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Profit sharing is one of the best ways to distribute your company’s profits. Set up a profit-sharing plan with other employees and divide your earnings between everyone involved automatically.
There are 7 types of profit-sharing plans. The first type is the flat-rate plan, which pays everyone the same amount of money.
The second type is a percentage-based plan, where employees earn more if sales go up and less if they go down.
The third type is an individual performance-based plan, where each employee gets paid according to their own performance on certain metrics.
The fourth type is a commission-only plan, where employees only get paid when they sell something.
The fifth type is a bonus-only plan, where employees can earn bonuses for selling things or hitting milestones.
Finally, there’s the sixth type which is a mixed model that has some features from different categories like the previous five types listed.
For company owners looking to inspire and reward their staff, a profit sharing plan may be a creative remuneration method. Profit sharing plans fall into two categories: those that defer earnings to a retirement plan and those that include gains in the basic pay plan. We’ll also discuss Gainsharing, which is a popular alternative that’s distinct from profit sharing but sometimes mistaken with it.
What Is Profit Sharing and How Does It Work?
When a corporation pays a part or percentage of its pre-tax earnings to a pool that will be dispersed among its workers, this is known as profit sharing. The amount allocated to each employee may be weighted according to their base pay or their ranking so that individuals with higher base salaries get a bigger share of the profits pool (which, in theory, motivates management to be tied to Final Thoughts).
Profit sharing is usually done on an annual basis and has some eligibility requirements, such as a one-year tenure with the company.
Profit Sharing Plan
The contract that stipulates what portion of earnings workers would get, eligibility restrictions, and other specifics is known as a profit sharing plan, or PSP. PSPs are as ancient as taxes in the United States, and they’ve been a mainstay of the economy since company owners learned that profit sharing may help them lower their tax bills.
Profit sharing programs have developed into two types as a result of history, economic developments, and corporate needs:
There are two types of profit sharing.
- Deferrals in a Retirement Plan
- Base Compensation: Profit Sharing
There is another sort of plan that is sometimes mistaken for profit sharing but is different in its own right: the profit sharing plan.
Gainsharing
Gainsharing is an incentive program similar to profit share in which a corporation assesses the success, such as sales, using a predefined formula. If the firm meets its target — say, increasing sales revenue over the previous year — all workers will be compensated, with the amount paid dependent on how much they exceed the goal.
Gainsharing plans resemble profit share plans in appearance, but they’re more common in businesses that employ restricted operational metrics such as productivity, quality, customer service, on-time delivery, and expenditure.
Take ABC Lead Generation Software, for example, which provides a web-based software as a service (SaaS) platform. Let’s assume ABC account executives sell 1,000 more clients than expected in 2017, and earnings increase by 30% more than expected (based on historical data and performance). If ABC had a profit-sharing scheme, its workers would have made out like bandits after a record-breaking year that exceeded expectations by 30%.
How to Create a Profit-Sharing Plan for Your Small Company
While businesses may choose the specific figures that go into establishing a profit-sharing plan, they must also create an official plan document (similar to a 401K).
Regardless of whether sort of profit-sharing plan is chosen, the Department of Labor suggests that company owners take the following steps to set up a profit-sharing plan:
- Adopting a written plan document is a good idea.
- Create a trust to hold the plan’s assets.
- Create some form of recordkeeping system, and
- Employees who are judged to be eligible should be informed about the scheme.
Businesses must next determine whether they wish to handle the administration and filing on their own or employ a third-party administrator (similar to commuter benefits or self-insurance). However, since businesses must maintain meticulous records and have a fiduciary duty for the plan, we suggest enlisting the help of a third-party administrator to ensure that you remain in compliance, particularly if you intend to amend it at any time. A profit sharing plan’s paperwork must be flawless, thus hiring a third party is the best alternative.
Independent financial brokers or firms that also provide retirement benefits are examples of third-party administrators that conduct profit sharing arrangements. We suggest locating a TPA by asking your network for a reference or asking a local small business group or even your state government’s recommended providers list to discover one that is nearest to your small company.
