a consultant, that's a one-time expense. Then you have an unexpected legal bill, also a one-time expense. Then you have a large repair, another one-time expense. Individually, each one might actually be unusual. But one-time expenses happen all the time.

And if you continually exclude them from your financial picture, you're going to end up with a business that looks much more profitable on your internal reports than it actually is.

The same thing can happen with revenue.

Maybe you have a temporary revenue stream that you don't expect to continue. You might decide not to include it in your ongoing projections. That could be completely reasonable, but if you start excluding revenue and expenses based on what you think will happen rather than what is actually happening, you can quickly lose track of what your business really looks like.

Two big problems with mental accounting

When mental accounting becomes a pattern, I see two major risks.

1. You can create a cash flow problem

The money doesn't care what category you put it in. If $8,000 leaves your bank account, you have $8,000 less cash. It doesn't matter whether it was a “one-time expense,” an “investment,” an “unexpected expense,” or something you don't think should count.

The cash is gone.

If you consistently exclude expenses from your projections because you believe they're temporary, you may convince yourself that you have more cash available than you actually do. Then the next big expense comes along, and suddenly you're scrambling to cover it.

This is one of the reasons I like to build some expectation of unexpected expenses into financial forecasts. You don't have to know exactly what the next expense will be, you just have to recognize that something probably will happen.

If your business historically has $10,000–$20,000 of repairs, equipment replacements, and other unexpected expenses every year, it probably isn't realistic to forecast those expenses at $0 simply because you don't know exactly what the next expense will be or you hope nothing breaks this year.

Your forecast should reflect reality, including some of the uncertainty that comes with running a business.

2. You can lose control of what your numbers actually mean

This is the bigger issue for me. If you start excluding multiple expenses, or even ongoing revenue or expenses because you believe they're temporary. you eventually lose your baseline.

You can't answer simple questions like:

“What does it actually cost to run this business? How profitable are we actually? How much cash do we really need?”

Your financial reports should help you understand your business. If you've mentally removed half of the things that make your business more expensive or less profitable, you're no longer looking at the financial picture, you're looking at the financial picture after you've edited it to fit the story you want to tell yourself.

And that's dangerous for decision-making.

Other ways we mentally account

The “one-time expense” example is only one form of mental accounting.

We might pretend cash isn't real money because it's already out of our primary checking account. Maybe you have money sitting in a payment processor or savings account, and because it isn't in your main bank account, you don't think of it in quite the same way. You might look at a large checking account balance and think all of that money is available to spend, even though some of it is already committed to payroll, taxes, or upcoming expenses.

Again, the money itself hasn't changed, our perception of the money has changed.

That's what makes mental accounting so interesting. It isn't necessarily about doing bad math, it's about the way our brains organize financial information to make it easier to process.

Sometimes those mental categories help us, but sometimes they hurt us.

The goal isn't to eliminate mental accounting

I don't think the answer is to stop mentally accounting altogether. That's probably impossible and dangerous.

Instead, the goal is to recognize when you're doing it and understand what you're giving up by doing so.

If you want to separate your tax money into a different bank account, great. If you want to create a separate savings account for a future investment, great. If you want to analyze a business expense separately because it was truly unusual, that's okay too.

But don't let that separate category cause you to forget that the money was real. Keep the expense in your financial statements, keep it in your cash forecast, and understand what it means for your business.

If you had an unusually expensive month, don't panic, but don't pretend it didn't happen either. Instead, ask:

What happened? Why did it happen? How often might something like this happen again? And what does it mean for the future?

Those questions turn an unexpected expense into useful financial information.

Don't let your financials tell you the story you want to hear

This is ultimately what I think is most important about mental accounting.

It's easy to look at your finances and remove the things that make the business look worse, but the purpose of financial reporting isn't to make you feel good about your numbers. It's to give you information you can use to make better decisions.

The goal isn't to create a perfectly clean financial picture where every expense is predictable and every dollar has one clearly defined purpose.

Running a business doesn't work that way.

The goal is to understand the difference between the financial picture we want to see and the financial picture that actually exists.

Because the heater really did cost $8,000. The Motion Mentors investment really did come out of our bank account. The overhead expenses at Swift really did have to be paid, even if they couldn't be assigned neatly to a program. And if we don't include those things in our analysis, we're not making the business more profitable, we're just making the numbers easier to look at.

And I'd much rather have financials that tell me the truth, even when the truth isn't pretty, because that's what gives me the information I need to actually fix the business.

Because “one-time” doesn't mean “didn't happen.”

And if it happened to your business, it belongs in the story your financials are telling you.

If any of this sounds like something you struggle with, schedule a call! I'm happy to help you troubleshoot for a few minutes or offer ongoing support.