Smart Business San Francisco

Gainsharing for Productivity and Profit

By Douglas DeRubeis

Productivity drives profitability, and employees drive productivity. So the question is: What drives employees? Most experts agree there’s no better way to influence employee productivity than through incentives. The challenge, however, lies in finding an incentive program that really works, because many do not. For example, one employer tried to pay an extra dollar per hour to each employee who arrived at work on time every day of the week. Unfortunately, that program didn’t take into account employees who showed up on time but still accomplished less than their occasionally tardy co-workers. Other employers have tried to motivate employees with promises of sharing any “excess profits” at the end of the year. But since “excess profits” rarely materialize or are immediately eliminated by the CPA, such unfulfilled hopes only leave employees demoralized.

On the other hand, gainsharing represents a properly constructed and profitable incentive.

What exactly is gainsharing? Rather than promising to share any “excess profit” at the end of the year, the employer shares with employees the monetary gains of increased productivity as it occurs. Does it sound crazy to reward employees prior to turning a profit? Take a closer look. Who creates the profit? It is the employees – by working harder and smarter, by establishing programs and reduce or eliminate waste and by avoiding mistakes through greater attention to detail. If those savings are shared with the employees as they are generated, it encourages greater diligence and more savings.

Gainsharing even works to turn around companies in dire financial straits. A second-generation job shop manufacturer was on the brink of bankruptcy when the owner heard about gainsharing. Desperate to try any measure that could salvage the company his father had built, he established a popular gainsharing plan. Within two years, the business was extremely profitable and growing. Because he made no other changes in that period, the success was 100 percent attributable to the gainsharing program. In short, gainsharing is not dependent on turning a profit. Rather, it increases profitability because the gains from greater productivity are shared from the get-go.

HOW IT WORKS
Gainsharing was developed in the 1930s by union official Joe Scanlon for the almost-bankrupt steel industry. His simple plan tied employee and company together in a system that rewarded both sides for productivity improvements. It amounted to the creation of a target wage cost per dollar of sales. When wage costs where reduced, the reduction was shared by the employees and company alike. And when wage costs rose above the target, the extra cost was also shared by both sides.

Here is an example of the Scanlon Plan. First, a company creates an average target of labor costs, represented as a percent of sales over an extended period (18 months to five years) and decides how the gains are to be shares; e.g., 50/50. Let’s say that during the target period, the company averages $250,000 in sales per month, with a wage cost of $100,000; i.e. 40 percent of sales. Therefore, 40 percent becomes the target. In the first month of operating the plan, the company achieves sales of $247,000. Since the target wage is 40 percent of sales, the allowable wage is now $98,800. However, a calculation of wage costs for the period shows that the actual wages only come to $92,000. Thus, the wage savings are $6,800, which is split 50/50; i.e., $3,400 each to company and employees. The employee share is then divided further, 50 percent paid now, and 50 percent withheld for future distribution.

The reason for withholding half of the employee distribution is to protect against wage costs that exceed the target. Let’s say in month two, sales are $225,000. The targeted allowable wages are $90,000. However, the actual wages come to $92,000, leaving an overpayment of $2,500. Because the reward was split 50/50 with the employees, the deficit is split in the same way. The company must absorb $1,250 of the deficit, and the employees have $1,250 removed from their pool.

Later, economist Allen W. Rucker refined this approach and created a plan that calculated productivity by representing total wages as a percentage of “value-added sales”; i.e., net sales plus or minus the change in inventory, less the cost of direct materials and supplies. Utilizing the figures from the previous example, let’s assume a net sales value of production of $250,000, an increase in inventory of $5,000, supply costs of $75,000 and total wage costs of $100,000. The value-added sales would be $250,000 + $5,000 - $75,000 = $180,000. Total wages, as a percent of value-added sales, become 55.55 percent, which now represents the target total wage. The calculation of the monthly plan pool and its distribution between company and employees remains identical to the Scanlon Plan.

Although many other gainsharing programs exist, for most manufacturers, the simple elegance of the Rucker Plan works well for many reasons:

• The calculation is simple, but meaningful.
• It is easy for employees to understand and follow.
• It eliminates variations caused by increased use of purchased inventory or material price fluctuations.
• It holds employees accountable only for what they can control. Increases in the productivity of all employees will translate into higher net profit, as long as management fulfills its responsibilities.
• It encourages the formation of peer groups and committees to constantly improve quality and efficiency issues.

Some conditions call for a modification of the plan, such as an increase in sales prices or the purchase of an automated system that replaces wages. Without modifications to the formula, the operation may seem more productive where no improvement truly exists.

CRITERIA FOR SOUND PROGRAMS
The choice of plan and any specific tailoring and modifications depend on each manufacturer’s unique needs. However, there are five tests a gainsharing program must pass. The incentive must be:

1. Easy to understand and administer – An incentive can not improve productivity if employees do not understand it. Complex distribution schemes incorporating all sorts of criteria (personal evaluations, years of service, position, etc.) become cumbersome, if not discriminatory. The most effective distribution is based on an individual’s wages represented as a percentage of total wages. For instance, if Bob has a wage base of $400 per week, and the company wage base is $2,000 per week, Bob’s wage represents 20 percent of the total wages. When the incentive is distributed, Bob will receive 20 percent of it.
2. Constantly measurable – The employees must be capable of knowing, within meaningful time frames, where they stand toward achieving the incentive. They know exactly what they have to do individually or as a team to receive their share of gain from the business.
3. Within the control of the employee – If employees do not have control of the criteria for achieving the incentive, it will lose its motivating characteristics.
4. Timely – An incentive should be calculated and distributed monthly at best, or at the very least quarterly. If a reward is too far in the future, it is merely a hope or dream.
5. Based on properly defined targets – Not every terrific gain in one area is significant to the whole. Employees must be held accountable for meaningful targets based on key business indicators averaged over a period of years.

One of the oldest pay-for-performance systems in the country has been in place at Lincoln Electric Co. in Cleveland, since the early 20th century. It has received some notoriety because it takes gainsharing to its ultimate conclusion. Instead of wages, the company pays piecework incentive rewards for all production work. While this approach is controversial, the firm has had decades of record financial results and impressive growth and always has a long waiting list of job applicants.

TAKE A LEAP OF FAITH
Gainsharing is an incentive plan whose time has come. In her book Raising Productivity and Real Wages Through Gainsharing, Anita U. Hattiangadi, a noted expert in the field, stated, “In fact, gainsharing seems to be the most effective incentive-reward scheme. Through gainsharing and employee involvement, firms are able to achieve significant and sustained productivity gains, raise the real wages of workers and improve firm performance. Research documents the significant productivity and real wage effects of gainsharing in firm case studies.”

The reality is gainsharing makes sense and is simple to apply. The greatest challenge is overcoming the misconception that profit has to come first or that it is going to increase costs. In reality, a gainsharing program decreases costs because every dollar that is produced and shared is a dollar that would not otherwise have been earned. It’s a tough concept to grasp at first, but those who really understand it have become believers forever. Properly constructed and administered, a gainsharing program always works to increase productivity and, hence, profitability.

Douglas DeRubeis is a consulting services director with International Profit Associates (IPA) Inc. IPA and its related companies provide comprehensive business consulting services and business valuation services to companies in the United States and Canada. For more information, call 847-495-6786 or visit www.ipa-iba.com.