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Economic Incentive System

Profit Sharing
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Profit Sharing
Definition of Profit Sharing
 Employees share a portion of the profits based
on corporate or division performance.
 16 % of ‘ees in medium/large firms covered
 No requirement for employee involvement
 more passive than gainsharing

 Profits shared on quarterly or annual basis.

 Workers share common fate with management.
 In US, 3/4 of plans used to fund retirement.
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Profit sharing is an organizational incentive plan

whereby companies distribute a portion of
their profits based on its quarterly or
annual earnings to their employees in addition
to prevailing wages.

Profit sharing gives employees a direct stake in the

profitability of a company, creating an atmosphere in
which employees want the business to succeed as
much as management does.
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History
Profit sharing was quite common in primitive fishing and
farming economies, in fact, it still persists among
fisherman in many parts of the world.

1790s - Albert Gallatin(Secretary of the Treasury under

Presidents Jefferson and Madison) introduced profit
sharing in his glassworks in New Geneva, Pennsylvania

19th century- companies such as General Foods and

Pillsbury distributed a percentage of their profits to
their employees as a bonus
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1916 - The first deferred profit-sharing plan was

developed by Harris Trust and Savings Bank of
Chicago

Profit sharing was also instrumental during World

War II, enabling wartime employers to provide
additional compensation to their employees
without actually raising their wages.
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Benefits of Profit Sharing:

 greater employee cooperation

 reducing labour turnover
 raising productivity
 cutting costs
 providing retirement security.
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Benefits of Profit Sharing:

 It brings employees together. They manage to work for a common goal and
they all aim for the success of the company.
 The additional income helps the employees have a comfortable life. As
we know, the more comfortable people are in their personal lives, the
better they work.
 It motivates people. Employees are interested to work more and be more
efficient if they get some extra financial gain whenever the company makes
a profit.
 It promotes the employee’s well-being. People feel more cared for and
thus more interested in taking care of themselves.
 Employees focus on profitability. This determines them to work together
as a team to reach the goals for the company.
 It brings the employee and the employer closer. Since they have common
goals, they feel closer to each other.
 It makes people more committed.
 Employees identify with the company. They will feel as if they belong to
it, making them feel at home.
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Drawbacks
 Weak line of sight
 External factors (business cycle) can influence profits
 Lack of employee control
 May restrict management’s ability to utilize profits.
 Union resistance
 Some countries use for ideological reasons (example:
Mexico requires profit sharing)
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Drawbacks
 Employees at the top are more motivated. They get a larger
percentage of the profit share, so they are more determined at
work.
 Personal earnings can be affected. When it comes to smaller
companies, there can be drastic fluctuations in the earnings of the
company. This can further affect the personal earnings of each of the
employees.
 People get money anyway. The employees will get their share of the
profit regardless of how much they contributed to the company. This
might be unfair for some of them and, in time, can even lead to a
decrease in motivation.
 People may focus on profit. Instead of thinking about the quality of
their work, people may focus more on the profit they’re getting.
 It triggers a low motivation. Just as we said before, in time, the
motivation will diminish. Thus, employees will consider the extra
money their right and will stop working hard for it.
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Types of Profit Sharing

 Tax Deferred Plan
 Funds retirement - most common plan
 Cash Bonus Plan
 Employees receive quarterly or annual
check for cash
 Ex: Hewlett Packard, GM, Ford, Nucor
 Mixed Plan
 Portion of money deferred, rest is given in
cash.
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Types of Profit Sharing:

1. Deferred plans direct profit shares into a trust fund on

behalf of individual employees and distribute them at a
later date, often at retirement.

2. Cash Bonus plans distribute cash or stock to employees

at the end of the year.

