Under Average Profit Method, goodwill is calculated on the average basis of the normal average profits of the last few years. To find out the value of goodwill only the normal profits of the business for specified years are taken into consideration in this method. It means all the abnormal gains or losses and all non-business incomes or expenses are ignored while calculating the profits of a particular year.
The profits so calculated for different years is then added and their average is computed. This average profit is then multiplied by the number of years’ purchases to ascertain the value of goodwill.
The formula for calculating goodwill under this method is Goodwill = Average Profit * Number of years Purchase
Number of years’ of purchase implies the number of years for which the firm expects to earn the same amount of profits.
Steps to Calculate the Goodwill by Average Profit Method
Step 1: Ascertain the total normal profits of the business for the past given years.
Step 2: Add all abnormal losses such as loss by fire, theft, etc., to the normal profits (as mentioned above ). This is because these are not incurred in the normal course of a business.
Step 3: Subtract all abnormal gains such as winnings from lottery, speculation, etc., from the normal profits. This is because these are not earned in the normal course of a business.
Step 4: Add all normal business income that was not previously added to the normal profits and subtract all normal business expenses that are not subtracted previously.
Step 5: Subtract all non-business income, i.e. income earned from outside the business of the firm.
Step 6: Add all the profits for different years after considering all the above steps to find out the total profits of the past given years.
Step 7: Calculate the average profits by dividing the total profits (calculated above) by number of years.
Step 8: Multiply the above calculated average profits by the number of years’ purchases to get the value of goodwill.
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