Super Profit Method of Calculating Goodwill

Goodwill is an intangible asset of a business. It means the good reputation a business earns through honesty, quality products, and good customer service. Because of goodwill, a business can earn more profit than normal. It also helps in earning profits in the future, as customers keep coming back. So, if one firm earns more profit than others in the same industry, it is often because of goodwill. It acts like a force that attracts old customers to the business.

Meaning of Super Profit Method:

uper profit is the extra profit a business earns over the normal profit. Goodwill is calculated by multiplying the super profit by the number of years’ purchase agreed upon.Profit is earned from the capital employed in a business. Some businesses earn more profit than others even with the same investment. Normal profit is the expected return on capital for similar businesses.

The Formula of Super Profit Method:

Super Profit = Actual Average Profit - Normal Profit

Goodwill = Super Profit x Number of Year Purchase

Steps of Super Profit Method of Calculating Goodwill:

1. Calculate the Average Capital Employed:

Average Capital Employed =  \frac{Opening~Capital~Employed+Closing~Capital~Employed}{2}

Where, Capital Employed = Capital + Free Reserves - Fictitious Assets

2. Calculate the actually expected profit, i.e., average profit:

Average Expected Profit =   \frac{Total~Profits~of~the~Past~Years}{Number~of~Years}

3. Calculate the normal profit on average capital employed by:

Normal Profit = \frac{Average~Capital~Employed\times Normal~Rate~of~Return*}{100}

* Normal Rate of Return refers to the rate of return normally earned by other firms in the same industry.

4. Calculate the Super Profit:

Super Profit = Actual Average Profit - Normal Profit

5. Calculate the value of Goodwill:

Goodwill = Super Profit x Number of Years' Purchase 

Illustration 1: 

The net profit of a firm earned during the past four years is as follows:

The capital employed by the firm is ₹45,000 and the normal rate of return is 8%. Calculate the value of goodwill based on the past three years' purchase of the average super profit for the last four years.

Solution: 

Calculating Average Expected Profit:

Average Expected Profit = \frac{₹31,600-₹29,500+₹26,200+₹32,700}{4}
= \frac{61,000}{4}
= ₹15,250

Calculating Normal Profit:

Normal Profit = \frac{Average~Capital~Employed\times Normal~Rate~of~Return*}{100}
=  \frac{45,000\times8}{100}
= ₹3,600

Calculating Super Profit:

Super Profit = Average Expected Profit - Normal Profit
= ₹15,250 - ₹3,600
= ₹11,650

Calculating Goodwill:

Goodwill = Super Profit x Number of years purchase
= ₹11,650 x 3
= ₹34,950

Illustration 2: 

M and N are partners sharing profit and losses in the ratio of 2:3. P is the new partner to be admitted in the firm of 2/3rd share. For this purpose, goodwill has to be valued at two years' purchase of super profit. The average maintainable profit of the firm is ₹53,000. The normal rate of return is to take 10% and the capital investment of the firm is valued at ₹1,94,600. Calculate the value of Goodwill.

Solution: 

Calculating Normal Profit:

Normal Profit = \frac{Average~Capital~Employed\times Normal~Rate~of~Return*}{100}
= \frac{1,94,600\times 10}{100}
= ₹19,460

Calculating Super Profit:

Super Profit = Average Expected Profit - Normal Profit
= ₹53,000 - ₹19,460
= ₹33,540

Calculating Goodwill:

Goodwill = Super Profit x Number of years purchase
= ₹33,540 x 2
= ₹67,080

Illustration 3: 

A firm earned the net profits during the last three years as follows:

The capital employed in the firm is ₹3,40,000, and a fair return on capital is 17%. Calculate the value of goodwill of the firm based on three years' purchase of average super profit.

Solution: 

Calculating Average Expected Profit:

Average Expected Profit =  \frac{Total~Profits~of~the~Past~Years}{Number~of~Years}
=  \frac{₹28,400+₹15,300+₹21,700}{3}
=  \frac{65,400}{3}
= ₹21,800

Calculating Normal Profit:

Normal Profit =  \frac{Average~Capital~Employed\times Normal~Rate~of~Return*}{100}
=  \frac{1,00,000\times 17}{100}
= ₹17,000

Calculating Super Profit:

Super Profit = Average Expected Profit - Normal Profit
= ₹21,800 - ₹17,000
= ₹4,800

Calculating Goodwill:

Goodwill = Super Profit x Number of years purchase
= ₹4,800 x 3
= ₹14,400

Related Articles:

• Capitalisation Method of Calculating Goodwill
• Accounting Treatment of Accumulated Profits and Reserves: Change in Profit Sharing Ratio
• Change in Profit Sharing Ratio: Accounting Treatment of Investment Fluctuation Fund