Calculating added value is straightforward. The value-added formula requires only simple linear mathematical operations. We only need two data: price and cost.
Well, in this article, we discussed the value-added formula at the beginning. Then, we take a simple example to calculate it. Then, in the next section, we discuss how it is applied in economics to calculate GDP.
Value-added formula 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 to make t-shirts are the following outputs:
To produce t-shirts, producers have to buy from inputs from fabric producers. And fabric producers buy inputs from yarn producers. 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, by applying the previous formula, we can calculate the added value in each output as follows:
- Cotton =$40
- Yarn = $50 – $40 = $10
- Fabric = $60 – $50 = $10
- T-shirt = $80 – $60 = $20
As you can see, the producers above add value by market their output at a price higher than the dollar they pay the input supplier. The higher the positive difference between the 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 also consider 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 over buying company products.
Calculating GDP using the value-added approach
Gross domestic product (GDP) measures the final output in an economy. It represents the monetary value of all final goods and services produced in an economy during a given period. And, we can find this concept 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.
- 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 the value-added approach.
- Value-added approach. We sum 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. The t-shirt manufacturer sells its product 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 the 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 consider the value of each input in each production chain, even if it’s the supplier’s contribution. For example, a t-shirt manufacturer actually adds only $20, not $80. The $80 price includes the value it adds and the input it buys (the $60 cloth).
How is added value different from profit?
Although we may see there are similarities, added value and profit are two different concepts. First, value-added only considers 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 consider the quantity sold, whereas 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 of its products. So, if the company can sell the product, the revenue per unit above will be the same as the selling price. If there were no sales, profit would 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 did this happen? Why can’t companies sell products?
Now, assume you are running a business. To satisfy the consumers’ needs and wants, 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 do not prefer 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. As a result, 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 it adds more value, sells more, or combines the two.
What to read next
- Value Creation: Definition, Shareholder Value, Customer Value
- 6 Benefits of Creating Value for Customers
- How does your company create value along the value chain?
- Added Value: Definition, Why It Matters, Formula
- Why is adding value important for a business?
- Value Added Formula and How To Calculate It
- Value Added: Meaning, Formula, Importance, Way to Create