Capitalisation of Average Profit vs Super Profit: Goodwill

You have calculated the average profit, found the normal rate of return, and reached the final line. Then comes the doubt: should you subtract capital employed, or is the answer already goodwill?

That doubt is understandable. Capitalisation of average profit and capitalisation of super profit sound almost identical. They also give the same goodwill when you use the same profit, capital employed and normal rate. But they reach that answer through different steps.

Here is the distinction to keep beside your notebook:

Let’s make that feel logical before using it in a question.

What does capitalisation actually mean?

Suppose an investment earns Rs. 15,000 each year, and the normal annual return is 10%. How much capital would normally produce that income?

Rs. 15,000 divided by 0.10 = Rs. 1,50,000.

Check it backwards: 10% of Rs. 1,50,000 is Rs. 15,000.

Capitalisation reverses the familiar calculation of return on capital. We start with annual earnings and ask what capital amount those earnings represent at a given rate.

Imagine a fruit tree. The yearly fruit is the profit; the value placed on the tree is the capital value. Counting this year’s fruit and valuing the tree are related questions, but their answers describe different things.

For goodwill, we want to identify the value associated with earning more than the normal return on the existing capital. That is why the word super matters. Super profit is the excess over normal profit, not a separate cash receipt and not the entire annual profit.

The formulas, with each answer clearly labelled

Let:

• P = average maintainable annual profit.
• C = capital employed for the question.
• R = normal annual rate of return written as a percentage number, such as 12.

Then:

Normal profit = C x R / 100

Super profit = P - Normal profit

The two capitalisation routes are:

Step	Capitalisation of average profit	Capitalisation of super profit
Start with	Average maintainable profit	Average maintainable profit less normal profit
Capitalise	P x 100 / R	Super profit x 100 / R
What that gives	Capitalised value of the business earnings	Goodwill directly
Final adjustment	Subtract C	No further subtraction of C

So:

Goodwill = (P x 100 / R) - C

or:

Goodwill = (P - C x R / 100) x 100 / R

These are the standard textbook routes described in NIOS’s lesson on admission of a partner.

Worked example 1: the same business, both routes

Meera and Kabir’s stationery business has average maintainable profit of Rs. 1,62,000, capital employed of Rs. 9,00,000, and a normal rate of return of 12%. Find goodwill using both capitalisation methods.

Route A: capitalise average profit

Capitalised value = Rs. 1,62,000 x 100 / 12 = Rs. 13,50,000.

This is not yet goodwill. It includes the value supported by the normal return on the existing capital.

Goodwill = Rs. 13,50,000 - Rs. 9,00,000 = Rs. 4,50,000.

Route B: capitalise super profit

Normal profit = Rs. 9,00,000 x 12 / 100 = Rs. 1,08,000.

Super profit = Rs. 1,62,000 - Rs. 1,08,000 = Rs. 54,000.

Goodwill = Rs. 54,000 x 100 / 12 = Rs. 4,50,000.

Stop there. The normal return has already been removed before capitalisation.

A useful check without repeating both methods

Add goodwill to capital employed, then apply the normal rate:

(Rs. 4,50,000 + Rs. 9,00,000) x 12 / 100 = Rs. 1,62,000.

We are back at the given profit. That confirms the relationship between the three amounts.

Why do the methods give the same answer?

Use the decimal rate r, where 12% becomes 0.12.

Capitalising super profit gives:

Goodwill = (P - C x r) / r

Divide both terms inside the brackets by r:

Goodwill = P / r - C

That is precisely the average-profit capitalisation formula.

In our example, the Rs. 1,62,000 annual profit contains two parts:

Annual earning component	Amount	Capital value at 12%
Normal profit	Rs. 1,08,000	Rs. 9,00,000
Super profit	Rs. 54,000	Rs. 4,50,000
Total profit	Rs. 1,62,000	Rs. 13,50,000

The normal-profit component capitalises back to the existing capital. Removing it before capitalisation or removing its capital value afterwards has the same effect.

This equality assumes matching inputs. Do not use adjusted profit in one route and unadjusted profit in the other. Do not switch between closing capital and average capital unless the question tells you to.

Professional valuations can use a different rate for excess earnings because their risk may differ. The ICAI Technical Guide on Valuation of Intangible Assets, paragraphs 5.11 to 5.14, discusses that distinction. For an ordinary school problem supplying one normal rate, use that rate consistently in both routes.

Which formula should you choose in an exam?

First, read the named method. If the question specifically asks for capitalisation of average profit, show that route. If it asks for capitalisation of super profit, show normal profit and super profit before the final answer.

If the question simply says capitalisation, the supplied information often makes one route shorter:

Information supplied	Convenient starting point
Average profit, capital employed and normal rate	Either route; average-profit capitalisation is shorter
Super profit and normal rate	Capitalise super profit directly
Assets and outside liabilities	Calculate capital employed first
Several years’ profits with unusual items	Correct the profits before choosing either route
Goodwill and a missing profit or capital figure	Rearrange the capitalisation relationship

A normal rate appearing in the question does not automatically mean capitalisation is required. Years’ purchase of super profit also needs a normal rate to calculate normal profit. The final instruction decides the final formula.

