What Is the Super Profit Method?
The computation of the super profit using this approach involves first determining the normal profit and then subtracting that figure from the average profit. The usual rate of return determines the normal profit, and the super profit is the anticipated profit that is made in addition to the typical profit. Alternatively, we may say that superprofits are additional profits, which is the same as saying that they are greater than the normal profit.
This concept is referred to as Alpha in the lingo of the stock market. The adjusted profit serves as the basis for calculating the average profit. If certain expenditures and incomes need to be changed, then adding or subtracting them according to the requirements is necessary. If there isn't any extra or super profit on the regular earnings levels, there won't be any goodwill to speak of.
Meaning of Super Profit Method
Steps for Using the Super Profit Method for Goodwill Calculation
Steps for Using Super Profit Method
The determination of goodwill utilising the super profit approach requires one to complete the stages outlined below.
Determine the entire amount of capital that the company has available. It will be the total of all the net current and fixed assets, together with the shareholders' equity.
Once you have established the usual rate of return, you can calculate the typical profit by multiplying the total capital utilised by that rate.
Determine the expected profit or the average profit that can be managed.
Determine the super profit by deducting the value of the normal profit from the predicted average profit. This will allow you to calculate the super profit.
To calculate the goodwill, multiply the super profit by the total years the business has been operating.
The standard formula for calculating normal profit is as follows:
Normal Profit = Normal Rate x Amount of capital
The super profit formula for calculating super profit is:
Super Profit = Normal Profit - Average profit
A company's goodwill may be calculated by:
Goodwill = Super Profit x Total year of Business
Capitalisation of Super Profit Method
Meaning of Capitalisation of Super Profit Method
After the computation of the super profit of other enterprises, the firm, corporation, or organisation has to know how much capital they will need to generate a profit equivalent to the other firms. This is a sort of approach utilised to know the rivals' profits and try to improve our profits as much as our competitors and give them a difficult struggle in the market. The formula is the same as in the Capitalisation of Average Profits, with the only variation being that instead of Average Profit, here we examine the Super Profits. It is computed as follows.
The formula for Capitalisation of Super Profits Method:
Goodwill’s worth = Profit x Normal Rate of Return/ 100
Conclusion
There are numerous ways to estimate goodwill worth. For example, goodwill is paid to boost profits/volume etc. It's possible that any of these approaches, depending on the field and circumstances, might have the desired effect. Remember that this is just a rough estimate and that a precise number can never be determined since the past may never be repeated exactly as predicted. Thus, in the end, the value is settled after much negotiation and consensus. This mathematical estimate is, at most, a point of reference.
FAQs on Capitalization and Superprofit Methods Explained
1. What is the Super Profit Method for valuing a firm's goodwill?
The Super Profit Method is a technique for goodwill valuation that is based on the excess profit a firm earns over the normal profit. Super Profit is the amount by which the firm's actual average profit exceeds the normal profit expected in that industry. Goodwill is then calculated by multiplying this super profit by a certain number of years' purchase.
2. How do you calculate goodwill using the Capitalisation of Average Profit Method?
This method involves two main steps to determine the value of goodwill. First, you calculate the total capitalised value of the business based on its average profits. Second, you subtract the actual capital employed from this value. The remaining amount is the goodwill.
- Step 1: Calculate Capitalised Value = (Average Profit × 100) / Normal Rate of Return.
- Step 2: Calculate Goodwill = Capitalised Value of the Firm – Actual Capital Employed.
3. What is the formula for calculating goodwill using the Capitalisation of Super Profit Method?
The Capitalisation of Super Profit Method directly capitalises the super profit to find the value of goodwill. It is a more direct approach than the capitalisation of average profits. The formula is:
Goodwill = Super Profit / Normal Rate of Return × 100.
To use this, you must first calculate the Super Profit (Average Profit - Normal Profit).
4. What is the key difference between valuing goodwill using the Capitalisation of Average Profit vs. the Capitalisation of Super Profit?
The primary difference lies in what is being capitalised. The Capitalisation of Average Profit Method first determines the total value of the business needed to earn the average profit and then subtracts the actual capital to find goodwill. In contrast, the Capitalisation of Super Profit Method directly calculates the capital needed to earn only the excess (super) profit, which itself is considered the value of goodwill. The final goodwill amount is the same under both methods.
5. Can you provide a simple example of calculating super profit?
Certainly. Imagine a firm has a Capital Employed of ₹10,00,000. The Normal Rate of Return in its industry is 10%. The firm's actual Average Profit for the year is ₹1,50,000.
First, calculate Normal Profit: ₹10,00,000 × 10% = ₹1,00,000.
Next, calculate Super Profit: Average Profit – Normal Profit = ₹1,50,000 – ₹1,00,000 = ₹50,000.
The firm's super profit is ₹50,000.
6. Why is the 'Normal Rate of Return' a crucial factor in both Super Profit and Capitalisation methods?
The Normal Rate of Return (NRR) acts as a benchmark for performance. It represents the minimum expected earnings on capital invested in a specific industry, considering the risks involved. Its importance is twofold:
- In the Super Profit Method, NRR is used to calculate the 'Normal Profit', which is then compared against the firm's actual profit to see if any excess (super) profit exists.
- In the Capitalisation Method, NRR is used to determine the total capital that should have been invested to earn a certain profit, providing a basis for valuing the entire business or its goodwill.
An incorrect NRR would lead to an inaccurate valuation of goodwill.
7. What does 'Capital Employed' mean in the context of goodwill calculation?
Capital Employed refers to the total funds invested in a business to carry out its operations and generate profits. It represents the net assets used by the firm. For goodwill valuation, it is typically calculated in one of two ways:
- Liabilities Side Approach: Capital + Reserves and Surplus – Fictitious Assets – Non-trade Investments.
- Assets Side Approach: All Assets (excluding goodwill, fictitious assets, and non-trade investments) – Outside Liabilities.
It is the base upon which normal profits are calculated.
8. In which business situations is the Capitalisation Method for goodwill valuation most appropriate?
The Capitalisation Method is particularly useful in situations where a business's earnings are stable and expected to continue consistently into the future. It is often preferred when valuing businesses with a long track record of steady profits, such as established retail stores or professional practices. Because it directly links the value of goodwill to the firm's earning capacity, it provides a logical valuation for buyers who are primarily interested in the return on their investment.
