When Is The Best Time To Implement Profit Sharing?

For the first time in a long time, companies are beginning to reckon with what types of changes will be called for in the economy that emerges when the current pandemic recedes. It strikes me that a serious reconsideration of profit-sharing will be among the items under consideration.

Last year the Business Roundtable issued a “Statement of Purpose of a Corporation” which revised a previous statement issued decades ago stating that the primary purpose of a corporation was to increase shareholder value. The new statement of purpose, which was signed by almost 200 CEOs of public companies, says, in part, “we share a fundamental commitment to all of our stakeholders” and then lists them as customers, employees, suppliers, communities and shareholders.

Companies have two types of capital: equity capital and human capital; and it takes both types to earn a profit.  Equity capital is rewarded via dividends and as profit improves so can dividends.  However, most companies don’t have a similar mechanism for rewarding human capital.  Employees are paid their wages and if profits improve, they do not receive a portion of that improvement.

In 1916, D. Hayes Murphy, founder of The Wiremold Company, recognized the interdependence between financial capital (himself) and human capital (the people doing the work). Contradicting the idea that only the financial capital would benefit from increased productivity at the expense of human capital, he said in a company book that “I believe that this company should pay the same wages that other companies…are paying for the same kind of work. But I also believe that any man or any woman who will really take an interest in the business of this company, and who helps to make profits for the company, should receive a share of those profits.” Mr. Murphy’s approach was simple: a percentage of profit was set aside to be shared with each employee in proportion to that employee’s wages.

There is an old expression: “When given lemons, make lemonade”. The current health crisis had handed businesses a bushel basket of lemons. Some will not survive. Most will survive but many will not return to profitability quickly. This represents an opportunity for companies to institute profit sharing plans, because the best time to begin one…is when you have little or no profits. And then, when the company returns to profitability, the employees, the human capital, will share in that success.

Having administered Wiremold’s plan for my entire tenure as its CFO taught me the following ten elements of a successful profit-sharing plan. I found that any plans that violate these principles run the risk of them becoming entitlement programs at best, or at the worst, de-motivators that generate the opposite effects that they are designed for.

1. Integrity: A good plan grows out of the conviction that people count: it should capture a sincere desire to have employees share in the company’s success. Any management that states an intent to share profits but does things that foster mistrust will lose its credibility with employees.
2. Include Everyone: Some companies have profit-sharing plans for select groups of employees (e.g., salaried employees). This creates a divide between the select group and those left out, fosters a “we-they” attitude, and belies the concept of team. At Wiremold, every employee—from the CEO to the janitor—was included.
3. Simplicity: Some profit-sharing plans can become very complex, with features like hurdle rates and sliding scales based on levels of profitability. Any plan that the employees cannot understand risks breeding mistrust and failing to achieve the desired results.
4. Unlimited Payout Potential: A limit on the amount of profit sharing an employee can earn sends a clear message that employees really cannot share in all of the increased value they create. This is indicative of a management perspective that profit sharing is an added cost. To the contrary, true profit sharing is fully self-funding: If there are no profits, there is no sharing.
5. Not a Substitute for Fair Wages: Profit sharing should not be used as a tactic for paying a lower wage than the prevailing market rate and relying on profit-sharing to bring total pay up to a competitive level. That is not profit sharing but merely a mechanism for putting a portion of the market-based wage at risk.
6. Predetermined Sharing Method: The profit-sharing payout formula must be established, and explained, in advance if the plan is to have credibility and operate in an atmosphere of trust.
7. Economically Meaningful: The plan must be capable of producing significant payments to employees at reasonable levels of profitability. A plan that awards employees an additional one or two percent in compensation will not motivate them.
8. Pay It Currently: Some profit-sharing plans defer payment by depositing the money in an account that is distributed to the employee at retirement. Wiremold paid profit sharing in cash each quarter so there was immediate linkage between the company’s success, or lack of it, and the payment.
9. Base the Plan on Profits: Plans that base payouts on criteria other than profits (e.g., gain sharing plans) generally sub-optimize results because they pay for results in one area without considering the impact on other interdependent parts of the business. The concept of tying profit sharing to the economic health of the company as a whole should not be violated; it reinforces the necessary notion that employees’ economic welfare is tied to the economic welfare of the business.
10. Communicate, Communicate, Communicate: Without effective and repeated communications, a profit-sharing plan will fail to achieve the desired results. Employees must understand why there is a plan (they are valued) and know its status on a regular basis. The President of each division held quarterly profit-sharing meetings to distribute the payments, but more importantly to discuss the results, what was required to improve them, and to solicit questions and comments from employees.

Wiremold’s profit sharing plan put 15% of world-wide pretax income into the profit-sharing pool each quarter. Interestingly, the amount in dollars was about the same amount that was paid to shareholders in the form of dividends. This reinforced the belief that equality in payments to both financial capital and human capital was important to the success of the company. 

There is a lot of talk these days of how this health crisis will never allow things to return to “normal”, but that there will be a “new normal”. If the almost 200 CEOs that signed the Business Roundtable’s revised “Statement of Purpose of a Corporation” are serious about their commitment to all stakeholders, now is the time to implement structural changes to allow human capital to share in the value that they create. Instead of just talking about it, these leaders of American capitalism need to put their money where their mouth is. As businesses reopen, there are many things that will be different. Let’s make profit sharing one of the widespread features of the “new normal”.