Pros and Cons of Employee Profit Sharing

Wallet on a wooden floor, representing profit sharing.

Derek Croucher / Photographer's Choice

Profit-sharing is an example of a variable pay plan. In profit-sharing, company leadership designates a percentage of annual profits as a designated pool of money to share with employees. Or, it can be a portion of employees such as executives or managers and those above them as situated on an organization chart.

The pool of money generated is then divided across the covered employees using a formula for distribution. This formula can vary from company to company. Employees can either share in terms of stocks and bonds. Or, of course, straight cash.

Who Benefits the Most

Profit-sharing, when distributed as a percentage of annual pay—a common practice—results in less money shared among employees holding lower-paying jobs and higher amounts shared with highly compensated employees.

A highly-paid senior employee can sometimes see very significant profit-sharing bonuses. For example, 40 or 50% of a senior executive's annual salary is not uncommon. However, a lower-level employee may only see 1 to 2% of his salary as their part of the company's profit-sharing.

Why Upper Management Receives More of the Profits

The disparity between a 40% share and 2% share reflects the belief that more highly compensated employees are responsible for managing the company, making decisions, taking more risk, and providing leadership to the other employees.

While a lower-level employee is secure that their salary will be the same year after year (perhaps with a modest increase) a high-level employee knows that if they don't help the company succeed, their compensation may decrease significantly.

When Profit Sharing Payments Are Made

Profit-sharing payments are generally made only if the company has been profitable for the time period specified, or when an employment contract with a labor union requires it, or when a senior employee requires the compensation. For people without contracts, the company can change the terms of the plan at will.

Profit-sharing usually occurs annually after the final results for the annual company profitability have been calculated. However, some organizations pay the profit-sharing dollars quarterly based on the premise that employee recognition is most effective when it occurs closer to the events it recognizes.

Setting up Your Plan

Employers can choose how to set up their profit-sharing plans, but they must set up an official plan with the relevant documents. The Department of Labor recommends that you:

  • Adopt a written plan document
  • Arrange a trust for the plan's assets
  • Develop a record-keeping system
  • Provide plan information to employees eligible to participate

Companies must keep strict records and have a strict fiduciary responsibility for the plan. Plan documents are legal documents that must be followed exactly. Companies are free to change their plans, but they must do so with the proper oversight.

Pros of Profit-Sharing

The positive impact of profit sharing is that it sends the message that all of the employees are working together on the same team. The employees have the same goals and are rewarded equivalently to reinforce this shared service to customers.

Employees who know that they will receive financial rewards if the company does well are more likely to be motivated to help the company succeed—they have a vested interest in their company's success.

For example, a sales department that pays commissions based on individual employee performance fails to build this sense of team. Each employee is on their own—and they act accordingly. However, an employer that is committed to fostering team and cooperation among employees shares the commissions earned with all of the department's employees.

Cons of Profit-Sharing

The weakness of profit-sharing plans is that individual employees can't see how their own work and actions impact the profitability of the company. Consequently, while employees enjoy receiving their profit-sharing money, it gradually becomes more of an entitlement than a motivational factor.

While senior-level employees are aware of what is going on and make decisions that make impact the bottom line, that's not the case with the front line receptionist. They may not understand that their interactions with vendors, clients, and random people actually make a difference in the profitability of the company.

Also, with profit-sharing, employees receive profit-sharing money regardless of their performance or contribution, so there's no reason to improve one's performance.