Calculating added value is very easy. The value added formula requires only simple linear mathematical operations. We only need two data: price and cost.
Well, in this article, we discuss the value added formula at the beginning. Then, we take a simple example to calculate it. In the next section, we discuss how it is applied in economics to calculate GDP.
Value-added formulas and examples of their calculations
By definition, value added is the difference between the selling price and input costs. To calculate it, we simply subtract the selling price of the product from the cost of the inputs used to produce it. Here is the mathematical formula:
Value added = Selling price per unit – Cost of input per unit
To apply the above formula, now, let’s take a simple example. The production chain involved for making t-shirts is the following outputs:
In order to produce t-shirts, producers have to buy from inputs from fabric producers. And, fabric producers buy inputs from yarn manufacturers. Lastly, yarn producers buy cotton from farmers.
T-shirt manufacturers spend an average of $60 on fabric and sell their products at $80 per unit. Meanwhile, the fabric producer buys the yarn for $50. Finally, the yarn producer buys cotton from farmers for $40 to produce its output. The following table shows the price (output value) of each:
|Item||Output value ($)||Value added ($)|
From the table above, we can calculate the added value in each output as follows:
- Cotton =$40
- Yarn = $50 – $40 = $10
- Fabric = $60 – $50 = $10
- Shirt = $80 – $60 = $20
As you can see, these producers add value by being able to market their outputs at prices higher than the dollars they pay input suppliers. The higher the positive difference between selling price and input costs, the more valuable a product is.
And to deliver high added value, it requires innovation either to make customers willing to pay more or to lower costs. Companies can do this, for example, by adding additional features or functionality to the product, processing input more efficiently, or branding. Thus, by innovating, they provide higher added value to their products.
On the other hand, because they have to compete with competitors, companies are also considering developing competitiveness. The added value they offer must also be attractive to customers, so they are willing to buy. In other words, they must provide better added value than competitors.
With better added value, consumers have a reason to buy the company’s products. When successful in doing so, the company can generate sales and profits.
On the other hand, if not, for example, because the added value is not better than competitors’ products, the company does not generate revenue, not even profit. Consumers prefer competing products than buying company products.
Calculating GDP using the value added approach
Gross domestic product (GDP) represents an indicator to measure the output of economic activity. GDP represents the monetary value of all final goods and services produced in an economy. And, the discussion can be found when we learn about macroeconomics .
The value added approach is one of two ways to calculate GDP. Another approach is to add up the values of all final goods and services.
- The value-of-final-output approach . Under this approach, we calculate the value of GDP by aggregating the values of all final outputs produced during a given year. We exclude intermediate output values to avoid double counting because their values are already reflected in the final output prices along the production chain. To overcome this, we can apply a value-added approach.
- Value-added approach (value-added approach) . We add up the value added output at each stage of the production and distribution process. Under this approach, we take into account the value added of intermediate output.
To see how both approaches work, let’s take the simple example above. Assume an economy produces only T-shirts. It represents the final product. T-shirt manufacturers sell their products for $80 per unit. Thus, under the value-of-final-output approach, GDP is equal to $80.
Meanwhile, under the value-added approach, we have to calculate the value added by each manufacturer along the clothing production chain, where respectively are:
- Cotton =$40
- Yarn = $10
- Fabric = $10
- Shirt = $20
If we add up all four, it equals $80 = ($40 + $10 + $10 + $20). We can see, it’s the same as the price of a t-shirt.
But, if we add up the output values in each production chain, it results in a double calculation. GDP would be worth $230 = $40 + $50 + $60 + $80, much higher than the true value of $80. Why did that happen?
That’s because we take into account the value of each input in each production chain, even if it is the supplier’s contribution. For example, a t-shirt manufacturer actually adds only $20, not $80. The $80 price includes not only the value he adds but also the value of the input he buys (the $60 cloth).
How is added value different from profit
Although we may see similarities, value added and profit are two different concepts. First, value added only takes into account the difference between the selling price and direct costs, namely the costs of inputs used to produce.
Meanwhile, profit can take into account direct and indirect costs. Examples of indirect costs are marketing costs, administrative costs and general costs. In this case, we calculate operating profit.
Second, when we calculate the company’s profit, we also take into account the quantity sold, while the value added does not. I mean, the company may still generate added value regardless of whether the product is sold or not. But, to make a profit, the company must be able to sell the product.
Profit = Revenue – Cost = Revenue per unit – Cost per unit
Now, assume the company charges the same price for all its products. So, the revenue per unit above will be the same as the selling price if the company is able to sell the product. If there are no sales, the profit will be equal to zero.
Thus, the company can only make a profit if it adds value and can sell the product. In some cases, a company may produce value-added products but not sell any products. So, the profit will be equal to zero. Why this happened? Why can’t companies sell products?
Now, assume you are running a business. To meet and satisfy the needs and wants of consumers, you have to compete with other companies. Your company may offer added value, but it is no better than your competitors. As a result, consumers are not willing to buy your product and choose a competitor’s product.
The second factor is changes in consumer tastes and preferences. It affects your consumer’s interest to buy. They may not buy your product perhaps because, for example, it is not environmentally friendly. Your product does not live up to the values and principles they adopt.
Then, assume, you managed to book a sale. In this case, your company will make more profit if you add more value, sell more or combine the two.