How To Structure Bonuses And Profit Sharing Plans – It isn’t That Hard

by Dec 5, 2018Bonuses

It’s a Great Way to Align and Reward Your Team

One of the most common questions I get asked by business leaders is: How do I create a profit-sharing or bonus plan?

In fact, one CEO, a client of mine, recently posed this very question to me. The business was doing well, and the CEO wanted to find a way to share some of its profits with the people helping to create that success. Importantly, he was also comfortable sharing some financials with them on how well the business was doing.

The good news is that answering the question is actually pretty simple and straightforward. To create a good profit-sharing plan–or an annual bonus that is based on the performance of the company–you need to do two things:

1. You have to decide on the size of the pool of money you’re going to pay out.

2. You have to figure out how you want to distribute the money out of that pool.

Each step involves a separate set of decisions that you, as the leader, need to resolve.

So let’s start with the question of how you decide on the pool of money you’ll use for your profit-sharing plan.

The key point here is that since this is a profit-sharing plan (and ultimately, bonuses are profit-sharing plans too), your business needs to be generating profits. That’s where the money for the bonus will come from. If you’re not profitable, and you’re running in the red, you might want to rethink the premise of creating a plan like this.

In the case of my client, his business generated a healthy $2 million in profit for the year. To fund his plan, he was comfortable contributing 10% of those profits–or $200,000. That 10% would be money that would essentially be coming out of the owner’s pocket–but he was good with that.

Going forward, he also planned to use the 10% threshold to determine his profit-sharing pool regardless of how much profit the company earned. In other words, if the company generated only $1 million in profit, the pool would be $100,000. If profits rose to $3 million, the pool would also grow to $300,000. Now likely, to generate higher levels of profit, there would be more people in the business so the bonuses don’t expand forever.

It’s a simple and elegant way to create your bonus pool that also scales or shrinks depending on how well the company performs and it aligns the team with the profit goals. Do we really need another person, or can we get it done with the current team becomes an interesting conversation when everyone makes less money if the people are hired?

Once you’ve resolved the issue of creating your bonus pool, now you have to decide on how to distribute the money to your people.

There are two techniques you can consider.

1. Equal distribution based on salary.

This means that you would pay out the bonus based on a percentage of how much the person was paid in salary.
In this case, the total salary of the employees was $1,000,000–which meant that the bonus would average about $20,000, or 20% of each person’s compensation ($200,000/$1,000,000 = $20,000 each). There is a lot of research that shows that an 8% bonus is typically enough to motivate an employee to change behaviors and perform better–so the 20% bonus was more than ample. Frankly, he could have been a bit less generous and still gotten the desired effect. 

2. Distribution based on contribution level

An alternate way to pay the bonus would be to compensate people based on their role in the business. You can do that by dividing up the pool into shares, where each share is worth a certain percentage of the pool. Then you pay the bonus based on the number of shares an employee is given–usually based on their position in the company. You might give one share each to front-line employees, for instance, while managers get two shares and senior executives get three.

In our example, the company has 20 employees and based on roles would have 25 shares. In this case a share is worth $8000 ($200,000/25 = $8000). So a front line person might get $8,000, a manager $16,000 and a senior executive $24,000. This probably means that more senior people get a greater percentage of their salary in bonus.

The key is to do some math to make sure the amount you allocate in each share adds up to your total bonus pool amount and the potential payout is motivating to the people involved.

Regardless of which distribution method you choose, you should also allow yourself as the owner or CEO to make further adjustments based on the performance of individual employees. If an employee who was due two shares of the bonus pool is severely underperforming, you shouldn’t hesitate to trim their shares to send them a clear message.

Conversely, if you have a superstar employee on the front lines, you might want to allocate more of the bonus pool to reward them for their hard work.

Remember, the goal of the profit-sharing or bonus plan is to reward employees for their contributions to the overall bottom line success of the business–it’s not an entitlement program. But, it provides a clear way for the team to understand what the potential bonus is if they do a good job and that is way better than a pure management judgment plan.

So, when you create the plan, explain how it works and that the better the company performs, the more the best performing employees will profit from that success as well. This will likely mean that you’ll have to be more transparent with your financial results.