Let’s take a closer look at how to set up each kind of profit-sharing plan.
How to Create a Retirement Strategy Profit Split
When you discover a broker who can assist you with the administration of a profit-sharing retirement plan, they will almost certainly want to look through your company’s financial history in detail. They’ll also want to warn you about the dangers.
If you opt to proceed, the broker will advise you on how to proceed:
- What percentage of the profit pie do you want to put up for grabs?
- Who is eligible for this program?
- Should the quantity provided be different for different levels of employees?
The broker will next set you up with instructions on how to begin your plan and make your staff familiar with the plan documentation and paperwork.
But what if you wish to include a PSP in your standard pay package?
How to Set Up Base Compensation: Profit Sharing
A compensation-based profit sharing plan may be appropriate for companies with a strong sales component that is in the hands of their workers. Profit sharing is used as a motivation in a variety of businesses, particularly those with a large number of conventional salesmen, such as software.
Once you’ve found a broker who can assist you, they’ll want to look through your company’s financial history in detail, just like you did before. They’ll also want to inform you about the hazards so you can make an informed choice about whether profit sharing is good for your company.
When you’re ready to go ahead, you’ll need to consult with your broker to figure out:
- How much profit do you want to utilize to motivate performance (without sacrificing quality)?
- Who is eligible for this program?
- Should you change the amount of money you have available?
The broker will next set you up with instructions on how to begin your plan and make your staff familiar with the plan documentation and paperwork.
Advantages of a Profit-Sharing Plan
There are several advantages to having a profit-sharing plan, albeit many of them are contingent on a solid corporate culture. A PSP, for example, should bring individuals together to work as a team toward a common objective. Your business culture and personnel, on the other hand, must have evolved into a team capable of working together at this level, which includes flawless communication, project management, and goal-oriented performance.
Profit sharing may provide the following advantages when done effectively and with the appropriate team:
- Employees are driven by the possibility of shared earnings, which enhances company performance and Final Thoughts.
- Employees are urged to work together for the company’s development and to concentrate on the company’s profitability.
- The plan’s implementation costs fluctuate with the company’s success, which is preferable to a standard 401K or another benefit plan, which has a fixed cost regardless of the company’s health.
As explained by Bob Shoyhet, the CFO of Melillo Consulting, who has implemented more than a dozen profit sharing plans:
“You will see that workers are instantly invested in the success of your organization. They’ll ask inquiries and inquire as to how they might assist. In a way, it becomes their business as well.”
Profit sharing does, however, come with significant risks and drawbacks.
Profit-Sharing Plans Have Risks
Profit sharing has its own set of risks and drawbacks:
- Employees’ compensation increases or decreases in unison. In general, there are no individual disparities for merit or performance with profit sharing, and discretionary incentives are eliminated from pay programs.
- You must continually discuss your company’s financial information with your personnel. There is no privacy when it comes to your finances, which may be upsetting for many company owners.
- Profit sharing is only concerned with achieving profitability. This may lead to cost-cutting, a reduction in quality, or working the line workers far longer than required.
- Employees may find it difficult to deal with large swings in wages as a consequence of plans, resulting in greater employee turnover during “low” years— just when you don’t have time or money to spend on recruitment.
- With FLSA and overtime requirements, you’ll need a reliable mechanism to recalculate workers’ compensation. As a result, many organizations only allow “exempt” staff to participate in the profit-sharing scheme, which may lead to friction between employees and management.
- Finally, individuals are pleased when they get a bonus and disappointed when they do not. You’ll be swinging back and forth between them feeling like they “deserved it” and a bad year being “the company’s fault,” which may be demoralizing.
Let’s take a look at an example of what a small firm is doing presently for their profit-sharing plan, as well as some of their findings.
What Is Being Done By Other Small Businesses
The narrative of Be The Machine’s profit-sharing model has many valuable lessons.
