Understanding Profit-Sharing: What Should Be Included in Profit Calculations?

Dear Sir/Madam, I am working with a small trading company where the owner has offered me to switch to a profit-sharing plan. Previously, I was on a salary basis, and now he is providing me with withdrawals to meet my daily needs. At the end of the year, he will calculate the profit and share 40% with me after deducting my withdrawals.

Understanding Profit Calculation in Profit-Sharing Plans

I wish to understand what aspects should ideally be considered while calculating the profit. Is it only sales, purchases, and fixed expenses, or do I also need to factor in rent, which he is requesting?

Thank you.

Hi Abhijeet, it would be better if you could be clearer. Do you mean to say that the profit sharing will be in a 60:40 ratio? There are various components involved in this profit sharing.

Are you investing any money in the company? If yes, then that will be considered as capital investment. Next comes drawings, meaning if you will be taking any money from the company, that will also be taken into consideration.

Consider the fixed assets such as your building, machinery, etc., liabilities, purchases and sales, as well as other expenses for running the company like salary, rent, debts, bills receivable, and bills payable, etc.

In short, Assets - Liabilities = (Net profit or Net loss), on which you will have to calculate your share.

Dear Nishu, thanks for the info. At this point in time, the company is not demanding investment in terms of commercials or assets. The building where we are working and the warehouse are owned by the company. One of the directors is proposing that if I choose a profit-sharing plan, then I will have to pay rent for utilizing this space. I feel this is not correct as I am not running my business; I am part of the company, and I will not have any extra authority in terms of choosing staff, their increments, or appointing new staff. I will only be getting a share based on the business I bring into the company. Please suggest.

Hi,

Is this done verbally? Has he given any written confirmation about this partnership thing? Because it's better if you ask your employer/partner what kind of partnership he is looking for. If he wants to make you a partner, share the profit in a 60:40 ratio and also wants you to pay the rent for his premises, then he is asking you to invest in his business monthly and then take the share. Make the points clear between you two, and it should be documented.

Dear Abhijeet, I feel that the arrangement is a little messy. Therefore, you need to be a little cautious. We need to have complete facts at hand, and only then can our opinion be provided. Let your employer provide the draft of the contract agreement. Erase the personal details from the agreement and upload it here. Proper opinions can be provided thereafter.

Profit Sharing and Rent Concerns

Company profits are shared with the investors and not with the employees (except statutory bonus, if applicable). As far as the payment of the rent is concerned, it could be a ploy to extract money from you. What if you pay rent and yet do not get sufficient money because of low profit? In this case, there is no liability towards the employer to pay you. Secondly, can you sustain the payment of rent? Please take this call judiciously.

Thanks,
Dinesh Divekar

Dear Abhijeet,

Prima facie, the offer looks lucrative. However, much would depend on your operating gross margin, financial costs, etc. As others have said, net profit can only be determined after accounting for gross income, gross margin, operating expenses, transfers to partners' capital accounts for investment costs, and other expenses. Finally, you will arrive at the possible net profit/loss.

Just for the sake of argument, what if the business ends up in a loss? That doesn't mean you should pay from your pocket. To clarify further, list the purchase cost of 'x' number of your product being traded, the possible sale price per unit for that product, assuming there will be no issues in selling them, and calculate the gross sale proceeds.

List all your expenses such as salary, electricity bills, conveyance, handling, communication, advertising costs, and rent if applicable, paid in cash/cheque/kind. Then, notionally compute VAT, other government levies, cost of investment, depreciation for equipment, and other assets used for the business. This will give you a net profit before tax (if applicable), followed by the net profit available for sharing among partners. This analysis will provide a clear understanding of the benefits and an overall picture.

Be honest; if it ends in a loss, you may consider continuing with a salary option. Perhaps in the future, once you are well-versed with all aspects of this business, you could venture into setting up your own business in a similar line.

Kind regards,
[Your Name]