What’s it: Value added is the difference between the input costs to make a product and its selling price. This concept is important in business and economics. For example, in business and management, we can come across this concept when we study value creation by the business.
Businesses generally produce goods and services by adding value to inputs. They process it into higher-value output. The higher the added value created, the more valuable the product.
Take a furniture company as an example. The company buys wood from loggers and converts it into various household items. To do so, they need wood as a raw material. In addition, they need labor, machinery, and equipment to produce furniture. These inputs are known as business resources or factors of production.
Then, we can find the added-value concept in macroeconomics when discussing measuring economic activity in the aggregate. Summing value-added along the production chain is one way to calculate gross domestic product (GDP). That would be equal to the aggregate value of final output, the general definition for GDP.
Why the value added is important for business
Three main reasons why added value is important for business. With it, companies gain more profits, differentiate their products from competitors’ products, and build customer loyalty. And all of those reasons are ultimately about making money in the long term.
Why is added value important for profit?
By adding value, businesses can charge customers higher prices than they pay suppliers. The higher the added value they create, the greater the profit they earn.
How does added value contribute to creating differentiation?
Offering added value alone is not enough to secure long-term profits. A company must compete with other competitors in satisfying the needs and wants of consumers. To sustain profits, companies must offer better value than competitors.
Since businesses must outperform competitors in the market, they must create a luring factor for customers. For consumers, it is why they should buy products from the company instead of competitors’ products. The value they add must be better than what competitors offer.
Adding value by differentiating offerings can be done in several ways. For example, smartphone companies add product features and functions such as embedding high-resolution cameras.
Offering convenience and special menus is also a way for restaurant businesses to attract customers and differentiate their services from those of competitors.
How do businesses build loyalty by offering added value?
When customers are satisfied with the value added by the company, they will continue to buy. They may also be willing to recommend the product to their relatives or people around them. It can save promotion costs.
Furthermore, maintaining satisfaction by offering superior value is the way to build strong, profitable relationships with customers in the long term. Loyal customers and constantly pouring money into the company. And they are reluctant to switch to competing products.
How to calculate the added value
The value-added formula is very simple. To calculate it, we simply subtract the selling price of the product from the input costs. Here is the mathematical equation:
Value-added = Selling price per unit – Cost of input per unit
To apply the above example, now, let’s take a simple example. A manufacturer spends $20 buying yarn to make a shirt and sells it for $35 per unit. On the other hand, yarn manufacturers process cotton purchased from farmers for $15.
In that case, both producers add a value to the input by:
- Shirt manufacturer =$35 – $20 = $15
- Yarn manufacturer = $20 – $15 = $5
Another example is a manufacturer selling a pair of shoes for $56. To produce it, it incurs a cost of $21. In this case, it adds $35 ($56 – $21) in value.
Calculating GDP using the value-added approach
GDP represents the monetary value of all final output produced by an economy during a given period. From the definition, we can calculate it by adding up the final output values. That is the value-of-final-output approach.
Alternatively, we can use a value-added approach to calculate GDP. In this case, we add the added value generated along the production chain.
Now, take the shirt example above and assume the economy only produces one shirt. Thus, under the value-of-final-output approach, GDP is worth a shirt at $35.
Meanwhile, we sum the value added by clothing manufacturers, yarn producers, and cotton farmers under the value-added approach. Specifically, the cotton value added is $15 because the farmer is at the end of the production chain. So, if we add up all three, it equals $35 ($15 + $5 + $15), which is the price of the shirt.
Distinguishing between value-added and profit
Value added is different from profit. Value-added only takes into account direct costs such as raw materials and direct labor. Meanwhile, we may consider indirect costs such as administrative, general, and marketing costs to calculate profit.
Another difference between the two concepts is about sales. When we talk about added value, we only consider the price of the output with the cost of producing it, regardless of whether the firm generates sales or not.
In contrast, profit is a function of sales. I mean, companies can make a profit if they add value and can sell products. No sales, no profit. And to market the product, they have to compete with other companies in the market.
Now, assume you operate a business. Your business produces value-added products but may not sell any products. And, it could happen because your business is not competitive. Or the tastes and preferences of the consumers you are targeting may have changed.
Your business may offer added value. But, because it’s not better than your competitors, consumers don’t buy your product. Instead, they prefer your competitors’ products.
In conclusion, to successfully meet and satisfy consumer needs and wants, the added value you generate must also be a reason for consumers to buy your product (a differentiating factor). For example, it could be a lower price or better quality than a competitor’s product.
The next factor is consumer tastes and preferences. It affects consumer interest to buy. And, nowadays, consumers have become more and more aware of environmental issues. So it encourages them to shift demand only to environmentally friendly products because it is in accordance with their values and principles. If you don’t, they won’t buy your product.
How to add value
There are various ways to add value to a product. And, in general, as in the formula above, businesses can do this in two ways: increasing the price consumers are willing to pay, lowering input costs, or combining both.
Companies can increase added value at each stage of the value chain. For example, they only use quality raw materials to produce quality products. Or they have an efficient logistics system, allowing for smoother production processes and faster delivery of goods to customers.
Another possible alternative is to offer a lenient credit policy. Another example is recruiting quality employees to serve and interact with customers.
Meanwhile, from the product aspect, adding value can be by offering:
- Convenience. Take the hotel business, for example. They can create value by offering beautiful panoramas and classy bedrooms.
- Time-saving. Foodservice companies are a great example, where they save busy people time rather than having to prepare their own meals.
- Additional features or functions. For example, smartphone companies are increasing the storage capacity of their products. Or, they install high-resolution cameras in their products.
- Customer service. For example, the company provides a delivery service to the customer’s home. Another example is by offering product installation in the customer’s home.
