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 exactly is the Value Added Method for calculating National Income?
The Value Added Method, also known as the Product Method, calculates national income by summing up the value added by each producing unit in the economy. It measures the market value of all final goods and services produced within a country's domestic territory during a year. Its main purpose is to measure the unique contribution of each industry to the national output.
2. What is the basic formula used in the Value Added Method?
The core formula is very straightforward: Value Added = Value of Output – Intermediate Consumption. Here, 'Value of Output' is the total market value of goods and services produced by a firm, and 'Intermediate Consumption' is the cost of raw materials and other non-factor inputs used in the production process.
3. Can you explain the Value Added method with a simple, real-world example?
Certainly. Imagine a baker, a miller, and a farmer.
- The farmer grows wheat and sells it to the miller for Rs. 500. The farmer's value added is Rs. 500.
- The miller grinds the wheat into flour and sells it to the baker for Rs. 800. The miller's value added is Rs. 800 (Value of Output) - Rs. 500 (Intermediate Cost) = Rs. 300.
- The baker uses the flour to make bread and sells it for Rs. 1,200. The baker's value added is Rs. 1,200 - Rs. 800 = Rs. 400.
4. Why is 'double counting' a problem, and how does this method solve it?
Double counting is a major error where the value of the same product is counted more than once in national income calculation. This happens if we add the value of intermediate goods (like flour) to the value of final goods (like bread). It gives a falsely high estimate of the economy's output. The Value Added Method brilliantly solves this by subtracting the cost of intermediate goods at each stage, ensuring that only the new value created at that stage is counted.
5. What is the difference between 'Value of Output' and 'Value Added'?
This is a key distinction. Value of Output is the total market worth of everything a firm produces, including the value of raw materials it used. In contrast, Value Added is the firm's net contribution to the economy. It represents the true new wealth created by the firm after deducting the costs of materials it purchased from others.
6. What are the main precautions to take when using the Value Added Method?
To ensure accuracy when using this method, a few key points must be remembered:
- The sale and purchase of second-hand goods should not be included, as their value was counted when they were first produced.
- The value of intermediate goods must be excluded to avoid double counting.
- Production of goods for self-consumption (e.g., a farmer keeping wheat for his family) should be included by estimating its market value.
- Commissions earned on the sale of second-hand goods should be included, as it is a fee for a new service provided.
7. Besides the Value Added Method, what are the other ways to measure National Income?
There are three primary methods to measure National Income. Besides the Value Added Method (or Product Method), there are the:
- Income Method: This method sums up all the incomes earned by factors of production, such as wages, rent, interest, and profit.
- Expenditure Method: This method sums up all the final expenditure incurred in the economy, including consumption, investment, government spending, and net exports.
