Profit Sharing Plans

A profit sharing plan, also known as a deferred profit sharing plan (DPSP), is a plan that gives employees of the company a share in the profits. It is essentially a collection of incentive plans that provide direct or indirect payments to employees on top of their regular salary and bonuses. There are usually restrictions as to how a person can benefit from such a plan, such as withdrawing funds, or the way in which shares are allocated. Payment into the plan is at the company’s discretion. Examples of companies which have such schemes include the financial services company First American and the Chinese telecommunications giant Huawei.

Profit sharing plans are generally only made if acompany has been profitable for a prescribed length of time, or when an employee contract demands certain compensation. Profit sharing usually occurs annually. Generally more senior employees can expect to see a substantial profit sharing bonus (figures of 40-50% of annual salary are not uncommon). Lower level employees are awarded less, on the order of 1-2% of their annual salary. This reflects the belief that the most compensated employees are responsible for ensuring the success of the company, and are generally part of the management staff.

Since a profit sharing plan is set up by the employer, it is up to the company how much they wish to allocate to each employee. The company can also adjust the plan as needed, sometimes deciding to make no contributions in a given year. When it does contribute, it needs a certain formula to decide on to allocate the profits. The most common of these formulas is the comp-to-comp method. Using this calculation, the company can derive the sum of its employees’ compensation. To determine the percentage of the profit sharing plan an employee is entitled to, each employee’s annual compensation is divided by the sum total of the compensation.

The positives of such a scheme are that it gives the employees a sense of shared ownership of the company. All of the employees are in some sense part of the same team. They have the same goals and are awarded the same compensation. Employees who are offered financial rewards are more likely to be invested in the success of the company. On the other hand, there are some weaknesses associated with such a scheme. For example, the employees do not normally know the impact of their work on the profitability of the company. Thus, there is a danger of the scheme becoming more of an entitlement than a motivational factor. Senior employees will usually be exempted from this, as they know what is going on and make decisions which have an impact on the company’s profitability. However, this does not apply to, for instance, a frontline receptionist.

Deciding whether to introduce profit sharing plans will depend on many factors, such as the size and profitability of the company, and how the company wishes to motivate its employees. Other options, such as bonus schemes that reward employees based on merit, may prove to be a better alternative in some cases.

Adam Watson

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