The weighted Average Profit Method is similar to the Average Profit Method for calculating the goodwill of a firm. Under this method, the only difference is that the weights such as 1, 2, 3, 4…etc. are assigned to the profit of each year.
Generally, the highest weight is assigned to the recent year’s profit and lower weights are assigned to the past year’s profits. The product of the weights and the profit are calculated and then are added to find out the sum total of the products. This total of product is then divided by the total of the weights to compute the weighted average profit. To find out the value of goodwill under this method, the weighted average profit so calculated is multiplied by the number of years’ purchase.
The formula for calculating goodwill by this method is Goodwill = Weighted Average Profit * Number of years’ Purchase
Steps of Calculate Goodwill by weighted Average Profit Method
Step 1: Assign the weights to each year’s profit in ascending order starting from the past year’s profit. It means the lowest weight will be assigned to the most past profits and the highest weight to the most recent profits. For example, if 2012 is the current year preceded by 2011, 2010, 2009, and 2008, then the weights are assigned from 2012 to 2008 as 5, 4, 3, 2, 1.
Step 2: Multiply the weights with the corresponding year’s profit.
Step 3: Calculate the total of the products.
Step 4: Divide the total of the products by the total of the weights in order to calculate the weighted average profit.
Step 5: Multiply the weighted average profit by the number of years purchase to get the value of goodwill.
The superiority of the Weighted Average Profit Method over Average Profit Method
The weighted Average Profit Method enjoys an edge over the Average Profit Method in producing better and reliable results. This is particularly in those scenario, where profits are continuously showing an increasing or decreasing trend over a period of years. This is because the Weighted Average Profit Method assigns more weightage to the recent years’ profits. Therefore, in order to compute a reliable valuation of goodwill one should go for Weighted Average Profit Method.
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