Economic Incentive System

Profit Sharing

Profit sharing is an organizational incentive plan whereby companies distribute a portion of their profits to their employees in addition to prevailing wages.

Profit sharing gives employees a direct stake in the profitability of a company, creating an atmosphere in which employees want the business to succeed as much as management does.

Benefits of Profit Sharing:

greater employee cooperationreducing labor turnoverraising productivitycutting costsproviding retirement security.

HistoryProfit sharing was quite common in

primitive fishing and farming economies, in fact, it still persists among fisherman in many parts of the world.

1790s - Albert Gallatin(Secretary of the Treasury under Presidents Jefferson and Madison) introduced profit sharing in his glassworks in New Geneva, Pennsylvania

19th century- companies such as General Foods and Pillsbury distributed a percentage of

their profits to their employees as a bonus

1916 - The first deferred profit-sharing plan was developed by Harris Trust and Savings Bank of Chicago

Profit sharing was also instrumental during World War II, enabling wartime employers to provide additional compensation to their employees without actually raising their wages.

Forms of Profit Sharing:

1. Cash plans distribute cash or stock to employees at the end of the year.

2. Deferred plans direct profit shares into a trust fund on behalf of individual employees and distribute them at a later date, often at retirement.

3. Combination plans pay part of the profit share out directly in cash and defer the remainder into a trust fund.

Vesting RequirementsIt is becoming less common for companies to

manage their own accounts, due to the fiduciary responsibilities and liabilities involved with them. Instead, companies typically contract the responsibility to financial management firms. The amount of future benefits depends on the performance of the account. The balance of the account will include the employer's contributions from profits, any interest earned, any capital gains or losses, and possibly any forfeiture from other plan participants, which may occur when participants leave the company before they are vested (that is, eligible to receive the funds in their accounts); the funds in their accounts are then distributed to the other employees' accounts.

The time required to become fully vested varies from company to company. Immediate vesting means employees are entitled to the funds in their accounts as soon as their employer makes the contribution. Some companies utilize partially vested schedules, entitling employees to, say, 20 percent of the account before gradually becoming fully vested over a period of time. Establishing a vesting schedule is one way to limit access to the account. Another way is to create strict rules as to when payments can be made from employees' accounts, such as at retirement, death, disability, or termination of employment.

Contribution Limits

The Internal Revenue Service also limits the amount that employers may contribute to their profit-sharing plans. Tax laws allow employers to contribute a maximum of 15 percent of an employee's salary to his or her account. If a company contributes less than 15 percent to an account in a particular year, they can make up the difference in a following year, up to a maximum of 25 percent of an employee's

salary.

Advantages & Disadvantages

In actuality, profit sharing is being successfully utilized in large and small companies, labor -intensive and capital-intensive industries, mass production and job-shop situations, and industries with volatile profits as well as those with stable profits. Profit sharing can reward employee performance, seniority, and thrift, depending on the design of the plan.

Profit-sharing plans do not always work. Roughly 2 percent of deferred plans are terminated annually, some as a result of mergers, others because companies are liquidated or sold. Profit sharing may also entail some disadvantages for a company. Such plans may limit the company's ability to reward the performance of individual employees. At smaller companies, tying employee compensation to often-uncertain profits may result in drastic income swings from one year to the next. Finally, some critics claim that profit sharing may encourage employees to focus only on increasing profitability, perhaps at the expense of quality or other goals.

SourcesGirard, Bryan. "Is There an ESOP in Your Company's Future? An

Employee Stock Ownership Plan Could Enhance Your Company's Bottom Line." Strategic Finance May 2002.

HR Guide to the Internet. "Profit Sharing." 1999. Available from < http://www.hr-guide.com/data/G444.htm >.

Metzger, Bert L. How to Motivate with Profit Sharing. Evanston, IL: Profit Sharing Research Foundation, 1978.

Profit Sharing/401(k) Council of America. "45th Annual Survey of Profit Sharing and 401(k) Plans." Pension Benefits (December 2002).