It’s important to reward your employees for a job well done. It’s common for companies to offer year-end bonuses to their employees for this reason. Many employees come to rely on them as a part of their salary. However, offering bonuses can become problematic during an economic downturn.
If your company cannot offer the usual bonus to employees, they may feel under-valued even if they’ve been working hard. Employee profit sharing is an alternative option that ties rewards to the year’s profits. So what is profit sharing and how does it work? And is profit sharing a good solution for your company?
What Is Profit Sharing?
When employers create a profit-sharing plan, they essentially give their employees shares of the profits generated by their company. A profit-sharing plan is also called a deferred profit-sharing plan (DPSP). With this plan, employees receive set percentages of the company’s earnings on a quarterly or annual basis.
How Does Employee Profit Sharing Work?
If you’re thinking about adding a profit sharing plan to your organization, you might be wondering how profit sharing works. At its most basic level, a profit-sharing plan includes any type of retirement plan funded entirely by discretionary employer contributions. This doesn’t include accounts like 401(k)s and IRAs because these accounts are at least partially funded by employees themselves.
To begin setting up a profit-sharing plan, business owners will first determine how much to give each employee, whether that’s a certain percentage or a profit allocation formula. According to the Internal Revenue Service, a common profit-sharing method is called a comp-to-comp plan. Using this method, employers calculate the total amount of employee compensation across the company. The employer then divides each individual employee’s compensation by the total company compensation. This result is then multiplied by the previously determined employer contribution. This equation will help you determine how much each employee receives through a comp-to-comp profit-sharing plan.
Profit-sharing plans can be implemented in any company, no matter its size or if it already offers other retirement plans. To set up the plan, employers must fill out the IRS Form 5500 and list every beneficiary of the plan.
The Benefits of Profit Sharing
There are many benefits of profit-sharing plans, but the most notable are that they incentivize employees to work hard and increase their loyalty to the company. But, depending on your company, there might also be drawbacks to plans like these. If you’re considering implementing a profit-sharing plan, it’s a good idea to note the pros and cons.
Profit sharing can help your company weather economic downturns while still providing rewards to employees. Employees may expect bonuses to be the same every year, regardless of how well the company did that year. With profit sharing, employees expect their share to be variable and won’t feel undervalued if they receive less in a poor economy.
Investment in the Company
When employees receive a share of the profits, they also feel that they have a greater stake in the company. Employees are more satisfied when they know that they’ll share in the profits. Offering profit sharing instead of bonuses directly ties employee pay into the health of the company. Employees who are more invested in the company instead of just their own jobs can be more productive.
The more profits the company receives, the more employees receive in bonus pay. Employees may be motivated to work harder so that the company receives more profit.
Profit sharing can also affect your company’s culture. Employees may feel that they are working toward a common goal. Their hard work doesn’t just benefit the company’s bottom line but benefits them directly as well. Employees may also hold each other accountable for staying on task. Slacking coworkers would affect their own share of the profits.
Profit sharing can be as flexible as necessary to meet your company’s needs. Different levels of employees can receive different percentages of the profits. For example, upper management can receive higher amounts compared to entry-level employees. The highest-level employees may have up to 50% of their salaries come from profit sharing while lower-level employees may receive 1–2%.
Not all employees may be able to see how their contributions affect the company’s bottom line. Upper management may regularly make decisions that affect the company’s profit and will know how they affect profit. Lower-level employees may not be as motivated to work hard if they don’t feel that their work is contributing to the company’s profits.
Profit sharing is also not tied to performance, so some employees may view their share of the profits as an entitlement rather than a reward. This could result in especially lower-level employees failing to improve their performance or productivity.
Making Profit Sharing Work
It’s essential that all employees understand how the profit sharing plan works. Employees who don’t understand how their jobs contribute to profits may be less motivated to improve performance or productivity.
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