A complete guide to profit-sharing advantages and strategies

By Indeed Editorial Team

Published 7 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Profit-sharing is an innovative compensation strategy that helps motivate and reward employees. The two main types of profit-sharing plans that businesses use are those that help employees increase their earnings each year and those that defer profits to a retirement plan. Understanding the various advantages associated with profit-sharing helps businesses determine whether it's a good move for them. In this article, we discuss what profit sharing is, provide advantages and outline steps on how to implement a profit-sharing plan along with an example.

Common profit-sharing advantages

There are several advantages of profit sharing that businesses can benefit from. These advantages range from higher earning potential for employees to reduced unemployment rates. Some profit-sharing advantages include:

Higher productivity

A profit-sharing plan directly links an employee's labour with the company profits and, in doing so, incentivise employees to work harder. This is because working harder to produce better results equates to more money in their bank accounts. This is in contrast to getting paid for how many hours they work, rather than the output they produce at that time.

In return, businesses benefit from more successful and profitable operations and fewer distractions in the workplace. Profit-sharing plans also allow businesses to make employees who're purely motivated by their salaries better share in the company aims and mission. Putting their compensation on the line means they engage and contribute more to the workplace.

Higher earning potential

Employees might earn more than their fixed wages when they work for a business with a profit-sharing plan in place. If the company operates a deferred profit-sharing plan, employees can save for their retirement much faster. It's important to remember that shared profit earnings are contingent upon how much profit the company generates. This means that earning potentials differ between businesses and from year to year. You still earn more than your usual salary and can contribute to a better standard of living with the additional income.

Cordial relations

Profit-sharing plans promote better relations between employees and management. This is because workers typically tried and avoid every type of conflict so that work productivity doesn't suffer. As a result, businesses benefit from a more positive work environment and can focus their efforts on boosting their operational efficiency.

Reduced labour turnover

Those who stay longer at a business stand to benefit more from profit sharing. This leads employees to increase their length of service or stay on for longer periods so they can earn their share in the profits. Also, most companies require employees to work for the business for a certain amount of time before they become eligible under the profit-sharing scheme. This probationary period usually lasts a year.

Related: How to calculate and interpret labour turnover rate

Reduced unemployment

Some companies decide to make employees redundant to reduce business costs when facing financial hardship. A profit-sharing plan instead allows them to decrease the profit-sharing amount for employees rather than decrease the number of employees who share in those profits. This leads to greater stability in the workplace and reduces employee apprehensions during challenging economic times.

Sense of ownership

Profit-sharing shows that a company invests in its employees and wants to create a sense of parity rather than competition among ranks. They also ensure employees consider company successes in alignment with their personal success. This fosters a greater investment in the company and makes employees feel more recognised and valued by management. A sense of ownership stems from employees transcending associate status and feeling as though they hold a personal stake in the business operations. This is especially the case when employees can contribute to a company's profits as stocks and bonds.

What is a profit-sharing plan?

A profit-sharing plan is an inventive plan where businesses give employees a share of the company's profits. Employees receive these profits through direct or indirect payments based on the type of profit-sharing plan. Businesses allocate a percentage or portion of their pre-tax profits to a pool that's then distributed among staff members. The amount distributed to each employee oftentimes depends on their base salary or ranking, with more senior employees receiving a larger percentage of the profit pool.

This serves to motivate employees tied to the bottom line. Senior management decides how much of its profits it wishes to share and can put restrictions in place as to when and how an employee can withdraw funds. The profit pooling process includes a predetermined formula to ensure that the amount of profit pooled is always in line with the company's annual earnings. For this reason, each profit-sharing plan is unique to a business and is a flexible approach to employee incentivisation.

Related: How to calculate your gross profit ratio and why it matters

Different types of profit-sharing

There are two main types of profit-sharing plans that businesses can set up. Which one you choose depends on how you want to reward employees and for what reasons. The two main types include:

Deferred

A deferred profit-sharing plan occurs when employers distribute contributes at certain times, such as when leaving a position, retirement or death. You put the deferred profit into a deposit account where it grows. This income has no taxes until employees receive it.

Direct cash

A cash profit-sharing plan is an incentive strategy that involves awarding employees cash bonuses at the end of each year. A business adds these contributions directly to the employees' paychecks. Unlike deferred profits, these profits are tax-deductible to the business. Some businesses choose to combine these two plan types and create a profit-sharing retirement plan that also regularly rewards cash bonuses.

How to set up a profit-sharing plan

How you set up your profit-sharing plan depends on the type of plan you choose. There are a few general steps you can take, such as creating a written plan document that outlines what you want to achieve with your profit-sharing plan and how you plan to implement it. Conversely, you can set up a trust for the sharing-profit plan assets and ensure you have an adequate record-keeping system in place to monitor the funds. Then outline your plan to other senior management members and receive feedback.

Here's a look at the profit-sharing plan you may choose to include and their specific steps:

1. Deferred profit-sharing plan

A typical deferred-sharing plan looks like this:

  1. Determine whether you want a broker to help you administer your retirement plan. Review your financial history in-depth with a broker so they can assess your circumstances. Brokers can also help you identify any risks associated with implementing the plan.

  2. Consider how much of the profit you want to make available. Assess your historical data on profits and determine what percentage of the profits you want to allocate to the profit-sharing plan. Your decision hinges on how much money the business makes and what amount is feasible enough to redistribute while still ensuring economic stability.

  3. Determine who is eligible. Deferred profit-sharing plans commonly start for employees upon their retirement. You can broaden your eligibility to include employees facing disability or death.

  4. Decide whether you want to vary the amount. Consider whether the employee's rank within the business affects how much they earn, as doing so can motivate employees to work harder to better their position in the company. Remember, this may require delicate communication to encourage healthy competition within the company.

2. Cash profit-sharing plan

A typical cash profit-sharing plan looks like this:

  1. Determine whether cash profit sharing is suitable for the business: Cash profit-sharing plans are more suitable for businesses with a strong sales component that depends on the selling efforts of their employees. This is because the compensation encourages employees to perform.

  2. Consider how much profit you require to incentivise performance: Determine how much you can offer employees to motivate them without eroding the quality of the business operations? Make sure that you offer employees an amount that the business can keep up with, and don't over-promise on a profit-sharing plan so that you can maintain trust within your team.

  3. Put preconditions in place: To prevent short-term employees from taking advantage of the profit-sharing plan, determine some requirements for eligibility. Consider making the plan available for employees who've worked for the company for more than one year or for those that reach a certain level within the company.

Related: How to calculate net profit in 3 steps (with FAQs)

Profit-sharing example

Here is an example of profit-sharing for best practice:

DelvComp, a gaming company, has three employees. Employee A earns £25,000 per year, employee B earns £50,000 per year and employee C earns £35,000 a year. This means the total compensation amount for all three employees is £110,000. The business shares 10% of the annual profits and the business earns £150,000 in a fiscal year. To calculate the amount of compensation to award each employee, they use the following formula:

(Annual profit x profit share percentage) x (employee earnings amount / total amount of employee compensation)

Using the formula given, DelvComp determines each employee will receive the following compensation:

Employee A: (£150,000 x 0.10) x (£25,000 / £110,000) = £3,409

Employee B: (£150,000 x 0.10) x (£50,000 / £110,000) = £6,818

Employee C: (£150,000 x 0.10) x (£35,000 / £110,000) = £4,772

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