Profit Sharing

Profit sharing is a form of performance-based compensation where employees receive a share of the company’s financial success. More specifically, this model emphasizes that business sustainability requires more than just cost efficiency—true success is measured in the market, particularly through sales performance and profitability.

Different profit-sharing models are distinguished based on the participation basis—the metric used to determine employee rewards:

1. Sales-Based Profit Sharing

In sales sharing, bonuses are tied to reaching or exceeding predefined sales targets or achieving growth within a business unit. This approach is especially effective for sales teams or senior management with direct market influence.

Key challenge: It often overlooks costs, which can encourage unprofitable growth. Market dynamics and product upgrades may also distort the link between employee actions and revenue gains.

2. Gross Profit Sharing

Here, profit-sharing is based on gross profit, typically defined as sales minus material costs and extraordinary income. A common tool is the wage constant, which reflects the average historical wage share of gross profit. If gross profit increases more than this constant, employees receive either full (in a proportional wage system) or partial payouts.

A well-known variant is the Scanlon Plan, which ties bonus distribution to productivity and cost-saving initiatives.

Limitations: This model becomes less effective with changes in production technology, outsourcing, or significant shifts in cost structures. It is, however, suited to service industries or highly automated businesses where rationalization is minimal.

3. Net Profit Sharing

In net profit sharing, the basis is the net income—the difference between total income and expenses. Increases in profit or improvements in cost-efficiency trigger bonus payouts.

This model is straightforward and commonly used, as it aligns employee rewards with the company’s overall financial health.

4. Value-Added Profit Sharing

This model rewards employees based on the value they help generate. Value added is typically calculated as the difference between gross profit and external inputs. From this, a portion is deducted to cover wages (the “wage constant”) and social security contributions—both statutory and voluntary.

A simplified example is the Rucker Plan, which uses added value after these deductions as the basis for distributing profit shares.

Challenge: Accurate valuation of added value is complex, so simplified formulas are often used in practice.

Conclusion

Profit-sharing schemes vary widely in scope, application, and complexity. Choosing the right model depends on organizational structure, industry, cost sensitivity, and the desired alignment between employee motivation and business performance.