Profit sharing – how it works

Profit sharing schemes can help incentivise staff, but can sometimes be seen as an entitlement, says Jamin Robertson

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Unicorn Grocery, a Manchester-based organic food co-operative, has, in the past, celebrated success by returning a portion of its profits to its 50 staff in equal shares.

However, since tax breaks on approved profit-sharing schemes were phased out by the government in December 2002, to make way for share incentive plans, standalone profit-sharing schemes have now become the exception rather than the rule.

Previously, approved profit-sharing schemes resulted in tax breaks for employers which distributed profits to all staff in the form of shares worth up to £3,000 per year or 10% of annual salary to a limit of £8,000.

According to the Chartered Institute of Personnel and Development’s (CIPD) annual Reward management survey 2005, just 14% of respondents operated a profit-sharing scheme. This meant that such plans were less prevalent than individual bonus schemes (44%) and those that utilised a combination of incentives (38%). Profit sharing was not directly analysed in the CIPD’s 2006 survey.

The amount to be paid out through a profit-sharing scheme is typically calculated according to a threshold set by the organisation. Should it return a profit higher than this pre-set amount, a portion of this extra cash will be shared among employees. This can either be paid as a set amount to all workers, or as percentage of salary.

The concept works best in organisations where profit is the principal focus. Steve Watson, director of RewardWorks, says: “If what you want to do is increase profit, then profit sharing is fine. But is profit the right measure? Is it in fact [more] revenue you want, or more likely, a combination of both?”Deborah Rees, managing consultant of Innecto Reward Consulting, adds that where profit sharing is suitable, employers can underline their mission statement with the offer of cash. “The key point of the scheme is to enable employees to understand what the metrics are that drive business success. Hopefully you’re then going to back it up with some money,” she says.

Although relatively few firms now operate standalone profit-sharing schemes, some employers still see a value in doing so. At the John Lewis Partnership, which employs 64,000 staff, for example, profit sharing remains central to its partnership ethos.

Chris Charman, a senior consultant in executive compensation and rewards at Towers Perrin, believes the John Lewis Partnership is an ideal type of organisation to offer a profit-sharing scheme because it enables front-line retail staff to identify how they impact on the business’ profitability.

“You can see it when you walk in the door, with [workers’] level of product knowledge and service. Even in terms of its procurement and wastage, [staff] will [realise the] impact on the bottom line.”

Last year, John Lewis Partnership paid out £106m through its scheme, which equated to a 14% supplement to workers’ annual salaries.

But Watson argues profit sharing can work equally well if the line of sight to profit is less obvious. In these cases, a share in a company’s overall profitability may be seen as a fair, easily-understood incentive compared with a subjectively-determined bonus.

Rees believes that profit-sharing schemes are more prevalent in smaller organisations. “Where there [are] 500 employees or less, [schemes] can be really successful because they make people feel they have a stake in the business. In large companies, say with 10,000 [staff] or more, [schemes] are more likely to be viewed as an entitlement.”

Profit sharing is also suitable for organisations that employ a number of people in broadly similar roles such as in a manufacturing plant or on a production line where staff typically contribute equally. In these cases, Watson believes schemes can foster employee loyalty and good performance. But despite the appeal of receiving a slice of the company pie, there can be drawbacks to profit-sharing schemes that have led to a preference for individualised reward schemes among both employers and staff.

This is largely due to the way profit-sharing schemes are structured. Anything that affects profitability such as a major capital investment, for example, has the potential to have a negative impact on the amount available for distribution – and consequently on employee goodwill.

Charles Cotton, reward adviser at the CIPD, believes many organisations are therefore moving to combination schemes that incorporate elements of both individual and group performance. This fits with a trend for profit sharing to be included within a multi-layered bonus payment. Giles Tulk, director of reward for PricewaterhouseCoopers, explains: “[Employers] may have a profit-sharing strategy but then operate a separate bonus for high flyers. That’s increasingly becoming the case.”

In large organisations, or those where profits are subject to major fluctuations beyond employees’ control, this strategy has an obvious appeal.

To get the most out of a profit-sharing scheme, employers must assess which factors are crucial to the success of both the business and the plan before they go about setting one up.

It is worthwhile bringing senior management together to determine just what makes the organisation tick. Rees cites the example of one client which initially viewed new business as the key to increasing its profitability. But when the board dug deeper, it established that better account management of existing clients was actually more crucial to its success.

Once employers have decided on the structure of their scheme, they must work to sell the benefit to staff. “It doesn’t work well [if] it is parachuted in to the front line with no communication,” Tulk explains.

Many agree that all-employee schemes work best, because these help to foster a team mentality. “There is value in more general schemes because they give the sense that ‘we’re all in this together’,” says Towers Perrin’s Charman.

Offering a sufficient incentive can also help boost the scheme’s chances of success. According to Tulk, a meaningful sum should constitute between 7% and 12% of salary.

Employers are advised to ensure staff understand the link between payments and results, to remove the risk of them viewing the scheme as an automatic entitlement. “If payments vary from year to year then people don’t get into [such] a mindset. Performance targets should be achievable, but not just a way of [gaining] some extra pay,” Tulk adds.

But employers must also be careful not to set the bar too high, because staff will lose interest if they do not receive a payout for several years.

The promise of an annual payment closely aligned to bottom line results should act as a strong incentive for staff to pitch in. But in a 2005 American study, forming the basis of the book The enthusiastic employee: what employees want and why employers should give it to them, the authors Louis Mischkind, Michael Meltzer and David Sirota, found profit-sharing schemes increased employee motivation from just 2% to 6%.

However, Watson believes there are benefits to be gained. “You can get a lot of loyalty out of [profit sharing]. The impact on service also appears to be good, because you can create a culture where it’s good to help.”

Innecto’s Rees adds: “Employees feel they are contributing and get a bit of entrepreneurial spirit.” Employers may even find schemes help improve staff retention, at least temporarily. “Nobody quits before Sunday, because [in some organisations] it’s [paid at] double overtime,” Watson says.

Profit Sharing tips

  • Sweeten the deal.Consultants recommend making a payment of between 7% and 12% of salary.
  • Money talks. A profit-sharing scheme allows employers to back up their mission statement with cash.
  • Identify what works. Point employees in the right direction by first establishing the factors that are crucial to business success.
  • Champion the team. By including all employees in one scheme, employers can foster a team ethos.
  • Time it right. Do not operate a profit-sharing scheme if it may coincide with periods of major investment that will adversely impact on profit.

Case study: John Lewis Partnership

For the past 10 years, John Lewis Partnership has paid an annual partnership bonus of between 9% and 22% of annual salary.The bonus is based on profits for the trading year beginning each February, and is determined by the organisation’s partnership board. After any capital is held back for reinvestment, the remaining profit is distributed among its 64,000 employees.

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Sam Hinton-Smith, a spokesman for John Lewis Partnership, claims employees place a high value on the scheme because the organisation also ensures it also pays market-rate wages.

He believes that profit sharing has advantages over alternative perks such as employee share schemes. “Obviously, it’s something we think is a fairly important part of the package. This kind of scheme doesn’t require any financial investment by our employees,” he explains.