Average Profit Method – Calculation & Steps

Introduction

The simplest method of valuation. It assumes that the past profits are a good indicator of future profits.

1. Simple Average Profit Method

Formula:

Value of Goodwill = Average Profit × Number of Years' Purchase

Steps:

1. Calculate Adjusted Profit for each year (Remove abnormal items).
2. Average = Total Adjusted Profits / Number of Years.
3. Goodwill = Average × Years' Purchase.

Adjustments (Crucial)

To find "Normal Business Profit":

• Add: Abnormal Losses (Loss by fire, Voluntary Retirement Compensation, Loss on sale of asset).
• Less: Abnormal Gains (Insurance claim received, Profit on sale of asset, Dividend income).
• Less: Partners' Remuneration (if not deducted).
• Less: Tax (if we need after-tax profit).

2. Weighted Average Profit Method

Used when profits show a Trend (Rising or Falling).

• Recent years are given higher weight (more important).

Formula:

Weighted Average Profit = Total Product / Total Weights Goodwill = Weighted Average Profit × Number of Years' Purchase

Table:

Weighted Avg = 79,000 / 6 = 13,167.

Illustration

Problem: Calculate Goodwill at 3 years' purchase of Average Profit of last 3 years.

• 2021: Profit 40,000 (Includes abnormal gain 5,000).
• 2022: Profit 50,000 (After charging loss by fire 10,000).
• 2023: Profit 45,000.

Solution:

1. Adjust Profits:
   • 2021: 40k - 5k = 35,000.
   • 2022: 50k + 10k = 60,000.
   • 2023: 45,000.
   • Total: 1,40,000.
2. Average: 1,40,000 / 3 = 46,667.
3. Goodwill: 46,667 x 3 = 1,40,000.

Exam Notes: Writing the Answer

Important Note: If the problem says "Weighted Average" but does not give weights, usually use 1, 2, 3, 4... for respective years.

"Years' Purchase": This means "For how many future years do we expect this profit to continue?". It will be given in the question. Don't confuse it with Number of Past Years.

Summary

• Logic: Past predicts Future.
• Simple Avg: For fluctuating profits.
• Weighted Avg: For Rising/Falling trends.
• Abnormal Items: Must be reversed.

Quiz Time! 🎯

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