We put forward some succinct answers that allow one a glimpse of our intuitive responses to certain arguments.
- Why share profit?
- Why bother modeling if the empirical method proves effective?
- How is a company’s risk divided?
- Who is eligible for profit sharing?
- What is the impact on governance?
- Suggested reading on subject of financial incentives
Why share profit?
Why would the owner of a production facility share the profits of his company with the employees who make it run?
Managers usually answer this by arguing that financial incentives (performance bonuses,commission on revenue) are efficient motivational tools which lead to productivity gains. To the same question,shareholders answer that the attribution of shares and stock-options are effective ways of ensuring management loyalty. Here,then,are two ways of sharing value which seem widely accepted. Everything would be fine if economists,basing their argument on case studies,did not express serious reservations about these convictions,which are all too often distorted by opportunistic yet rational individual behavior.
Profit sharing is not an end in itself; it is the means of aligning the interests of providers of labor and of capital, indeed of creating a genuine community of interests.
The alignment of the interests of providers of labor and capital is a condition of minimizing structural costs, of efficient governance and of combining energies around the company project. It ensures that the stakeholders will maximize their return on investment while preserving the conditions for development of the company.
Why bother modeling if the empirical method proves effective?
The WorK is K method is the result of an in-depth theoretical approach which involves rigorous quantitative modeling. On top of more classical methods,it adds a non-accounting treatment and pays close attention to the allocation of capital.
The objection often made of economists’ theoretical approach is the example of the billiard player:
- It is not necessary to understand complex laws of physics to be an excellent billiard player.
- This is true,but it might well help.
- It is not necessary to understand agency theory to motivate one’s workforce.
- Again true, but why ignore what is within easy reach?
- It is certain that billiard balls make no calculations before following their optimal trajectory.
- Observation : without having recourse to sophisticated theories, employees and managers are quick to draw the best out of any incentive schemes, even at the risk of threatening the company’s profitability or harming the interests of the other stakeholders.
Basing the creation of profit and its allocation between the various stakeholders on solid, tested economic reasoning is an essential condition for the robustness of a company project which, inevitably, will be subjected to opportunistic behavior from certain parties.
How is a company’s risk divided?
The creation of profit by a company is subjected to factors that can even lead to net destruction of value. The loss is naturally borne by the financial capital. The reconstitution of capital from the profits in the following years is a necessary condition for the reactivation of profit sharing. Risks when they are moderated are thus perfectly shared. If the losses are big,other more complex methods can be used to ensure sharing the risk in the company.
Who is eligible for profit sharing?
We recommend limiting the attribution of variable remuneration to managers and operational employees having real influence on the profitability of the activity and with a stake in sharing the company’s fortunes,good or bad;we then speak of “partnered human capital”.
But before bemoaning some sort of injustice,let’s remember that the attribution of a substantial variable part does not come on top of a fixed wage equal to what is observed on the labor market. It is accompanied by a compensatory reduction in the fixed component in the remuneration package.
Let’s also bear in mind that it is not desirable,from the company’s point of view,to have employees and managers in charge of accounting and internal control benefiting from a system of financial incentives based on the result that they themselves calculate and approve. Likewise,some professions are less responsive than others to incentives,and may even be resistant.
In sum,not all employees wish to expose all or part of their remuneration to the vagaries of the company’s risks. The employees and managers whose remunerations are essentially made up of fixed wages represent the “waged human capital”. They are in a situation comparable to that of lenders (banks in general),who receive a more modest yet more secure remuneration than that received by equity investors.
Partnered human capital and waged human capital are the components of a company’s human capital;belonging to one or other of these groups carries no value judgment.
What is the impact on governance?
The alignment of interests ensures that the providers of partnered human capital and the providers of financial capital are in a situation of community of interests,which means they are inclined to make the same strategic choices for the company. Because of this,both parties are fairly neutral with regard to sharing power. It seems good sense to take into account all the stakeholders in the composition of decision-making organs;that said,no theoretical or legal obligation has any real bearing on the choice of a particular mode of governance.
Suggested reading on the subject of financial incentives
The section ‘Documentation’ provides references for numerous articles and books on the subject of financial incentives,profit sharing and alignment of interests.
We recommend that any manager interested in an overview of the subject to read the following book, notably the chapter on financial incentives: Pfeffer and Sutton (2006) “Hard Facts,Dangerous Half-Truths &Total Nonsense: Profiting from Evidence Based Management”, Jeffrey Pfeffer and Robert Sutton, Harvard Business School Press.
As a warning concerning financial incentive strategies, the authors make an appeal for moderation and reflection before implementing changes: “Be careful what you wish for,you might just get it.”
In other words, don’t set out alone on the great adventure of optimal profit sharing.