What Does the Value Added Method of Measuring National Income Mean?
There are three methods for calculating national income namely Income Method, Expenditure method, and Value Added Method. In this article, we will understand the value-added method for calculating national income. The value-added method is used to calculate the national income in different stages of production in the circular flow. It represents the contribution (value-added) for each producing unit in the production process.
Every individual organization adds a certain value to the product, which it purchases from some other firm as intermediate goods. When the value added by every individual organization is summed up, we get the value of national income.
What is the Value Added Method?
Value-added refers to the additional value to the raw material (intermediate goods) by an organization, using its production activities. It is calculated as the difference between the value of output and the value of intermediate goods. The value-added method is a widely used method for calculating national income as it avoids double counting, which is quite a serious error while estimating national income.
Value Added: Value of Output - Value of Intermediate Goods ( Raw Materials)
What are the other Names of value added methods?
The value-added method for calculating national income is also known as:
Product Method
Inventory Method
Net Output Method
Industry Origin Method, and
Commodity Service Method
Value Added Method Example
Suppose a baker requires only flour to produce goods. He purchases flour from the miller as an intermediate good worth Rs.30 and using its producing activities convert the flour into bread and sell the bread for Rs. 50.
In This Example:
Flour is an intermediate good and its value is Rs.30 and is known as the value of intermediate consumption.
Bread sold to the baker is output and intermediate consumption is known as value-added. It implies that the baker has added a value of Rs. 200 to the flow of final goods and services in the economy.
As we have discussed above, the difference between the value of output and the value of intermediate goods is termed as a value-added method. It implies that the baker has added a value of Rs. 20 to the total flow of final goods and services in the economy.
What Does Intermediate Consumption Mean?
The use of intermediate goods in the production process is termed intermediate consumption and expenditure on them is known as intermediate consumption expenditure. In the example given above, flour is an intermediate good for the baker.
Flour is considered an intermediate good because its value is merged with the value of bread. However, any machinery purchased for baking bread is not considered as an intermediate consumption because its value will not be included in the value of intermediate consumption.
What Does the Value of Output Mean?
Value of output refers to the market value of all goods and services produced during one year.
What are the Steps of Value Added Methods?
The main steps for estimating national income by the value-added method are:
Step 1: The first step is to recognize and classify all the producing units of an economy into primary, secondary, and tertiary sectors.
Step 2: In this step, we will calculate the Gross Domestic Product at Market Price (GDPMP). For calculating (GDPMP), we will calculate Gross Value Added at Market Price (GVAMP) of each sector and total of (GVAMP) gives (GDPMP) i.e. ∑GVAMP = GDPMP
Step 3: Now, we will calculate domestic income (NDPFC). For calculating domestic income, we will subtract the amount of depreciation and net indirect tax from the Gross Domestic Product at Market Price (GDPMP). This means NDPFC - Depreciation - Net Indirect Taxes.
Step 4: Now, we will calculate net factor income from abroad (NFIA) to get national income. In this step, NFIA is added to the domestic income to get the national income of the country i.e. NFIA + NDPFC = NNPFC
Precaution of Value Added Method
Following are the precautions to be considered in the value-added method:
Intermediate goods must not be added to the National Income as these are already added to the value of final goods. If included again, it will result in double counting.
Dealings (sale and purchase) of second-hand goods should not be included in this calculation. These goods are already included in the financial year in which they were produced, and they are not added to the current flow of goods and services. However, any brokerage fee or commission paid on any sale or purchase of such products are to be included in this calculation as it is a productive service.
Self-consumption services, i.e. domestic services like services of a housewife are not to be included in the national income calculation as it is challenging to figure out the market value of such work. These are produced and consumed within a household, and they do not enter the market. Therefore, these are regarded as non-market transactions. However, paid services like maids, drivers, etc. should be mentioned.
On the other hand, self-consumption goods should be counted in national income calculations because they contribute to the output of a financial year. However, their value is to be estimated as these products are never sold in the open market.
The estimated value of houses owned by individuals should be included. The reason is, owners who live in their own homes are enjoying similar housing services like people who live in rented places. Hence, the value of such services is estimated as per the market rate. This estimation is known as imputed rent.
