We recently started a profit sharing experiment within our company and a number of people have asked why we did it and how it works, so I thought I would share with all. And contrary to probably the most frequently asked question that we get - “How do you make money?” - yes, we do make money, and there are some profits to share.
Why Share Profits?
We started our profit sharing experiment for three reasons;
- We want everyone to have a greater understanding of our finances so that they have more information to make independent decisions,
- We want everyone to have a more significant financial stake in the financial decisions that are made, and
- We want to achieve greater profits by sharing the knowledge and the incentives (the first 2 points).
How We Calculate Profit
In putting the plan together, we realized that there can be wild swings in profit from one month to the next and that we recognized profit on an accrual basis and as such the actual cash to back that profit may not be on hand when the profit is booked. To smooth out the swings and manage profit payments we decided to calculate profit on a cash basis using a moving six-month average. This reduces the profit highs and lows and helps the company manage its cash flow to meet the profit sharing payout from one month to the next.
Further, the company can’t pay out all of its profit. The company needs to reinvest, build equity, and the owners need to be rewarded for the greater risk that they bear. Given this, we allocate twenty-five percent of the profit to the profit sharing pool. Once again, this is an experiment so that number may change once we have more experience with this plan.
How We Allocate Profit
How do we allocate everyone’s share of the profit? We believe that everyone synergistically working as a team is what produces great results. However, we recognize that there are some on the team with less experience and as such their influence on profit could be less, whereas those with more experience have more direct responsibility for making it happen, which is typically reflected in their base compensation.
With this in mind, we think everyone should partake equally in the profit sharing payout up to the amount of their base compensation in any given month. In other words, the most that anyone can earn is twice their base pay if that level of profit can be obtained. What this means is that the profit sharing paid out to higher earners, those with more responsibility and influence will likely be a smaller percentage of their base compensation from one month to the next as everyone will receive the same amount up to their monthly base compensation. A case could be made that the high earners are making a greater contribution in theory. However, we took the opposite approach. The amount paid to higher earners in profit sharing, as a percentage of their base, will be less until everyone who makes less is fully paid out. They are paid more base compensation with the expectation that they will produce greater results. It is on them to produce those great results that allow them to fully max out their potential profit sharing from one month to the next. They should not be rewarded more than everyone else until their leadership delivers those numbers.
For example, there are eight people partaking in profit sharing in this fictitious company below. There is enough profit this month to pay the full base compensation of the two lowest base compensation earners, the next two and the two after that (tier one, two and three). There is not enough to fully match the two highest earners, and they will receive the amount paid out to the tier immediately below them.
Knowledge Is Power - Share The Financials
With the above in mind, we began profit sharing two months ago. We pay out everyone’s share of the profits monthly to enable a fast feedback cycle on the lessons learned and changes made. Knowing how the company is doing based upon the profit allocation you receive is a good first step, but it is only part of the story. To align everyone within the company and to make sure that we have all of the facts that we need to make decisions, day in and day out, we must understand what makes up that profit. To this end, the financials of the company are reviewed and discussed with everyone at the close of every month. Everyone needs to know how we make our profit so that they can independently make better decisions. The result is everyone knows how we are doing, where we have problems and opportunities, and they are rewarded for the decisions that they make based on that knowledge by the profit we share.
How We Measure The Experiment
The goal of this experiment is to have a return on the investment of profit sharing. We want to lower costs and increase revenues by aligning all minds within the company to achieve just that. To this end, we are running this experiment for six months, and we want to achieve an increase of twenty percent in our overall profits by months four, five and six over the same three months last year. Why not compare the full six months? We think it will take us the first three months to get everyone fully up to speed with the plan and the financial education, and it will only be in month four that we will truly be in a position to realize the return on investment that we want. So far the experiment is working great with everyone taking a far more active role in all of the financial decisions that we need to make from one day to the next, and as can be expected, the additional profit sharing added on to everyone’s base compensation is more than welcome.
Do you have experience working in a company with a profit-sharing plan? Or do you have any thoughts about working this way? I’d love to hear from you.