How to Calculate Goodwill Using the Super Profit Method – Explained with Formula and Examples
The Super Profit Method is an important concept in accounting and business valuation, especially for calculating the goodwill of a business or firm. Goodwill represents an intangible asset, such as reputation, customer loyalty, or a strong brand, that adds to a company’s market value beyond its tangible assets and liabilities. Understanding the Super Profit Method is essential for students and professionals in commerce, as it frequently appears in business transactions, mergers, acquisitions, and financial reporting.
Definition and Concept of Super Profit
Super profit is the extra profit a business earns over what is considered the normal expected return for its type and risk level. In other words, it is the surplus of actual or estimated future business profits over the normal profit. The normal profit is calculated as the profit that a similar business would expect to earn on its capital invested, given the average rate of return in that industry.
The core idea is that some businesses outperform the industry standard due to special advantages. Goodwill is then valued by multiplying the super profits by a specific number of years (called years of purchase).
Key Formulas Used in the Super Profit Method
| Formula | Description |
|---|---|
| Normal Profit = Capital Employed × (Normal Rate of Return / 100) | Expected profit for a similar business and risk level |
| Super Profit = Average Estimated Profit – Normal Profit | Extra earnings above normal profits |
| Goodwill = Super Profit × Number of Years of Purchase | Final value of goodwill using the super profit method |
Step-by-Step Approach to Calculate Goodwill Using Super Profit Method
- Compute the total capital employed in the business (sum of all net current assets, fixed assets, and shareholders’ equity).
- Determine the normal profit by multiplying the capital employed with the normal industry rate of return.
- Calculate the average actual or estimated profits of the business (usually average of 3-5 years).
- Compute super profit by subtracting normal profit from average estimated profit.
- Multiply the super profit by the agreed number of years of purchase to get goodwill.
Practical Example of the Super Profit Method
Suppose a company, XYZ Ltd, has capital employed of ₹20,00,000. The expected return (normal rate) from similar investments is 20%. However, the business earns an average actual profit of ₹5,00,000.
- Normal Profit = ₹20,00,000 × 20% = ₹4,00,000
- Super Profit = ₹5,00,000 – ₹4,00,000 = ₹1,00,000
- If the number of years of purchase is 3, then:
Goodwill = ₹1,00,000 × 3 = ₹3,00,000
This means the goodwill of XYZ Ltd, based on its super profits, is ₹3,00,000.
Key Principles and Applications
- The Super Profit Method is most useful when a business earns profits higher than the industry average—usually due to factors like strong brand, good management, or loyal customers.
- This method is popular in situations like business sales, merger deals, partnership changes, and corporate conversions.
- Calculations are straightforward, making the method suitable for small businesses as well as for situations that require quick goodwill estimation.
The concept also adjusts for risk since higher business risks generally reflect in higher required returns, impacting normal profit and super profit calculations.
Methods of Goodwill Valuation
| Method | Description |
|---|---|
| Market Capitalization | Goodwill = Market Capitalization - Net Identifiable Assets |
| Expected Future Earnings | Goodwill = Expected Future Earnings - (Return on Net Tangible Assets × Net Tangible Assets) |
| Super Profits (Excess Earnings) | Goodwill = Super Profit × Number of Years of Purchase |
| Capitalization of Excess Earnings | Goodwill = Excess Earnings / Capitalization Rate |
| Cost to Recreate | Goodwill = Cost to Create or Reproduce |
Advantages of the Super Profit Method
- Simple and easy to apply: Straightforward steps and formulas.
- Focuses on excess profit: Measures value generated above normal business returns.
- Suitable for small and owner-managed businesses: Quick goodwill estimation with less financial data.
- Considers business risk: Uses capitalization rates to reflect risk factors.
- Intuitive: Clearly shows value driven by brand, reputation, or relationships.
Conclusion and Further Practice
The Super Profit Method allows for logical, fair calculation of goodwill by focusing on profits made over usual expectations. It is practical for evaluating a business’s unique strengths that drive profits above the industry norm. To gain mastery, practice calculating normal profit, super profit, and goodwill with sample data and mock questions.
Explore similar commerce concepts, accounting methods, and practical business applications on Vedantu for further learning and readiness for exams or business tasks.