Any changes in the inventory must be included in this calculation. Net increase in inventory stocks is involved in national income calculation as a part of capital formation.
Problems of Double Counting
While calculating national income, only the value of final goods and services is to be added. The problem of double counting occurs when the value of intermediate goods is also included with the value of final goods.
Double counting refers to the situation where the value of a product or expenditure is counted more than once. A commodity passes through the different stages of production before reaching the final stage. When the value of a commodity is calculated at each stage of production, it is likely to include the cost of input more than once. This situation leads to double counting.
Let us Understand with an Example:
Suppose, a farmer produces 70 kg of wheat and sells it to the miller (flour mill) for Rs 700 to miller (flour mill). For farmers, wheat of Rs 700 is a final product. (If the intermediate cost for a farmer is zero, then his total value-added will be Rs 700).
For a miller (flour mill), wheat is considered as his intermediate good. Miller converts wheat into flour and sells it for Rs 900 to a baker. Now, flour of Rs 900 is a final product for the Miller. (Value added by miller = 900 – 700 = Rs 200)
For the baker, flour is considered as her intermediate good. Baker manufactures bread from flour and sells the entire bread to final consumers for Rs 1.100. Bread of Rs 1,100 is a final product for the baker. (Value added by baker = 11,00 – 900 = Rs 200)
In the given example, wheat is a final product for farmers, flour is the final product for the miller and bread is the final product for the baker. As a general rule, every producer treats his commodity as the final output. It means: Total value of output = 700 + 900 + 1,100 = Rs 2700. However, we can see in the given example that each transaction contains the value of intermediate goods.
Here, the value of wheat is included in the value of flour and the value of flour is included in the value of bread. As a result, the values of wheat and flour are counted more than once. This causes a double-counting issue as it leads to an overestimation of the value of goods and services produced. To calculate the value of national income precisely, we must avoid this problem of double counting.
FAQs on Value Added Method for National Income Calculation
1. What is an example of a value added method?
An example of the value added method is calculating the total value added by all firms in producing a final product, like bread. Each stage, such as wheat farming, milling, and baking, adds value, and these are summed to find the overall contribution to national income.
2. What is the formula for value added?
The formula for value added is:
- Value Added = Value of Output − Value of Intermediate Consumption
3. What is the value added approach?
The value added approach is a method to calculate national income. It adds the value each firm adds to its products at every stage of production, preventing double counting. This economic technique helps measure the real contribution of different industries to the economy’s GDP.
4. What is a value added example?
A value added example can be seen in the car industry. If a factory buys steel for $2,000 and sells a car for $20,000, the value added is $18,000, showing the increase in value created by assembling and marketing the car.
5. How does the value added method prevent double counting?
The value added method avoids double counting by subtracting the cost of intermediate goods from total output. This ensures that only the actual value created at each production stage is included in calculating national income or GDP, eliminating repeated counting of the same value.
6. Why is the value added method important in economics?
The value added method is important because it gives a true measure of an economy’s productive power. By only counting the additional value created, it accurately tracks how much each firm, sector, or industry actually contributes to national income or GDP.
7. What are the main steps in the value added method?
Main steps in the value added method include:
- Calculating output value for each firm
- Subtracting intermediate goods or services costs
- Summing up net values across all sectors
8. What is intermediate consumption in the value added method?
Intermediate consumption refers to all the goods and services a firm uses up in the production process, like raw materials or energy. It is subtracted from output value to avoid counting these costs multiple times when using the value added method.
9. How do you calculate total value added for an economy?
To calculate total value added for an economy, sum the value added by all industries. For each firm, subtract intermediate costs from output, then add these net values across the economy. Mathematically, $$\text{Total Value Added} = \sum (\text{Output} - \text{Intermediates})$$.
10. What advantages does the value added method offer over other methods?
The value added method offers these advantages:
- Avoids double counting
- Shows actual contribution of each firm
- Makes cross-sector and international comparisons easier
11. Where is the value added method used in practice?
The value added method is commonly used in national accounting to estimate Gross Domestic Product (GDP). Governments and economists rely on this method for accurate GDP calculation and to assess the productivity of various economic sectors or industries within a country.
