In this method, primarily average profit is computed on the basis of the previous few years’ profits. At the time of computing average profit preventative measure must be taken with regards to any abnormal items of profit or loss which may affect profit in the mere prospect. It must be denoted that average profit may be based on either weighted average or simple average.

1. In
this method, primarily average profit is computed
on the basis of theprevious few years’ profits.
 At the time of computing average profit
preventative measure must be taken with regards to
any abnormal items of profit or loss which may affect
profit in the mere prospect
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2. 
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It must be denoted that average profit may be based
on either weighted average or simple average.
After computing average profit, it is multiplied by a
number as agreed upon.
The product will be the worth of the goodwill. The
significant drawback of this
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3. 
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method of computing goodwill is that any tendency in
the height of profitability is not reproduced in the
valuation of goodwill.
If the simple average is used, that is, every year profits
are provided the similar weightage,
no differentiation is made amongst a business that has
increasing profits and one that has dropping profits.
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4. 
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To triumph over this, it is essential to provide more
weightage to the profits of recent years.
However, if the weightedaverage profits are considered
say, for latest four years the last year must begiven a
weightage of 4, the previous year,
a weightage of 3, preceding to that, a weight of 2, and
the prime year a weight of 1.
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5. 
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To acquire the weighted average profit, the profit of the
year is required to be multiplied by its weightage, and
the aggregate total must be divided by thecollective
number of the weights.
Since goodwill values depend on a sequence of
estimates and presumptions,diverse weightings would
create diverse outcomes.
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6. 
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After computing average profit, it is multiplied by a
number as agreed upon. The outcome will be the worth
of the goodwill.
Let us discuss an illustration to understand the valuation
of goodwill under average profit method.
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7. 
X, Y and Z are partners who share profits and losses in
the ratio of 4:2:1. Theyadmit M for 1/4th share. For the
purpose of admission of M, the goodwill of theconcern
must be valued on the basis of 2 years’ purchase of last
3 years’ averageprofit. The profits were 2012-13=
$62,000, 2011-12 = $60,000, 2010-2011 =$40,000 and
2009-2010 = $65,000. Compute the value of goodwill.
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8. 
The average profit of latest three years =
$(62,000+60,000+40,000)/3 = $54,000
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The value of goodwill = $54,000 x 2 = $108,000
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