Average Profit Method

Average Profit Method of Goodwill Valuation

The Average Profit Method is the most commonly used technique for calculating goodwill when profits are relatively stable.

Formula

Goodwill is calculated using:

Goodwill = Average Profit × Number of Years' Purchase

Steps to Calculate Goodwill

Step 1: Calculate Total Profit

Add profits of previous years.

Example:

Year 1 Profit = ₹80,000
Year 2 Profit = ₹90,000
Year 3 Profit = ₹1,10,000

Total Profit = ₹2,80,000

Step 2: Calculate Average Profit

Average Profit = Total Profit ÷ Number of Years

Average Profit = ₹2,80,000 ÷ 3 = ₹93,333

Step 3: Apply Years' Purchase

Goodwill = Average Profit × Years' Purchase

If goodwill is valued at 3 years purchase:

Goodwill = ₹93,333 × 3 = ₹2,80,000

Important Adjustments

Before calculating average profit, adjust profits for:

Add Back

• Abnormal losses
• One-time expenses
• Non-recurring charges

Deduct

• Abnormal gains
• Non-operating income
• One-time profits

These adjustments ensure future maintainable profits are used.

When to Use This Method

The average profit method is suitable when:

• Business profits are stable
• Question asks for simple goodwill
• No normal rate of return is given

Final Thoughts

The Average Profit Method is easy to apply and frequently asked in Class 12 Board Exams and CA Foundation exams.

Mastering this method helps students solve goodwill valuation problems quickly and accurately.