Worked example 2: when capital employed is hidden in assets

A firm gives these figures specifically for its goodwill valuation:

• Total assets at agreed values: Rs. 14,40,000, including existing goodwill of Rs. 90,000.
• Outside liabilities: Rs. 3,00,000.
• Average maintainable profit: Rs. 1,57,500.
• Normal return: 10%.

There are no other exclusions or adjustments.

Step 1: find the relevant net assets

Assets excluding existing goodwill = Rs. 14,40,000 - Rs. 90,000 = Rs. 13,50,000.

Capital employed = Rs. 13,50,000 - Rs. 3,00,000 = Rs. 10,50,000.

We are estimating goodwill afresh, so the old goodwill figure must not inflate the asset base used here. Partners’ capital is not an outside liability to deduct again.

Step 2: capitalise the average profit

Capitalised value = Rs. 1,57,500 x 100 / 10 = Rs. 15,75,000.

Goodwill = Rs. 15,75,000 - Rs. 10,50,000 = Rs. 5,25,000.

Step 3: check through super profit

Normal profit = Rs. 10,50,000 x 10% = Rs. 1,05,000.

Super profit = Rs. 1,57,500 - Rs. 1,05,000 = Rs. 52,500.

Capitalised super profit = Rs. 52,500 / 0.10 = Rs. 5,25,000.

For more practice on the asset side, use the capital employed guide.

Worked example 3: correct the profit before capitalising it

The average is only useful if it represents the earnings the question asks you to maintain. A one-time gain can make the business look stronger than its recurring operations justify.

Consider this original practice case:

Year	Reported profit	Additional information	Adjusted profit
Year 1	Rs. 1,20,000	Includes a one-time gain of Rs. 18,000	Rs. 1,02,000
Year 2	Rs. 90,000	After charging a non-recurring loss of Rs. 24,000	Rs. 1,14,000
Year 3	Rs. 1,38,000	No adjustment needed	Rs. 1,38,000

The question also says a new recurring annual expense of Rs. 10,000 will arise in future. It has not been charged in these historical profits. Capital employed is Rs. 7,20,000, and normal return is 12%.

Average adjusted historical profit:

(Rs. 1,02,000 + Rs. 1,14,000 + Rs. 1,38,000) / 3 = Rs. 1,18,000.

Maintainable profit after the new recurring expense:

Rs. 1,18,000 - Rs. 10,000 = Rs. 1,08,000.

Now capitalise:

Goodwill = Rs. 1,08,000 / 0.12 - Rs. 7,20,000 = Rs. 1,80,000.

Check by the other route:

Normal profit = Rs. 7,20,000 x 12% = Rs. 86,400.

Super profit = Rs. 1,08,000 - Rs. 86,400 = Rs. 21,600.

Goodwill = Rs. 21,600 / 0.12 = Rs. 1,80,000.

The INFLIBNET lesson on goodwill valuation explains the underlying need to remove abnormal items and consider future recurring expenses. Here, each adjustment has been stated explicitly so you can see its effect.

Do not subtract the Rs. 10,000 future expense again after arriving at Rs. 1,08,000. It is already included in that maintainable-profit figure.

Capitalisation is different from years’ purchase

Return to Meera and Kabir’s business. Average profit is Rs. 1,62,000, super profit is Rs. 54,000, and the normal rate is 12%.

Four different instructions produce these results:

Instruction	Calculation	Goodwill
Three years’ purchase of average profit	Rs. 1,62,000 x 3	Rs. 4,86,000
Three years’ purchase of super profit	Rs. 54,000 x 3	Rs. 1,62,000
Capitalisation of average profit	Rs. 1,62,000 / 0.12 - Rs. 9,00,000	Rs. 4,50,000
Capitalisation of super profit	Rs. 54,000 / 0.12	Rs. 4,50,000

The two capitalisation results agree. The years’ purchase results need not agree with them.

At 12%, the capitalisation multiplier is 100 / 12, or approximately 8.3333. It is not three merely because the question mentions three years of historical profits. The number of years used to calculate an average is a different idea from years’ purchase.

If this is the step that keeps tripping you up, revisit the super profit method with years’ purchase.

Worked example 4: find a missing profit

Goodwill calculated by capitalisation is Rs. 3,60,000. Capital employed is Rs. 8,40,000 and the normal rate is 15%. Find the average maintainable profit.

Start with the relationship:

Capitalised value = Capital employed + Goodwill.

Capitalised value = Rs. 8,40,000 + Rs. 3,60,000 = Rs. 12,00,000.

Profit = Rs. 12,00,000 x 15% = Rs. 1,80,000.

A second check is helpful:

• Super profit = Rs. 3,60,000 x 15% = Rs. 54,000.
• Normal profit = Rs. 8,40,000 x 15% = Rs. 1,26,000.
• Total profit = Rs. 54,000 + Rs. 1,26,000 = Rs. 1,80,000.

Notice why multiplying goodwill alone by 15% would give the wrong answer to this question. That gives super profit, while the question asks for total maintainable profit.

What if super profit is zero or negative?

