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Added Value: Definition, Why It Matters, Formula

Updated on · By Ahmad Nasrudin Tag: ,

Added Value Definition Why It Matters Formula
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What’s it: Added value is an improvement or addition to something to make it more valuable. Businesses do this by processing inputs into outputs and increasing their value. It creates value when consumers are willing to pay output higher than the dollar paid to input suppliers. So, mathematically, it equals the selling price minus the input costs.

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The added value can take on a physical or non-physical dimension. For example, when processing wood into furniture, the furniture company changes its shape. In other cases, they provide free installation service at the customer’s home. It also adds value to their furniture products.

What is the relationship between the added value and the selling price?

Businesses create value for their customers by adding value to their offerings. It is successful if the customer is willing to pay more, allowing the business to charge a higher price than the input costs.

Conversely, if there is no added value, there is no opportunity for the business to sell at a high price. In fact, there is no demand. They cannot sell products because consumers are reluctant to buy.

For such reasons, adding value is vital to business continuity. Without it, they cannot make a profit.

Why is the added value important?

Businesses must add value to operate profitably. Therefore, they must be able to sell their output for more than the dollars they pay suppliers. That way, they still have money left over to cover other costs – apart from input costs – and earn a net profit.

Adding value can make the difference between surviving and failing. And failure to make a profit can bankrupt the business. Several reasons explain why added value is vital to a business.

  • Earn more profit by setting higher prices.
  • Create attractiveness and differentiate it from competitors’ products.
  • Drive customer loyalty by satisfying them.
  • Divert customers away from competitors.
  • Increase market share and strengthen market position.
  • Save long-term costs, such as promotions.

Let’s get a little out of context above. Value added is also important for calculating the economy’s output. When we calculate gross domestic product (GDP), we can use two approaches:

  1. Summing up the monetary value of the final goods and services produced by the economy in a given period.
  2. Summing up the added value generated along the production chain in the given period.

The second approach above is to avoid double-counting when we count all goods and services using the first approach. That’s because we include intermediate goods into the GDP calculation. In fact, their value is already included when calculating the value of final goods and services.

Earn profit

By adding value, businesses attract more consumers. As a result, they are willing to spend more money to buy. And, for businesses, they can charge more than input costs.

Take cotton for making clothes as a simple example. Household consumers will not buy it because it cannot be used directly. They have to process it first before they can use it.

But, if your business processes it into clothing, the price can increase several times over. So you could sell it at a higher price than cotton.

On the other hand, despite paying a higher price, consumers are willing to buy. As a result, clothes can meet their needs more than just cotton.

So adding value allows businesses to charge customers higher prices than the dollars they spend paying suppliers. The higher added value should be positively correlated with the profits they generate.

Differentiate the product offered

Adding value is a way to differentiate your product from other products in the market. As a result, customers have reasons to continue to buy your product over your competitor’s products.

Since many competitors exist in the market, the value your business adds must be better than your competitors. It is a way to secure long-term profits. You can satisfy your customers better than your competitors can. In this case, you are creating a luring factor for the customer.

Success in creating value for customers and outperforming competitors doesn’t just make your customers loyal. Your competitors’ customers are likely to switch to your product.

There are several ways to create added value and differentiate offerings, depending on the nature of each business. For example, smartphone companies may add new features such as a larger capacity to attract consumers. Or, they embed a high-resolution camera into their new product.

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Meanwhile, the restaurant will probably create a cozy atmosphere. So, visitors feel at home. Or, they have superior service and friendly staff.

Build strong long-term relationships

Customer loyalty is indeed important to secure money in the long run. But, it also requires businesses to continue to maintain their existing edge.

Competition in the market is dynamic. Some new competitors may emerge and offer better alternatives. Or, existing competitors change their competitive strategies and are effective at diverting your customers’ purchases. And for this reason, your business should always be able to deliver higher levels of customer satisfaction to drive loyalty.

When customers are always satisfied with your product, they don’t just keep buying. However, they are also likely to recommend your product to their relatives or people around them. Or, they give a positive review and share it on their social media. It can all save promotion costs.

And, ultimately, adding value is how you satisfy your customers. Your success in doing so makes your business have a strong bond with customers in the long term.

What is the difference between the value added and net profit?

The added value is not equal to the net profit of the business. By definition, the added value is the difference between the selling price of the product and the cost to produce it. It excludes other costs such as marketing or financial costs.

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Meanwhile, net income takes into account all costs. Thus, it equals total revenue minus all expenses.

In addition, business revenue does not only come from selling products or providing services. Businesses may invest their idle money into financial markets to earn interest income or capital gains. Then, they might also earn some money by selling some old equipment. We include these when calculating net income but not when calculating added value.

How to calculate added value?

The formula for calculating the added value is easy. First, you need selling price data. Then, you subtract it with the input costs. Here is the mathematical equation:

Value added = Selling price – Input cost

Take a simple example. Your business spends $500 to produce an output. Then, you set the selling price at $750 per unit. As a result, your business generates an added value of $250 ($750-$500).

The positive difference between the two represents your profit. But, as I’ve mentioned, it’s not a net profit. You have to add up other revenue and costs to get a net profit.

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How to add value?

There are many ways to add value. First, it may involve changing the form of the input. For example, manufacturers convert bauxite into the aluminum plate, then use it as a car body.

Second, adding value can also involve other aspects without being directly related to converting inputs. An example is branding as done by famous fashion designers. Providing support services such as free shipping of goods is another example.

In addition to the examples above, there are several ways to add value, including:

  • Added new features, such as embedding higher resolution cameras on smartphones.
  • Improve performance, for example, developing new versions of software with faster processing speeds.
  • Provide excellent service as consultants do through their solution suggestions.
  • Offer convenience, such as what restaurants and hotels do, which makes visitors feel at home.
  • Save consumers time as offered by fast-food restaurants.
  • Make it easy for customers to get product benefits, such as free installation services at customers’ homes.
  • Offering superior design as luxury jewelry manufacturers do.
  • Friendly and sincere service like how the staff handles complaints and smile when shoppers arrive.
  • Reducing search costs such as by promoting products, making products easily recognizable.
  • Provide customized services, such as designing clothes according to each customer’s unique demands.
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