For other valuable commerce and accounting topics, refer to Vedantu’s resources on areas like difference between kinetic and potential energy, difference between power and energy, and energy conservation.
FAQs on Super Profit Method for Goodwill Valuation in Commerce
1. What is the super profit method of goodwill?
The super profit method is a technique for valuing goodwill based on the excess profits a business earns over normal expected profits. It involves these steps:
• Calculate average (adjusted) profit for recent years.
• Determine normal profit using capital employed × normal rate of return.
• Find super profit by subtracting normal profit from average profit.
• Goodwill is valued as: Super Profit × Number of Years’ Purchase.
2. What is the formula of super profit method?
Goodwill (Super Profit Method) = Super Profit × Number of Years’ Purchase
Where:
• Super Profit = Average Profit − Normal Profit
• Normal Profit = Capital Employed × (Normal Rate of Return ÷ 100)
3. How do you calculate normal profit and super profit?
Normal profit is the expected profit based on industry rates.
Super profit is profit above this normal level.
Steps to calculate:
1. Find normal profit: Normal Profit = Capital Employed × (Normal Rate of Return ÷ 100)
2. Compute super profit: Super Profit = Average Profit − Normal Profit
4. Why is super profit method used in goodwill valuation?
The super profit method is used when a business earns profits higher than the normal industry expectation. It values goodwill by considering only the extra earning power of the firm due to reputation, location, or management efficiency. This provides a fair amount for goodwill especially during partnership changes, mergers, or acquisitions.
5. What is the difference between average profit method and super profit method?
The average profit method uses total average profits to value goodwill, while the super profit method uses only profits above normal earnings.
• Average Profit Method: Goodwill = Average Profit × Years’ Purchase
• Super Profit Method: Goodwill = (Average Profit − Normal Profit) × Years’ Purchase
This makes the super profit method more suitable for firms with consistent excess earnings.
6. What does 'years of purchase' mean in the super profit method?
'Years of Purchase' refers to the number of years for which the business is expected to earn super profits in the future.
• It is a multiplier applied to annual super profit.
• Its value is usually set at 2 to 5 years, as per industry standard or by partnership agreement.
• Example: If super profit is ₹50,000 and years of purchase is 3, goodwill = ₹1,50,000.
7. When is the super profit method most appropriate?
The super profit method is most appropriate when:
• The business has stable excess profits over standard industry returns.
• There are unique intangible benefits like reputation or location.
• During admission, retirement or death of a partner, or when selling the business.
This method suits cases where only the excess profits justify goodwill.
8. How do you find capital employed for normal profit calculations?
Capital employed is the total investment used in a business to earn profits.
Formula:
Capital Employed = Total Assets − Outside Liabilities
It includes fixed assets plus working capital. Use balances from the balance sheet but exclude fictitious assets and non-business assets.
9. Can you provide a stepwise example of super profit method calculation?
Yes, here’s a stepwise example:
1. Average Profit: ₹4,00,000 (given)
2. Capital Employed: ₹20,00,000
3. Normal Rate of Return: 10%
4. Normal Profit = ₹20,00,000 × 10% = ₹2,00,000
5. Super Profit = ₹4,00,000 − ₹2,00,000 = ₹2,00,000
6. Number of Years’ Purchase: 3
7. Goodwill = ₹2,00,000 × 3 = ₹6,00,000
10. What are the advantages of the super profit method?
Advantages of the super profit method:
• Simple and easy to apply
• Focuses on earning power above normal expectations
• Useful for businesses with strong brand, reputation, or unique advantages
• Suitable for quick goodwill estimations
• Considers industry risk via normal rate of return
11. What types of businesses benefit most from super profit method valuation?
Businesses with strong intangibles (like brand value, unique customer relationships, prime location, or superior management) benefit most from super profit method valuation. This includes service firms, retail enterprises, and businesses consistently outperforming industry norms.
12. What adjustments should be made to average profit before using it in the super profit method?
Before using average profit in the super profit method:
• Exclude abnormal, non-recurring profits or losses
• Adjust for non-operating incomes and expenses
• Deduct partners’ remuneration (if not already considered)
• Account for tax (if question specifies profits after tax)
This ensures the average profit reflects normal ongoing business operations.