3. Combination/Mixed plans pay part of the profit share out

directly in cash and defer the remainder into a trust
fund.
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Other Types
 There are three other main forms: traditional, ageweighted, and
comparability.
 Traditional profitsharing plans are based on a salary-ratio formula,
and the employer gives a uniform percentage to each participant
in the program.
 Preferred by smaller businesses and firms featuring professional
services, age-weighted profit sharing determines contributions on
the age and salary of each employee, and older persons receive a
greater amount, comparatively.
 Finally, new comparability divides employees into different
categories based on various factors, such as job title, seniority,
and age, and awards a certain amount based on the division in
which they fall.
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Vesting Requirements
It is becoming less common for companies to manage their
own accounts, due to the fiduciary responsibilities and
liabilities involved with them. Instead, companies typically
contract the responsibility to financial management firms.
The amount of future benefits depends on the performance
of the account. The balance of the account will include the
employer's contributions from profits, any interest earned,
any capital gains or losses, and possibly any forfeiture from
other plan participants, which may occur when participants
leave the company before they are vested (that is, eligible
to receive the funds in their accounts); the funds in their
accounts are then distributed to the other employees'
accounts.
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The time required to become fully vested varies from

company to company. Immediate vesting means
employees are entitled to the funds in their accounts as
soon as their employer makes the contribution. Some
companies utilize partially vested schedules, entitling
employees to, say, 20 percent of the account before
gradually becoming fully vested over a period of time.
Establishing a vesting schedule is one way to limit access
to the account. Another way is to create strict rules as to
when payments can be made from employees' accounts,
such as at retirement, death, disability, or termination of
employment.
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Most favorable conditions for

profit sharing

 Private sector firm

 Mature firm or Growing firm (not Declining firm)
 Firms that operate in unstable markets
 “Shock Absorber” Effect - preserves jobs during
business downturn.
 Complements “pay for performance” plans based
on individual or team contributions.
 May support a cooperative labor relations strategy.
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Profit Sharing Plans

 A profit-sharing plan is a type of qualified defined
contribution plan in which you, the
employer, contribute to the accounts of
participating employees.
 The term "profit-sharing plan" actually describes a
broad category that includes several specific types
of qualified retirement plans. Employee stock
ownership plans and stock bonus plans, 401(k)
plans, age-weighted profit-sharing plans, and new
comparability plans are all considered profit-
sharing plans, although each has its own unique
features.
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Here are the steps for a

profit-sharing plan
 Write a plan document;
 Arrange a trust for the assets included in the plan;
 Develop a system to keep your records;
 Offer the information in the plan to all the employees
that are eligible.
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Advantages

In actuality, profit sharing is being successfully

utilized in large and small companies, labor -
intensive and capital-intensive industries, mass
production and job-shop situations, and industries
with volatile profits as well as those with stable
profits. Profit sharing can reward employee
performance, seniority, and thrift, depending on the
design of the plan.
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Disadvantages

Profit-sharing plans do not always work. Roughly 2

percent of deferred plans are terminated annually, some
as a result of mergers, others because companies are
liquidated or sold. Profit sharing may also entail some
disadvantages for a company. Such plans may limit the
company's ability to reward the performance of
individual employees. At smaller companies, tying
employee compensation to often-uncertain profits may
result in drastic income swings from one year to the
next. Finally, some critics claim that profit sharing may
encourage employees to focus only on increasing
profitability, perhaps at the expense of quality or other
goals.
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Profit Sharing Examples

Case Study: Huawei
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 Huawei is a Chinese telecom founded in 1987 by Ren
Zhengfei. It’s a private company. Today, more than
170,000 people work there, helping around 3 billion
people worldwide. What makes it remarkable is the fact
that it’s the only Chinese company that gets more sales
revenue from outside China than inside it.
 What’s even more impressive about it is the fact that
when designing the company, Zhengfei had no idea about
the incentive systems that existed in the West. He simply
designed an Employee Stock Ownership Plan (ESOP).
Today, he holds just 1.4% of the total share capital of
Huawei. The rest is owned by its 82,471 employees, as
the 2014 Annual report issued by Huawei showed.
Currently, the total of the employees’ bonuses, salaries,
and dividends equals 2.8 times the annual net profit of
the company. As such, you can see how adopting a profit-
sharing plan can work better than other business options.
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Thank You
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Questions

 Which profit is paid to employees. EPIT or EAT?

 Who Use this type of plans?
 Who determine the profit sharing percentage?
 What is difference b/n profit sharing and ESOP?