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What’s it: Profit-sharing is a bonus paid to employees based on the company’s profit performance. It is an additional incentive beyond the salary they receive. When it exceeds the target, the company distributes a portion of the profit as a bonus. Each receives according to a predetermined formula; it may be proportionally based on the basic salary for each position or based on performance.
Also known as profit-related pay or profit-sharing plans.
Why is profit-sharing important for the company?
Profit-sharing is a way for companies to appreciate employees for their hard work so far. In addition, it is also a motivating factor to encourage improvements in employee performance and productivity in the future. Or the company needs it to make the new strategy successful.
The company indirectly links employee performance with compensation to them. First, the company offers employees more pay if it achieves the targeted profit. And, to achieve profit targets, companies need employees to be more productive and efficient in carrying out their work. Thus, it can sell more output at a lower cost.
Then, if the profit target is achieved, the company distributes part of it as a bonus to employees. Management appreciates them for their hard work over the past year.
Employees naturally want to earn more dollars. Thus, they are trying hard to help the company book higher profits in the future. As a result, they can get more compensation.
How does the company determine profit sharing?
Employees are happy with this scheme because they receive more dollars. Besides salary, they receive a share of the company’s profits. Meanwhile, the remaining profits will be distributed to shareholders as dividends or retained as internal capital.
How much each employee receives depends on their base salary. Bonuses may be distributed proportionally to them according to their salary or based on individual performance evaluations.
Take the simplified case. A company distributes profits of about $100 as a bonus. An employee has a base salary of $1, which accounts for about 0.1% of the total salary paid to all employees. As a result, he gets a share of $0.1 = $100 x 0.1%.
In specific cases, the formula for calculating bonuses to individual employees can be more complex than the example above. For example, the company might adjust the percentage and not share it proportionately. It aims to avoid possible disappointment among employees because it is considered unfair. Why? When divided proportionally, those with higher salaries will get higher bonuses than those with lower salaries.
So, instead of dividing it proportionally, the company might determine the percentage based on employee achievements. Companies evaluate their performance to determine which are performing well and which are not. And, those who excel will earn a higher percentage.
What are the advantages of profit sharing?
Motivating factor. Employees are eager to perform better. They strive to help the company achieve the targeted performance, i.e., the targeted profit in the years ahead. They are motivated to do that because it allows them to earn more bonuses. As a result, they strive to be more productive and efficient in their work, producing higher output at lower costs.
Reduce conflicts of interest. Shareholders have an interest in getting more dividends. But, on the other hand, employees want higher compensation. And, providing more compensation reduces the profit available for distribution as dividends. Thus, the profit-sharing scheme is a way to compromise these two conflicting interests.
Not burdensome. The bonus is taken from the profit made by the company. Sometimes the company gives it, and sometimes it doesn’t. Thus, it should weigh less on its profits than when calculated on a revenue basis.
Attract external talent. More external professionals, even from competitors, to work in the company. Profit-sharing schemes allow them to earn more dollars.
What are the disadvantages of profit sharing?
Expensive. Companies have to spend more money because they pay salaries and provide bonuses. It was even higher if they had many employees. Or, it could be a problem if the company holds little cash.
Less profit for shareholders and internal capital. Normally, companies distribute profits as dividends or held as retained earnings. However, if some are distributed to employees, fewer dividends to shareholders or internal capital (retained earnings). Thus, shareholders may intervene and only allow less profit to be distributed as bonuses. Or it could hinder future growth due to insufficient internal capital.
Employee disappointment. There are times when companies do not distribute bonuses because profits fall or even lose, for example, during a difficult economy. As a result, employees are disappointed, which may cause their morale to drop.
Unfair. If paid proportionately based on base salary like the example above, it can cause jealousy among employees. There is a gap in the bonuses received by each. Higher-paid employees get more bonuses than lower-paid employees. As a result, employees with low salaries feel it is unfair.
Not motivating. If the bonus is distributed proportionately, it may not be closely tied to individual effort. High performers may receive fewer bonuses because their base salary is low. Thus, it may not be effective in increasing motivation. Quite the contrary, it lowered their spirits.