Take capital employed of Rs. 6,00,000 and a normal rate of 10%.

Normal profit is Rs. 60,000.

If maintainable profit is also Rs. 60,000, super profit is zero. Both capitalisation routes produce zero goodwill.

If maintainable profit is only Rs. 48,000, the raw calculation becomes:

Rs. 48,000 / 0.10 - Rs. 6,00,000 = negative Rs. 1,20,000.

That tells us the earning-based capital value falls below the given capital employed. The business is still making an accounting profit, but it is earning less than the assumed normal return.

For a basic valuation question, explain that there is no positive goodwill under this method and show the shortfall if relevant. Follow any specific instruction on presenting the result. Do not turn the negative amount into positive goodwill, or invent a journal entry for a negative goodwill asset.

Valuing goodwill and deciding its accounting treatment are separate tasks.

A final-answer check that catches common errors

Before boxing your answer, ask:

1. What did I capitalise? Total profit or only excess profit?
2. Is this amount capitalised value or goodwill? Label it before proceeding.
3. Have I used the same rate throughout? Check percentage versus decimal form.
4. Have I deducted normal earnings twice? This often happens when capital is subtracted after capitalising super profit.
5. Does the answer rebuild the given profit? For matching inputs, (capital employed + goodwill) x decimal rate should equal maintainable profit.

Try these six questions

Use both routes for the first two. For the others, choose the shortest appropriate route and label your answer.

1. Average profit is Rs. 1,44,000, capital employed is Rs. 8,00,000, and normal return is 12%. Find goodwill by capitalisation.
2. Average profit is Rs. 96,000, capital employed is Rs. 6,00,000, and normal return is 10%. Find goodwill.
3. Super profit is Rs. 27,000 and normal return is 9%. Find goodwill by capitalisation of super profit.
4. Goodwill is Rs. 2,50,000, capital employed is Rs. 7,50,000, and normal return is 10%. Find average maintainable profit.
5. Average profit is Rs. 1,50,000. The normal rate is 15% and capitalised goodwill is Rs. 2,00,000. Find capital employed.
6. Super profit is Rs. 40,000 and normal return is 10%. Compare capitalisation with three years’ purchase of super profit.

Answers with short workings

1. Capitalised value = Rs. 1,44,000 / 0.12 = Rs. 12,00,000. Goodwill = Rs. 4,00,000. Alternatively, normal profit is Rs. 96,000; capitalise the Rs. 48,000 excess.
2. Capitalised value = Rs. 9,60,000. Subtract Rs. 6,00,000 to get Rs. 3,60,000. Super profit is Rs. 36,000, giving the same answer at 10%.
3. Rs. 27,000 / 0.09 = Rs. 3,00,000. There is no further deduction of capital employed.
4. (Rs. 2,50,000 + Rs. 7,50,000) x 10% = Rs. 1,00,000.
5. Rs. 1,50,000 / 0.15 - Rs. 2,00,000 = Rs. 8,00,000.
6. Capitalisation gives Rs. 4,00,000; three years’ purchase gives Rs. 1,20,000. Different final multipliers explain the difference.

Frequently asked questions

What is the formula for capitalisation of average profit?

Goodwill equals average maintainable profit multiplied by 100 and divided by the normal percentage rate, less capital employed. Keep the first calculation in brackets so you subtract capital only after capitalising profit.

What is the formula for capitalisation of super profit?

Goodwill equals super profit multiplied by 100 and divided by the normal percentage rate. Super profit is maintainable profit less the normal return on capital employed.

Why is capital employed subtracted only in the average-profit route?

Average profit includes the normal earnings attributable to existing capital. Capitalising it includes that capital value. Super profit has already excluded those normal earnings, so its capitalised value represents only the excess.

Will both capitalisation methods always give the same goodwill?

They agree when they use the same maintainable profit, capital employed and rate. Different assumptions, including a separate capitalisation rate for super profit, can produce different results.

Is capitalised value the same as goodwill?

Capitalised average profit is not goodwill by itself. Under this method, it equals capital employed plus goodwill. Capitalised super profit, however, gives goodwill directly.

Do I use years’ purchase in the capitalisation method?

Use the rate-based multiplier, 100 divided by the normal percentage rate. Use an agreed number of years’ purchase only when that method is requested. The number of historical years does not determine the capitalisation multiplier.

Should I include existing goodwill in capital employed?

In the standard school net-assets calculation for valuing goodwill afresh, exclude existing goodwill before deducting outside liabilities. Apply any other exclusions or valuation adjustments specified in the problem.

Can a profitable business have zero goodwill under this method?

Yes. If its maintainable profit is exactly equal to the normal return on capital employed, super profit is zero, so capitalised goodwill is also zero.

What should I do when the calculated goodwill is negative?

Show the calculation and explain that it indicates an earnings shortfall rather than positive goodwill under this method. Follow the question’s presentation requirements and do not change the sign merely to obtain a positive answer.

What is the quickest way to check my answer?

Add calculated goodwill to capital employed and multiply by the normal rate in decimal form. With consistent inputs, the result should equal the average maintainable annual profit used in your working.