Some common sense advice based upon our own experience:
There are many different kinds of plans, and each of course has pros and cons. We are most familiar with a so-called “cash” plan, which quite simply puts after-tax cash in the employees’ hands on a regular, periodic basis. Opponents of this style say that the motivational impact is marginal, either because the payments come to be viewed similarly to Christmas bonus entitlements, or because the time lag from “response” to “stimulus” negates. However, a cash plan works well with a heterogeneous work-force, i.e., employees at different ages and stages in life. The after-tax funds can be applied to debt reduction, pension contributions, savings towards future goals or immediate self-gratification!
A common alternative is a deferred profit sharing plan. This plan requires a formal trust fund to exist and, therefore, is necessarily more complex. The money must be invested to earn a rate of return and that income must be allocated to all participants appropriately. The employer can deduct the payments immediately while the recipients defer tax until they actually withdraw the funds. However, tax law integrates such amounts into the annual “pension adjustment” statistic which derives one’s RRSP eligibility.
An alternative of course is a combination of both cash and deferred plans.
In a survey of Canadian corporate executives on their attitude to profit sharing plans, the highest ratings for these plans were scored in generating “employee interest in firm performance” and in achieving “overall company objectives”.
A U.S. survey attributed profit-sharing plans with a very high positive impact on employees’ perception of compensation fairness.
A recent U.S. study by Kruse found an observable productivity gain in the initial years after introduction of a plan; however, long term gains were not observable. Thus, it is important to determine what your objectives are: productivity gains? fair compensation? superior compensation? “best practices” management?
David E. Tyson points out in his book Profit Sharing in Canada: The Complete Guide to Designing and Implementing Plans that Really Work that the timing and motivation of introducing a plan must be considered. With the wrong environmental conditions, the new idea may backfire. Key conditions include:
- Reasonable HR environment, e.g. no pending union drives or strikes
- The existence of profit
- Management commitment
- Competitive compensation levels extant
We have seen first hand the dismal failure of a profit-sharing plan that was promised to middle management in a modestly performing company with little profit and inept senior management, plus a rag-tag compensation system. When the following year-end results brought no profit, the furore was considerable. Within a year, most of management had left.
Senior management should be involved in the design and implementation of a new plan. However, once the plan is “mature”, personnel in charge of compensation can execute the annual calculations. Management should solicit feedback periodically on the success of the program.
Tyson is very keen on an “open books” approach to profit-sharing plans. By this, we mean open access for all employees to the financial results of the company: balance sheet, income statement, etc. If this is already your practice, then obviously you will have no trouble with this. If, however, you subscribe to a “closed books” approach, then much of Tyson’s advice about establishing an employee profit-sharing committee becomes redundant.
The most common base as reported by Tyson was profit (48%). The next most common was base payroll (20%).
Where a company has multiple operating divisions, we apply branch accounting to determine the contribution of each division.
Definition of Profit
This draws the old cocktail party joke: What is profit? Answer: What do you want it to be? The first issue is whether the calculation is performed pre or post corporate tax. We support the former, which Tyson indicates 82% surveyed think like-wise. After this, the cocktail party question is indeed valid!
The second issue is whether the following should be included or excluded in the profit statistic:
- Extraordinary items
- Passive earnings
- Owners’ salaries
- Branch profit/loss
- Head office allocations (to branch profit)
Our approach is to exclude extraordinary items but include passive earnings. We also include owners’ salaries at some reasonable base level. The financial impact of other branches is excluded. It is also feasible to exclude a base level of profit for the pure return to shareholders.
Tyson reported a fairly equal split between plans that do and don’t exclude a baseline profit amount.
The third issue is what percentage of profit should be carved off for the plan. In the survey cited by Tyson, the overwhelmingly common figure was 10%, followed by 15%.
Frequency and Timing
According to Tyson, by far the most common frequency was annual, and typically this happened after the due course of financial statement preparation, typically 3-4 months after the company’s year-end.
This is precisely what we do in the plans we administer. If this time delay backs into other payouts, e.g. Christmas bonuses, you may need to review the schedule.
