Benefits and Compensation

The 3 Approaches to Profit-Sharing

When you consider a profit-sharing plan, there are three main ways to set it up: straight, hurdle, and goal.

A profit-sharing plan is a group incentive plan that includes all employees in an organization and that focuses on overall business unit profit (or a similar bottom-line financial goal). What are the advantages and disadvantages?

Advantages

  • Funded from profits, so there is low risk for the company.
  • Can be used to supplement company retirement contributions.
  • Can be linked to company objectives other than profit.
  • Provide an opportunity to train employees on financial measures and the operational business factors that affect those measures.
  • Easy to integrate with suggestion plans and other reward and recognition systems.
  • Can be either pay-at-risk or add-on programs.

Disadvantages

  • Profit may be too broad an objective to really focus employees on behaviors that need to be changed for the organization’s success.
  • Can be demotivating if there is no profit to share.

The Three Types

Basically, there are three common types of profit-sharing plans, each with its own uses and objectives:

  • Straight profit-sharing plans
  • Hurdle-rate profit-sharing plans
  • Goal-driven profit-sharing plans

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1. Straight Profit-Sharing Plans

Straight profit-sharing plans have been around for a long time and are the most prevalent form of profit-sharing among companies that use this type of group incentive. Under a straight profit-sharing plan, all employees are eligible and, generally, an award pool is generated from the first dollar of profit.

The plan does the following:

  • Sets aside a certain portion of profits for employee bonuses according to a formula
  • Designates whether the percentage of profits is before-tax or after-tax

For the majority of companies with straight profit-sharing plans, a certain percentage of employee bonuses are deferred. In this way, these companies’ plans are used as a vehicle to supplement their employees’ defined benefit retirement funds.

After retirement plan funds have been earmarked, the remaining profit pool is generally distributed to employees in a quarterly or annual cash bonus. Some companies distribute awards or a portion of awards as employee stock.

Generally, all employees are eligible. Some companies prorate awards if employees have been with the company fewer than 3 years. Generally, all employees share equally as a percentage of their base pay.

Some companies base the plan award on the level of the employee’s pay or organization level.

Significant variations exist in the ways that companies address the timing of straight profit-sharing payouts. Many companies prefer to pay once a year because this strategy smoothes performance cycles and is easier to administer. However, it also decreases motivational impact because the length of the performance period is so long.

Other companies pay quarterly, or even monthly, with semiannual distributions to “true-up” payouts to real profits. More frequent payouts have both advantages and disadvantages:

  • Pro: Increase employee identification with organizational goals.
  • Pro: Reinforce employee involvement and information-sharing structures.
  • Con: Be unwieldy in highly volatile product and market cycles.

2. Hurdle-Rate Profit-Sharing Plans

Unlike a straight profit-sharing plan that funds from the first dollar of profit, a hurdle-rate profit-sharing plan establishes a minimum-profit threshold and then shares the gain with employees when the threshold is exceeded.

Gain, or profit improvement, is what the plan seeks. In this way, hurdle-rate profit-sharing plans are similar to gain-sharing plans. The threshold is a predetermined level of profits, or some other financial return measure, rather than aproductivity baseline, as in gain-sharing.

Plans often distribute higher amounts to those higher in the hierarchy under the assumption that individuals with higher salaries are in higher-impact roles and make a greater contribution by virtue of their knowledge, experience, and position.


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Various considerations must be taken into account when establishing the threshold level. A company that wants to send a strong performance message to employees may freeze current salaries and fund pay “raises” from its hurdle-rate profit-sharing plan. In this case, a fairly low threshold—say 5 percent return on sales (ROS)—may be set. On the other hand, a company that pays at or above the market in base pay may set a high profit threshold— say, 10 percent ROS. The higher the threshold, the lower the risk to the company, but care has to be taken that the goal is achievable. If it is not, the company could run the risk of announcing a new plan that it fails to fund, a situation that will turn employees into unbelievers.

Generally, the award threshold is the level of profits (or return) that management expects based on environmental scans, forecasts, and the business planning process. Thus, the threshold reflects realistic expectations for what the company hopes to achieve, and the sharing is from truly “excess” profits, attributable to better-than-anticipated results.

Some of these plans begin to fund below full plan achievement—for example, at 90 percent of plan—to reflect the difficulty in accurately forecasting and to account for the fact that goals in the business plan may already be “stretch” goals.

Many hurdle-rate profit-sharing plans are being considered in conjunction with contingent-pay strategies. While the plan funds from profits, the cost to the company is offset somewhat by lower-than-normal annual planned salary increase budgets. Employees, while putting some pay at risk (a portion of future pay increases), can make out better if the company does well.

In tomorrow’s Advisor, the third type of plan, plus an introduction to a new, affordable, downloadable guide to writing job descriptions that will help you with hiring, training, and compensation.