Average Profit Method: A Brief Overview
There are three methods to commute the goodwill of the firm: the Average Profit Method, Super Profit Method, and Capitalisation Method. In the case of the valuation of goodwill under the method of average profit, the goodwill can be measured by the simple average profit method and the weighted average profit method. In this context, weighted average profit is briefly discussed along with its formula and computation method.
What is the Weighted Average Profit Method?
Being an intangible asset, the valuation of goodwill is a complicated task; hence, method selection plays a major role in determining its value. So the very basic method is the average profit method. To determine the goodwill valuation under this method, the average profit of all the given years is multiplied by the year of purchases specified in the question.
In the case of weighted average profit, the weights are assigned in the question, or the weights are given in ascending order, meaning less weight to the later years and more weight to the most recent years. It is considered a better-than-average method due to the allocation of weights to specific years.
The number of years of purchase means the specific number of years in which the business will earn the same amount of profits due to the efforts made by the company during its previous years. The weighted average method of calculating goodwill is used when different weights are given for different years.
Weighted Average Profit Formula and Computation
Steps to be followed while computation of goodwill in case of the weighted average profit method:
Step 1: Computation of weighted average profit is as follows:
Fill in the details in the above manner to arrive at the total of profit and weight.
Step 2: The formula of weighted average profit is as follows
Weighted Average Profit= Total of the product of profit and weights/Total of weights
Step 3: Valuation of goodwill is computed as follows:
Value of goodwill= Weighted average profit X Number of years of purchase
Hence after following the above procedure we can arrive at the value of goodwill as per the weighted average profit method.
Conclusion:
Lord Lindley states, “The term goodwill is generally used to denote the benefit arising from the connection and reputations.” It is directly related to the profits earned by the organisation, and it has added advantage over the other organisations in the same industry. Goodwill can be classified into two categories: purchased goodwill, which is acquired by paying consideration in cash or kind, and self-generated goodwill, which is generated from the company's efforts to outshine the markets.
FAQs on Valuation of Goodwill Using Weighted Average Profit Method
1. What exactly is the weighted average profit method for valuing goodwill?
The weighted average profit method is a way to calculate the value of a business's goodwill. It gives more importance to the profits earned in the most recent years. The main idea is that the latest profits are a better indicator of how the business will perform in the future.
2. What is the step-by-step process for calculating goodwill using this method?
To calculate goodwill using the weighted average profit method, you follow these steps:
- Step 1: Calculate the adjusted profit for each past year by removing any unusual or non-recurring income or expenses.
- Step 2: Assign 'weights' to each year's profit, giving the highest weight to the most recent year (e.g., 1, 2, 3 for three consecutive years).
- Step 3: Multiply each year's adjusted profit by its weight to get the 'product'.
- Step 4: Calculate the Weighted Average Profit by dividing the total of all products by the total of all weights.
- Step 5: Finally, calculate Goodwill by multiplying the Weighted Average Profit by the agreed 'number of years' purchase'.
3. Why is the weighted average profit method often preferred over the simple average profit method?
The weighted average profit method is preferred when there is a clear trend in profits (either increasing or decreasing). Unlike the simple average method, which treats all years equally, this method gives more value to recent performance. This provides a more realistic and forward-looking valuation of goodwill because recent trends are more likely to continue in the near future.
4. When is it most appropriate to use the weighted average profit method?
This method is most suitable when a business's profits show a consistent upward or downward trend over the last few years. If profits are fluctuating randomly without a clear pattern, the simple average profit method might be more appropriate. The weighted method is specifically designed for situations where a trend exists.
5. What are the main methods for valuing goodwill in accountancy?
In accountancy, goodwill is typically valued using one of three main methods, each with its own variations:
- Average Profit Method: This includes the Simple Average Profit and the Weighted Average Profit methods.
- Super Profit Method: This method calculates goodwill based on profits earned above the normal industry average.
- Capitalisation Method: This can be based on either the capitalisation of average profits or the capitalisation of super profits.
6. Can you show a simple example of how to calculate weighted average profit?
Certainly. Imagine a business has profits for the last three years:
- Year 1: ₹80,000 (Weight: 1) → Product: ₹80,000
- Year 2: ₹90,000 (Weight: 2) → Product: ₹1,80,000
- Year 3: ₹1,00,000 (Weight: 3) → Product: ₹3,00,000
First, find the total of products: ₹80,000 + ₹1,80,000 + ₹3,00,000 = ₹5,60,000.
Next, find the total of weights: 1 + 2 + 3 = 6.
The Weighted Average Profit = Total of Products / Total of Weights = ₹5,60,000 / 6 = ₹93,333 (approx).
7. What is the logic behind assigning different weights to different years?
The logic is that a business's recent performance is a much better predictor of its future earnings than its performance from many years ago. By assigning a higher weight to the most recent year's profit, you are acknowledging that the current state of the business (its market position, customer base, and operational efficiency) is more relevant for a future-looking valuation like goodwill.
8. Are there any disadvantages to using the weighted average profit method?
Yes, there are some limitations. The biggest one is that the choice of weights can be subjective and can be influenced by the buyer or seller to arrive at a desired valuation. Additionally, this method is not very effective if profits are highly erratic and show no clear trend. It also focuses only on profits and ignores the value of assets used to generate them.
9. How are the 'weights' and 'number of years’ purchase' decided in a real-world business deal?
In a real business scenario, these figures are determined by negotiation between the buyer and the seller.
- Weights are typically assigned in a simple ascending order (1, 2, 3...) to give more importance to recent years, but the parties must agree on this.
- The 'number of years’ purchase' reflects how long the buyer expects the firm’s excess earnings to continue. This is influenced by factors like the company's reputation, industry stability, and competitive advantage.
There is no fixed rule; it's a matter of mutual agreement based on perceived value and future potential.
