Profit Sharing Ratio: Meaning and Calculation

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:

1. 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. 

2. 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. 

3. 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.  

4. 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. 

5. 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:

1. 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.

2. 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. 

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