Would you be willing to spend $20,000 to get $80,000 back, and you get to hold onto your $20,000 until you receive your $80,000, and if the $80,000 doesn't come through, you owe nothing?
That's how a profit-sharing plan works. In continuing or our series on building compensation systems that drive success, we’re going to focus on profit-sharing.
Profit-sharing is the most commonly used bonus plan in corporate America. The philosophy of profit-sharing is "we win together and we lose together." It is based on a simple premise: if the company makes money, it can afford to share some of that money with the people who created the profit. Conversely, if the company fails to make money, no one deserves a payout. Naturally, there are pros and cons to profit-sharing plans.
Profit sharing plans turn employees into pseudo-owners by aligning employees' financial interests with the owners. Everything ends up pointing to the same ultimate goal: profit.
Effective profit-sharing plans are easy to design and prevent you from paying bonuses when you can least afford to.
Profit-sharing plans are easy to explain and understand. They get everyone thinking about all parts of the business, realizing that even customer service can have a huge impact on profit and therefore everyone should act their best with customers.
To convince your employees that you are basing bonuses on real profits, you may have to walk them through your company's income statement. This can open the door to a lot of headaches since many employees, especially field workers will question the size and value of various expenses, such as office salaries or other legitimate business expenses.
They may challenge everything including the cost of office equipment purchases such as that new copy machine you just bought. Employees may question investments made in equipment, buildings, marketing, and the hiring of additional support people. These expenses directly affect the size of the profit-sharing bonuses. It also impacts how efficiently the company runs. With future spending decisions, you will havea new dynamic to consider: "How will the employees react to this expense? And more importantly readiness to defend the expenses in a logical fashion."
Profit-sharing plan design
When you roll out your new profit-sharing bonus plan, your employees will ask you four blunt questions:
- Who is eligible for the bonus?
- How big is the bonus?
- When do we receive the bonus?
- How do you determine how much money each employee receives?
As you work to educate your team across these various areas, here are the best practices and key considerations for your plan.
1. Plan participants
The only groups you should seriously consider excluding from your profit-sharing program are your sales force and senior management. If your sales team is paid commissions from gross profits, which is the approach we recommend (we will tackle this topic in our next article), than they are already on a profit-sharing program and to be included in the company wide program would be double dipping. If you have implemented a separate bonus plan for your senior managers, you are best to leave them out of the company wide profit-sharing plan. Otherwise, their participation will strike your craftsmen and office staff as being unfairly generous to a group of already highly paid employees.
2. Size of bonus
Deciding how much of the profit to share with your workers will be your toughest call. Profit-sharing programs reach into your owners' pockets, pull money out and put the money into your employees' pockets. That can be very hard for owners to do, especially when the amount being pulled gets large.
Practically, the right value is the one that motivates your workers to take ownership of their job with an unqualified commitment to success. That may require your company to give away 25% of its profits. One way to reduce the overall impact is to pay below-market rate wages. That gets them focused on profitability because without it, they are getting paid less than their peers at other companies. It also gives them the opportunity to make considerably more than their peers. While 25% may be really tough for you to swallow, 10% is probably more along the lines of what you are willing to go with.
Unfortunately, sharing 10% of the profits is not likely to fire up your organization. They will appreciate the bonus, but they will not break their backs to turbo-charge the bottom line. Here's why. If your company nets 15% and you share 10% of that, you are sharing 1.5% of sales. Your total labor costs, including front office wages, probably runs 25% (depending on size and industry) of sales. The 10% profit bonus equates to only 6% of total labor costs. 6% is a nice little bonus but nothing for them to get too excited about.
Another factor that impacts their reaction to the bonus opportunity: loss of overtime. The fastest way to improve profits is to greatly reduce overtime. If your crews are used to a lot of overtime, you will not be able to afford a profit-sharing plan that can offset the lossof overtime pay. If your crews receive minimal overtime pay annually, a normal profit-sharing program will drive the desired improvements you seek because the field workers will not be giving up anything financially in their pursuit of improved performance. If your crews are accustomed to substantial overtime, you would be best served by reducing the reliance on overtime prior to rollingout a profit-sharing plan.
3. Timing of bonus
Your payout procedure needs to accommodate two conflicting forces: (1) the more frequent the payout, the better your incentive plan will drive the work effort you are seeking and (2) you will not know your true profit until after closing the books at year end. Your plan needs to try to find a balance between the two. A simple five step approach will serve you well.
Step 1: Budget the bonus basedon projected sales, field costs, and overhead expenses.
Step 2: Pay out the bonusquarterly, based on performance against the budget.
Step 3: Hold back 20% of theearned quarterly bonus until year-end.
Step 4: Hold meetings toexplain the size of the bonus.
Step 5: Pay out the year-endbonus within 30 days of fiscal year end.
Bonuses must be paid out on time as promised. Your bookkeeping staff must consider the deadline for bonus checks to be as rigid as the deadline for payroll.
4. Splitting the bonus
Divvying up the bonus will be the most second emotional aspect of your bonus plan. You have two options. Rest assured, either choice will displease some workers and please others.
- Same size bonus for everyone.
- Same percentage bonus for everyone.
With the first option, each individual receives the same bonus. For example, each employee receives a $2,000.00 bonus. With the second option, each individual receives an equal percentage bonus. For example, each employee receives a bonus equal to 5% of their pay. The higher paid workers receive the largest bonuses. As you can well imagine, the field workers and office staff prefer the equal payout, and managers and salesmen prefer equal percentage bonuses.
A profit-sharing plan can be a great and easy incentive plan to implement to begin motivating your employees to that next level of success. There are also more complex individualized performance-based rewards you can implement, and we will explore those in upcoming articles. Next week we will dive into building successful sales commissions.