Patrick West, Owner, and Founder of Be The Machine, told me that the company’s profit sharing strategy was put in place from the beginning when he started his marketing agency in NYC and Florida. He adopted it right away because he believes it is critical for people to feel involved in the business as well as for the firm to feel invested in them.
As part of the remuneration package, Be The Machine offers a year-end profit sharing scheme (not the retirement kind). Participating workers are given a share of the company’s year-end earnings under the profit sharing scheme, which is based on percentages. After all direct project expenses (manufacturing, shipping, etc.) and indirect operations costs (salaries, rent, etc.) have been included, profits are described as revenues.
Patrick points out that calculating the previous year’s accounts takes until March, and that the payments paid to staff are classified as bonuses. Over the last two years, the system has run quite well. However, if the firm expands and evolves in the next years, Patrick warns that this may not always be the case.
When asked why he chose a profit sharing plan over retirement contributions for his company, Patrick explained that he wanted a plan for his company that was much more transparent and simple than at previous jobs, and that modern employees, particularly millennials, crave tangible benefits, which a compensation-tied PSP provides.
While he recognizes the risk of revealing firm financials to all workers, he also believes it provides them with a reality check on genuine entrepreneurship and how a business operates (versus how people maybe think it works).
Patrick went on to say:
“Employees, without a question, cherish the money when it arrives in their accounts, but I think they value the plan’s presence and business openness much more.”
If profit sharing is still not for you, let’s look at some more options.
Alternatives to Profit Sharing Incentives
Profit sharing, with all of its paperwork and possible liabilities, may seem to be a little too much for your business. You may, however, continue to hunt for a means to tie your workers to your company’s bottom line and, more broadly, to the company’s goal.
For your small company, here are four alternate motivation and incentive ideas:
Idea 1: Financial Bonuses Based on Company Objectives
A customer I worked with on the West Coast has a unique bonus platform. They had three revenue targets that were spread out throughout the year. Everyone received a bonus if the organization reached its objectives. No one did if the firm didn’t (even the C suite). That was all there was to it.
This straightforward attitude might work for your small company as well. It’s a good idea to have something offered more than once a year to keep everyone engaged. Perhaps every two years, every three years, or every trimester, like my customer does.
Idea 2: Financial incentives based on individual achievements
Perhaps your company’s objectives aren’t appropriate. Individual revenue targets might make more sense to incentivize your workforce if you create widgets (aka actual items) or have a strong sales component to your business foundation, such as a restaurant where waitstaff can upsell. If you have sales commissions or sales revenue percentages available, these targets should be set reasonably often (i.e. monthly for a restaurant) or at least bi-annually, quarterly, or on a trimester basis.
This is different from typical performance management and discretionary performance incentives in that it is a specific revenue objective, almost like a quota, that you are requiring individuals to reach before rewarding them. You might, for example, pay each employee who sells more than $1000 in services a 5% incentive.
Idea 3: Traditional Performance Management
That isn’t to argue that performance-based objectives and evaluations aren’t a viable option for motivating your staff. It is a simple approach to implement performance assessments in which good performers are rewarded with incentives and promotions while bad performers are not. Traditional performance evaluations should ideally drive your staff to work at a high level and achieve their objectives.
Idea 4: Fringe Benefits
If having incentives like the previous three suggestions isn’t feasible for your small firm, you may explore adding goal-related fringe benefits. Perhaps your whole staff wants a high-end cappuccino machine and munchies in the break area. Link that type of reward to business or team success, and you’ll be able to persuade them to come in and enjoy their nice coffees on the firm’s dime.
Final Thoughts
When done right, profit sharing may be a unique method to build a business culture that is centered on the firm’s success. It may also be a huge hassle since it entails fluctuating employee morale, possible recruiting or retention concerns, and a lot of paperwork. Before implementing any profit-sharing arrangement, you should thoroughly analyze your alternatives.
