Average Profit Method, Meaning and Examples

Average Profit Method: Goodwill is a crucial element in business valuation, often determining the excess value of a company during mergers or acquisitions. One popular method to calculate goodwill is the Average Profit Method, which helps in estimating the business's worth based on historical profit performance. This method is particularly useful for businesses with steady income and can provide a reliable measure of goodwill by averaging the profits over a specific period.

In this article, we'll break down the Average Profit Method, its significance in calculating goodwill, and provide practical examples to help you understand the process.

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What is the Average Profit Method?

Select the Relevant Years: Determine the years for which the average profit will be calculated. Typically, this period includes the most recent years to ensure relevance and accuracy.

Compute the Total Profits: Sum up each year's profits to obtain the total profit over the chosen period.

Calculate the Average Profit: Divide the total profit by the number of years to compute the average profit . This provides a representative figure for the business's regular, ongoing profits.

Average Profit = Total Profit / Number of Years

Estimate the Goodwill: Multiply the average profit by the anticipated number of future profits (number of years' purchase) to determine the goodwill value.

Goodwill = Average Profit * Number of Years' Purchase

Simple Average Method: In the simple average method, goodwill is determined by multiplying the average profit by the agreed number of years of purchase.

Goodwill = Average Profit x No. Of years of purchase 

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

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

Examples of Average Profit Method

• Year 1: Profit: $100,000
• Year 2: Profit: $120,000
• Year 3: Profit: $130,000
• Year 4: Profit: $110,000
• Year 5: Profit: $140,000

Total Profit = $100,000 + $120,000 + $130,000 + $110,000 + $140,000 = $600,000

Average Profit  = Total Profit / Number of Years = $600,000 / 5 = $120,000

Let's assume the agreed number of years of purchase is 3.

Goodwill =  Average Profit x Number of Years of Purchase Goodwill = $120,000 x 3 = $360,000

So, in this hypothetical example, using the  Average Profit Method, the calculated goodwill for Company XYZ is $360,000.

Example 2 

• Total Profit = $80,000 + $90,000 + $85,000 + $100,000 + $95,000 = $450,000
• Average Profit = Total Profit / Number of Years = $450,000 / 5 = $90,000
• Assuming the agreed number of years of purchase is 4,
• Goodwill = Average Profit x Number of Years of Purchase
• Goodwill = $90,000 x 4 = $360,000

Example 3

• Total Profit = $120,000 + $130,000 + $140,000 + $120,000 + $150,000 = $660,000
• Average Profit = Total Profit / Number of Years = $660,000 / 5 = $132,000
• Assuming the agreed number of years of purchase is 5,
• Goodwill = Average Profit x Number of Years of Purchase
• Goodwill = $132,000 x 5 = $660,000

What is Goodwill?

Goodwill is an intangible asset that represents the extra value a company retains beyond its tangible assets. It includes elements such as a strong brand, loyal customer base, good employee relations, and proprietary technology. When a business is acquired, the purchasing entity may pay more than the fair value of its tangible assets, and this excess amount is considered goodwill.

Goodwill is recorded on a company’s balance sheet as an intangible asset and is subject to annual review to determine if its value has decreased, following International Financial Reporting Standards (IFRS).

Valuation of Goodwill

Goodwill thus represents the additional value a company garners through effective business operations. This surplus value stems from various facets, collectively enhancing the company's overall value. In some instances, the value of goodwill can be so substantial that gauging it through a simple process becomes challenging.  In the case of KFC, it's evident that the restaurant chain gains an edge through its brand name. Potential buyers would need to compensate the chain extra for this advantageous position in the event of an acquisition.

The monetary value a buyer will pay for this added advantage is termed goodwill.  Buyers investing in goodwill anticipate regular profits and super profits stemming from the acquired goodwill. Valuation of goodwill becomes imperative during the following:

• Alterations in profit-sharing ratios among existing partners
• A partner's retirement
• The induction of a new partner
• A partner's demise
• The dissolution of a firm where the business is sold is a going concern.

Usage of Average Profit Method in Goodwill

1. Profit Calculation: The Average Profit Method involves calculating the average profits of a business over a certain number of years. This average is computed by adding the profits of the chosen years and dividing by the number of years.
2. Exclusion of Non-Business Factors: The calculated average profit only includes the profits related to the business's regular operations. Any abnormal gains or losses and non-business incomes or expenses are excluded from this calculation.
3. Normalization: The method helps in normalizing the profits by taking into account the regular, stable earnings of the business over the chosen years.
4. Multiplication by Purchases Factor: The average profit is multiplied by a 'number of years' purchases factor, which signifies the number of years the company expects to maintain the same profit levels.
5. Goodwill Calculation: The result of this multiplication is the estimated value of goodwill for the business.

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