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A Review of the Various Types of Profit Sharing Agreements

written by: N Nayab•edited by: Jean Scheid•updated: 5/26/2011

Profit sharing is a type of a variable pay plan where the company designates a part of its profits to the employees. Profit sharing agreements makes explicit the formula for allocating and distributing profits, the nature of the payout, and the periods of calculation and disbursal.

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    Direct Cash Plans

    Cash Bonus The most common and simplest sample of a profit sharing agreement is regular variable pay linked to company profits, where the employer receives a predetermined percentage or share of profits as a cash bonus or stocks at the end of the fiscal year.

    The earliest instance of such profit sharing occurs in the 19th century, when companies such as General Foods and Pillsbury distributed a percentage of their net profits to their employees as a bonus. Employers found this idea useful during hard economic times when they were unable to pay the guaranteed wage increases.

    The amount of payouts under direct incentives depends on the formula stipulated in the profit sharing agreement. The most common formulas are:

    • A predetermined flat percentage of the net profit of the company, or unit
    • Flat percentage of pay provided the company profits reach certain levels
    • A discretionary amount decided by the board of directors every year
    • Allocating a corpus for disbursal among employees, and making disbursals as a ratio of employee compensation to total compensation of all employees in the plan
    • A predetermined ratio based on compensation, service credits, job description, nature of employment, or other factors. Such plans when differentiating employees on compensation run the risk of discrimination against lower paid employees and violating non-discrimination regulations in force.

    The advantages of direct cash incentives are simplicity, ease of administration, and flexibility. The financial statements provide ready information on profits, making allocation of the profit to employees transparent. This approach, however, becomes inequitable and unscientific when the company is large with multiple streams of income, making determining of unit level profits or individual contribution to profits difficult. Moreover, direct cash payment of profit share attracts tax on the employee.

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    “Gain-sharing" is when the company shares with the employee the cost savings resultant from employee’s performance rather than the net profit. It is more a productivity measure than a profitability measure. Payment is usually a lump sum bonus after accounting for the savings made in the specified period.

    Gain-sharing takes many variants, such as

    • Scanlon plans that bases rewards on the ratio between labor costs and sales value of production.
    • Rucker plans that bases rewards on a ratio of the value of production required for each dollar of wage bill.
    • Improshare or "Improved productivity through sharing" that shares gains by identifying the difference between the estimated hours of production and actual production time.

    Gain-sharing helps in overcoming the obstacles that simple profit sharing plans pose in large and complex organizations, and helps effect equitable shares of the spoils at unit level. The linkage of pay to productivity motivates employees to put in better performance and promote ownership of work. The problem with gain-sharing, however, lies in committing to an incentive first without actually seeing improved performance.

    Well-known companies that successfully adopt gain-sharing are Carter-Day, Consolidated Diesel, Dresser Rand, Dover Rotary Lift, Gradall Company, Ingersoll-Rand, Mixer Systems, Proen Products, Rexnord, Webster Electric, and others.

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    Deferred Plan

    Deferred Profit Sharing Plan Deferred profit sharing plans are the same as cash incentive plans, with the difference being instead of the employee getting the money when due, the money goes to an individual account and realizes to the employee only on death, disability, retirement, or on separation from the company, subject to conditions. The money accumulates and earns interest in the account.

    The earliest instance of deferred profit sharing plans was by Harris Trust and Savings Bank of Chicago in 1916. World War II saw a freeze in wages. This led to a spurt of interest in deferred profit sharing, for it provided employers with a way to compensate employees without increasing wages.

    The most popular sample profit sharing agreement with the deferred option bases itself on the 401(k) plan that allows employees to defer a portion of their salary to the plan, and thereby, save tax on such deferrals. Some 401(k) plans also have an employer contribution. Disbursing the amount before the employee retires, becomes disabled, dies, or reach 59 ½ years attracts penalty that offsets the tax saving advantage.

    Like direct stock options, companies may also offer deferred stock options, with employees becoming eligible for shares of the company later, upon meeting certain conditions.

    The biggest advantage of deferred plans is its tax-free nature. It also makes an effective and less hassle-free alternative to pension plans. Employees save on income tax and employers can write off employer contributions to a profit-sharing plan as business expense. The deferred nature of profit sharing also means companies gain employee loyalty and commitment over an extended period.

    The disadvantage of deferred profit sharing plans for the employee is the very nature of deferred payment, which may make realization uncertain if the company goes back on its word, or if the employee leaves in acrimonious circumstances. Companies now entrust the management of deferred plans to third party agents, who can defraud or indulge in manipulations with the amount. From the company’s perspective, deferred profit sharing plans means spending time and resources in complying with the fiduciary duties associated with the scheme, and making provisions to honor the liabilities that accrue.

    Many employers allow the employee an option between cash plans or deferred plans, or offer a combination plan that includes both options.

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    The concept of profit sharing variable pay has gained tremendous popularity in recent years. More and more companies adopt various profit sharing agreements as an incentive tool to raise employee motivation and commitment, and as a means to link pay with performance or results.

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    1. “Profit Sharing Plans." Retrieved from on May 05, 2011.
    2. Midwest Pension Actuaries. "Profit Sharing Plans." Retrieved from on May 05, 2011.
    3. Reference for Business. “Profit Sharing." Retrieved from on May 05, 2011.

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