Average Profit Method

There are different methods of valuation of goodwill for a business and the valuation method to be used by the business depends on the assumptions made by the valuer.

The choice of the method of goodwill is solely based on the partnership deed that is made at the time of forming a partnership.

The various methods of goodwill valuation are:

1. Average profit method

2. Super profit method

3. Capitalisation Method

4. Annuity method

In this article we will be discussing the Average Profit Method of goodwill valuation.

What is Average Profit Method

Average Profit method is one of the simplest methods of goodwill valuation that is used commonly. In this method, the value of goodwill is calculated by multiplying the average estimated profit or average future profit with the number of years of purchase.

There are two different methods of calculating average profit which are:

1. Simple average

2. Weighted average

Simple average: In the simple average method, the goodwill is calculated by multiplying the average profit with the agreed number of years of purchase.

Goodwill = Average Profit x No. of years of purchase

Weighted Average: In the weighted average method, weights are assigned to the profits of each year with more weightage for the recent years. The goodwill is calculated by multiplying the weighted average profit with the number of years of purchase.

Weighted Average Profit = Sum of Weighted profits / Sum of weights

Goodwill = Weighted Average Profit x No. of years of purchase

If the profits are observed to be constant over a period of few years then there should be equal weightage given for all the years which is the simple average method.

And if the profit is fluctuating every year then the preference shifts to weighted average method with necessary weightage given to profits obtained from recent years.

Example of Average Profit Method

The following illustration will help in understanding the concept of Average Profit method more clearly.

Lal Chand and Co. has these profits in the following years

2010 – ₹5000

2011- ₹4000

2012- ₹5000

2013- ₹3000

2014- ₹5000

Calculate the goodwill at 4 years of purchase.

Solution

Average Profit = Total Profit / No.of years

= 5000+4000+5000+3000+5000

= 22000/5

= 4400

Goodwill = Average Profit x No. of years of purchase

= 4400 x 4

= 19600

This article was all about the topic of Average Profit Method, which is an important topic for Commerce students. For more such interesting articles, stay tuned to BYJU’S.

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