Profit-Sharing

Profit-sharing is an incentive pay system where the employees are entitled to a predetermined part of the company's profits. It can be applied in various ways and for various reasons. In the theoretical literature, profit-sharing is often seen as an arrangement with the purpose of aligning the interests of employees and capital owners. Profit-sharing was known already in the 19th century and has become particularly common in countries where legislative measures have prescribed or encouraged its application. A defining feature of profit-sharing is that the employees' share of the company's performance is determined beforehand and not in a discretionary fashion. Usually, profit-sharing is thought of as remuneration in addition to the base wage covering all or most employees.

Three basic types of schemes are commonly distinguished. In cash-based schemes, profit shares are paid immediately in ready money. In share-based schemes, employees are encouraged to become part owners of the company. In deferred profit-sharing, employees cannot take part of the profit shares until a certain time has passed. Gains-sharing can be regarded as a bonus incentive system related to, but distinguished from, profit-sharing. In gains-sharing schemes, employees are entitled to a predetermined part of efficiency gains. Generally, gains-sharing runs on a monthly basis, whereas profit-sharing usually runs on an annual or quarterly basis.

In theory, there are several reasons why some employers apply profit-sharing. An important motive is to link the employees' interests to the company owners'. By connecting a part of the remuneration to the company's performance, employees get incentives to perform at their best and encourage their colleagues to do the same. However, some economists argue that the positive incentive effect is hampered by a free-riding problem. If the profits are shared between a large number of individuals and the contribution of each individual to the company's results is small, profit-sharing has weak prospects of boosting employee effort.

Another property of profit-sharing that may be attractive for employers is that it has the potential of reducing personnel turnover and making investments in firm-specific training more worthwhile. As labor costs automatically adjust to the business cycle, firms can avoid layoffs in bad times and employees will be less inclined to quit voluntarily in good times. In empirical research it has proven hard to establish an effect of profit-sharing on productivity. This is partly because of problems with establishing the direction of causality; it is difficult to know whether companies become more productive by imposing profit-sharing or if more productive companies are more inclined to impose profit-sharing.

Historically, profit-sharing has its origins in the 19th century or even farther back in time. A pioneer company was Redouly & Co., whose owner, Edme Jean Leclaire, introduced a profit-sharing scheme in 1842, along with participation in management, for a selected group of employees. Some decades later, profit-sharing had spread to such countries as France, Great Britain, and the United States. The idea had several famous advocates among scholars and intellectuals, and it was discussed in 1889 at a congress in Paris. This congress, among others, established the definition of profit-sharing that basically is still in use today.

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