It is worth considering whether the timing of the profit-sharing process should be separate from, or adjunct to, the annual compensation review process. Practically, we have seen pros and cons for both.
In either case, profit-sharing is a part of your overall compensation program. As such, you must decide where your firm’s compensation will be situated competitively: at, below or above market.
We apply participation throughout the company. Employees must have been with the company at least one full year, as of the fiscal year-end date, to receive full entitlement. Tyson reports this to be the most common service hurdle. However, employees with 9, 10 or 11 months service receive a pro-rated entitlement in their first year. Employees who have departed voluntarily since the year-end also receive their entitlement postpartum. Employees who leave during the fiscal year receive nothing. We have not observed an inclination of departing employees to “hold on” for a few months. Employees who are severed receive a pro-rated estimate of their entitlement.
We have been involved with a plan which only included middle management.
Non-employees, e.g. sub-contractors, typically are excluded even though they may work full-time in the organization. Where the firm has a lot of sub-contractors, this policy might require review. However, including them might jeopardize their self-employment relationship in the eyes of CCRA.
We include part-time employees who have a minimum of 50% FTE. Their entitlement is pro-rated implicitly in the allocation calculation by the wages that they receive relative to the other staff.
Staff whose base compensation package includes a variable component, e.g. commissions or target bonuses, are excluded from participation. In some years, they received a token allocation from the profit-sharing pool, but this was discontinued. Tyson addresses this point and endorses the view that we have taken.
Share can be progressive, regressive or proportional, relative to base compensation. The actual algorithm for the calculation can be simple or complex.
At its simplest, share is simply pro-rata to the individual’s share of gross payroll (proportional). In a more egalitarian approach, everyone would receive the same amount (regressive). In a more elitist approach, the profit-share pot may be divided into unequal sub-pots (progressive) which are allocated to various categories of staff, e.g. senior staff, long service staff, meritorious staff, etc.
If base compensation is the base, then this typically excludes, for instance, overtime earnings or any performance bonuses.
The share algorithm can be more complicated if one wishes to use a mix of the different entitlements, eg base compensation and length of service. The “K.I.S.S.” principle may be valid here in terms of explaining the plan to employees.
We believe that merit should not be considered in the algorithm, but treated as a separate component of the overall compensation system. In this regard, management should train itself to the appropriate lingo “profit-sharing” and not sloppily refer to it as a bonus system.
We have found that employees view profit-sharing more favourably if the share calculation is “scientific” and without management bias.
Tyson cites a broad frequency distribution of the different types of algorithms in surveys.
According to Tyson, whatever methods are decided upon, the bottom line is that the profit-sharing amount must be at least 3-5% of base compensation in order to be seen as relevant. We apply this test annually in the plans we administer as a final reasonableness test. Kruse defines a “high-contribution” plan as one that exceeds 3.63%.
Most, but not all, aspects of the plan should be communicated to employees. For instance, if the books are “closed”, we don’t recommend that it become known that, say, 15% of company profit goes into the pot. The enterprising employee may undertake some studious calculations to estimate the profitability that management was seeking to keep private. However, the rest of the workings should be laid out in a memo prior to commencement of the plan. These details then should be added to the permanent information package related to benefits, etc. for all employees. The existence of the plan, and its terms, should be disclosed to potential new candidates in job interviews.
We recommend that a “point-man” be designated to handle staff enquiries about the program. Managers should be instructed to direct questions in that direction. We believe this is more efficient than training all managers in the minutiae of the program.
Profit-sharing compensation of course is taxable to the employee and thus subject to the regular payroll with-holdings. As with overtime cheques, this unavoidably cuts into the “joy” of the surprise! We have considered offering the option of direct transfer to employees’ RRSP plans in order to mitigate the tax with-holding, but this can be a cumbersome administrative burden.
If a bank payroll system is used, then a personal letter from the CEO should announce the gross entitlement individually to each employee. The occasion can be used for “greater hype”, as appropriate to the culture of the firm, e.g. a staff meeting could be staged to deliver the news.
The profit-sharing process is easily maintained in a spreadsheet application which contains the following data:
- Commencement date
- Year’s base compensation
- % of total compensation
- Profit share
- Share/base compensation