The Ratio determining the Share of Each Partner – Profit Sharing Ratio
‘Profit Sharing Ratio’ is a common term that is prevalent in a partnership type of business. This is simply the ratio at which the partners share their profit in the business.
In this context, we have widely discussed the Profit Sharing Ratio. Its meaning, about the ‘new profit-sharing ratio’, the calculations which estimate the new profit-sharing ratio, ways to calculate the new profit-sharing ratio, a few solved problems based on Profit Sharing Ratio, and at the end of the chapter some FAQs related to the topic are also shared. Students are suggested to study each section with utmost concentration to gain knowledge.
Meaning of New Profit-Sharing Ratio
The new profit-sharing ratio is the proportion in which the old partners, as well as the new partners of a firm, agree to distribute the future profit of that organisation.
It is necessary to decide the new profit-sharing ratio when a new partner joins a business because, in the future, he/she will be entitled to share the profits. However, if this ratio is not agreed upon at the time of admission of a new partner, the profit will be distributed equally among all the partners, whether existing or new.
Why is a New Ratio introduced in a Business?
There are different scenarios when there is a need for a new ratio in a business. The business can have its new ratio at the time of:
If the partners want to revise their existing profit-sharing ratio without inclusion or exit of any member
When a new partner joins a firm
At the time of death or retirement of an old partner
However, the calculation of the new profit-sharing ratio in retirement is done simply by removing that retiring person’s share. In this scenario, the gaining ratio of the continuing members will be = retiring person’s share* Acquisition ratio.
Instances of computing New Profit - Sharing Ratio
This ratio is calculated differently for different scenarios. A few profit-sharing examples are given below which links to different scenarios. They are as follows:
Case 1: The share of a new partner is given without mentioning the sacrifice made by existing or old partners. In this case, it can be assumed that the existing partners will sacrifice their old ratio. To calculate a partner’s sacrificing ratio, you need to deduct his/her new profit-sharing ratio from its older counterpart. Even though the new ratio will be different figuratively, the profit-sharing proportion might remain the same for former members.
Case 2: When the new partner will buy a share from old associates in a particular ratio. In this instance, the existing partners do not make any sacrifice from their end. Therefore, firstly you only have to deduct the amount in which a new partner has purchased his/her share from existing members, and then the revised ratio will be calculated for everyone.
Case 3: On retirement or death of a partner, a new profit-sharing ratio of remaining partners will be additions of old ratio and gaining ratio as the existing partners gain his/her share from the retired partner’s absence.
Case 4: An incoming partner obtains his/her share from existing partners who have made a sacrifice to favour the new one, in a particular ratio. In this case, the shares sacrificed by old partners will be deducted from their share, and that would be added to a new member’s share. Then a new profit-sharing ratio will be calculated.
Case 5: When a new partner draws his/her entire share from anyone partner of the business. In this respect, first, you have to compute the sacrificing share of that particular partner and have to deduct it from his/her current ratio and that share will be credited to the new partner’s share. However, the ratio will be unchanged for other existing members as they have not sacrificed their share.
What are the Factors of Profit-Sharing?
When a partnership business is being created, the partners can dictate their respective share of profit and loss by mentioning the same in their agreement. While, when there is no such agreement made the shares are being divided equally.
So, in cases where agreement is being formed, the partners can share their profit and losses based on any factors, anyway, the two most prevalent factors are:
Responsibility shared by partners
The responsibility of the partners is one of the most important factors. Suppose, the responsibility in the daily functioning of the business is carried by A, while partner B makes rare visits to the business, hence profit is shared in the ratio of 80:20 among A and B respectively.
Capital Contribution by partners
In a partnership business, partners contribute to the capital. Some partners may contribute more while some less. Thus accordingly, the shares can get affected.
For example, Partner A contributed Rs. 30,00,000 and Partner B has contributed Rs. 75,00,000 in their partnership business. Thus accordingly, A and B’s profit-sharing ratio is fixed at 30:70 respectively.
Apart from these two factors, there is another factor that might affect their profit-sharing decision. That factor is – Mixture of Factors
A mixture of factors denotes that partners in the business can share their profit-sharing ratio after considering both the prior factors, that is responsibility shared by partners and Capital Contribution by partners. Suppose, A has contributed Rs. 20,00,000 in the business and taking all the major responsibilities in the business. Whereas, B has contributed Rs. 80,00,000 and only taking care of minor issues in the business. So, they reach a decision where A and B will be sharing profit in the ratio of 40:60.
How to calculate New Profit-Sharing Ratio?
The formula where we calculate the new profit-sharing ratio can be different considering several circumstances, but the following illustration is one of the ways to calculate it.
1. A, B, and C are partners sharing profits in the ratio of 3:3:2. C retires, and his share is taken up by A. Calculate the new profit-sharing ratio of A and B.
Ans: Share gained by A = 2/8
Gaining ratio of A and B = 2/8:0 that is 1:0 Since B has not gained anything from C, therefore, share obtained by B=0
Since B has not gained anything from C, therefore, share obtained by B=0
New share of continuing partner= Old share + share gained
A = 3/8+ 2/8= ⅝
B = 3/8+0= ⅜
Hence, a new profit-sharing ratio of A and B is= 5/8: 3/8 that is 5:3.
However, like a new ratio, there is no fixed profit-sharing formula that exists as the profit of an organization is distributed according to each partner’s varying contribution.
