What is Average Profit Method?

Average Profit method is one of the simplest methods of goodwill valuation that is used commonly. In this method, the value of goodwill is calculated by multiplying the average estimated profit or average future profit with the number of years of purchase.

There are two different methods of calculating average profit which are:

1. Simple average

2. Weighted average

Simple average: In the simple average method, the goodwill is calculated by multiplying the average profit with the agreed number of years of purchase.

Goodwill = Average Profit x No. of years of purchase

Weighted Average: In the weighted average method, weights are assigned to the profits of each year with more weightage for the recent years. The goodwill is calculated by multiplying the weighted average profit with the number of years of purchase.

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

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

If the profits are observed to be constant over a period of few years then there should be equal weightage given for all the years which is the simple average method.

And if the profit is fluctuating every year then the preference shifts to weighted average method with necessary weightage given to profits obtained from recent years.