Partnership Profit-Sharing Ratio Problems
1. X and Y are two partners sharing profits in the ratio of 3:1. Z is admitted for 1/8th share of profits. Calculate the new profit-sharing ratio of X, Y, and Z.
Ans: Since Z’s share is given without mentioning what Z obtains from X and Y, it is assumed that Z receives a share from X and Y in their old profit-sharing ratio. Hence, the sacrificing ratio by X and Y will be= 3:1.
Firm’s share= 1
Remaining share= 1-1/8= ⅞
Now,
X’s new share= 3/4* 7/8= 21/32
Y’s new share= 1/4* 7/8= 7/32
Z’s new share= 1/8* 7/8= 7/64
New profit-sharing ratio of X: Y: Z= 6:2:1.
2. Manish, Kunal, and Vineet are partners sharing profits in the ratio of 5:3:2. Manish retires, and the new ratio between Kunal and Vineet is 2:1. Find the gaining ratio.
Ans:
Share gained = New share - Old share
Kunal = 2/3 - 3/10= (20 - 9)/30 = 11/30.
Vineet = 1/3 - 2/10= (10 - 6)/30= 4/30.
Therefore, the gaining ratio of Kunal and Vineet is = 11/30:4/30 that is 11:4.
Try to memorize different new profit-sharing ratio formulas for various instances and practice as many problems as you can to score better in the final examination.
For more such topics on partnership and solved maths, stay tuned to Vedantu’s website.
FAQs on Profit Sharing Ratio: Meaning and Calculation
1. What is a profit sharing ratio?
A profit sharing ratio defines how business profits and losses are divided among partners in a partnership firm. This ratio outlines each partner's entitlement to the net profit or loss generated by the business during an accounting period. These ratios are usually agreed upon in the partnership agreement and are expressed in terms like 2:1 or 3:2:1, representing the share each partner receives. Accurately setting the profit sharing ratio ensures fairness and transparency, helping partners avoid future disputes over income distribution. Having a clear profit sharing ratio is crucial for effective partnership management and smooth financial operations.
2. How do you calculate the profit sharing ratio?
To calculate the profit sharing ratio, you divide the total profits or losses according to the agreed ratios among partners. This process involves assigning shares based on either capital contributions, roles, or terms specified in the partnership agreement. For example, if three partners agree to share profits in a 2:2:1 ratio and the net profit is $50,000, you add the ratio parts (2+2+1 = 5) and assign to each partner: Partner 1 gets (2/5) × $50,000, Partner 2 also gets (2/5) × $50,000, and Partner 3 receives (1/5) × $50,000. Using the right calculation is key for fair profit allocation to all partners.
3. What is a good percentage for profit sharing?
A good percentage for profit sharing depends on business size, partner roles, and industry norms. There is no universal answer, as the ideal share is influenced by capital contributed, expertise, and the workload of each partner. Commonly, profit sharing ranges from 10% to 30% for passive investors, while active partners may receive higher percentages reflecting their involvement. The most appropriate percentage is one that feels fair to all parties, aligns with contributions, and motivates partners to work toward shared business goals. Regularly reviewing profit sharing percentages can help keep the partnership balanced and sustainable.
4. What is the formula for share profit?
The formula for share profit in a partnership is straightforward. You multiply the total profit or loss by the partner's profit sharing ratio. Mathematically, this is expressed as: Share of Partner = Total Profit × (Partner's Ratio / Total Ratio). For example, if the net profit is $12,000 and a partner's ratio is 3 out of a total of 6, their share is $12,000 × (3/6) = $6,000. This formula ensures each partner receives their fair portion based on the agreed profit sharing ratio, avoiding misunderstandings and maintaining transparency in profit allocation.
5. Why is profit sharing ratio important in partnership?
The profit sharing ratio is crucial in a partnership as it directly affects how earnings and losses are split. Without a clearly stated ratio, profit distribution can become unpredictable, leading to confusion and disputes among partners. It also sets expectations about financial rewards and responsibilities. A well-defined profit sharing ratio boosts trust, transparency, and teamwork within the business, helping resolve conflicts and providing a framework for handling profits or losses efficiently.
6. Can profit sharing ratios change over time?
Yes, profit sharing ratios can change if all partners agree. Reasons might include changes in capital contributions, addition or retirement of partners, or revised responsibilities. To legally change the ratio, partners typically create an amendment to the original partnership agreement, stating the new terms. Adjusting the profit sharing ratio helps keep the arrangement fair and relevant as the partnership evolves, ensuring that each partner's share matches their current role and investment in the business.
7. What happens if the profit sharing ratio is not mentioned?
If a partnership agreement does not specify a profit sharing ratio, profits and losses are usually divided equally among partners. This default provision is outlined in most partnership laws to avoid disputes and ensure fairness. For example, if there are three partners and no ratio mentioned, each will automatically receive one-third of the profits and bear one-third of any losses. Specifying a profit sharing ratio in the agreement, though, leads to better clarity and customized outcomes for the business.
8. What factors influence the determination of profit sharing ratio?
Several factors influence how a profit sharing ratio is determined in a partnership. These may include the amount of capital each partner invests, their specific skills, the effort they put into daily operations, and prior agreements. Additional roles, such as management responsibilities or bringing in key clients, can also play a part. By considering these elements, partners can set ratios that are fair and encourage commitment to the business’s long-term success.
