Value Added Method of Measuring National Income

As the circular flow of income explains, there is continuous flow of income from the households to the firms and from the firms to the households. 

The goods and services produced by firms lead to the generation of factor incomes which are distributed among households. This factor income gets translated into expenditures when households purchase the goods and services from firms. 

The expenditure provides revenue to the firms, which is used to produce goods and services. This circular flow in the economy continues. Therefore, the national income of a country can be looked upon by three ways: through the production of goods and services, through the generation of income and through expenditure on goods and services. This gives us three different methods of estimation: 

• Finding the value added during the production of goods and services in the economy also known as the Product Method or Value Added Method
• Finding the total income generated in the economy also known as the Income Method
• Calculating the total expenditures on final goods and services in the economy also known as the Expenditure Method

This blog discusses the Product Method or the Value Added Method of Measuring National Income

The Product Method or the Value-Added Method of Measuring National Income

This method basically calculates the value added for all goods and services produced in the entire country in an accounting year, and sums up that value to get the total product in the country also known as GDPMP.  

From this GDP at market price we can estimate National Income or NNPFC.

How is the Value Added Estimated ?

As a first step an enterprise is classified as either falling into Primary or Secondary or Tertiary Sector.

Then the Value added by each enterprise in a year is estimated and added up to get the GDP.

Value added is the value of the final product of the enterprise minus the value of intermediate good. 

The method says that in order to calculated value added, we need to find value of output and intermediate consumption. We will discuss them one by one.

 

Value of Output

Since firms ultimately sell the output to either other firms or consumers, therefore the value of the output is the sales revenue which the firms get after selling the output. Hence, the value of output is the value at which the product is sold. 

In other words, it is the sales of the firm.

Sometimes, the firm may not sell the entire output either voluntarily or involuntarily. It may stock the product, which is also called an inventory. So, even though the inventory or stock is not sold, yet it is produced in the economy, so its value will be added in the estimation of GDP. 

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The change in stock is calculated as the closing stock for the accounting year minus the opening stock for the year. So, if the stock at the close of the year is Rs. 1000 and at the beginning of the year Rs. 400, this means that the change in stock is Rs. 600. 

The value of the last period's inventory is subtracted, so as to get the current years value. Change in stock is calculated because we measure the stock for only the current accounting year not for the last year. 

Intermediate goods/consumption

Intermediate goods are goods which are used in the production of other goods and services or the final goods or services; or other intermediate goods. They help in adding value to the final goods and services. 

Intermediate goods can be in the form of raw materials or inputs aiding in the production of goods and services. These goods can become the part of the final good or may get transformed into another good during the production process. For example, wheels in a car become a part of the final good but are not the final good itself. Similarly, rubber which is used to make tyres is completely transformed through the production process. 

These goods are not counted in the GDP calculation as the value of these goods is included in the final value of goods and services. For example, nuts and bolts when assembled in a car become a part of the final product and the value of that final product (car in this case) is calculated and included in the GDP and the value of nuts and bolts is not calculated separately.

Example of Value Added

Let us explain value added by taking  an example, say the production of tomato ketchup. It is majorly made out of tomatoes, which go from the farm to the factory to the shop. 

➤Starting with the farmer, suppose he produces tomatoes and sells to the factory. Assume that he sells the tomatoes to the factory at Rs. 400. While producing the tomatoes, he had to incur intermediate cost of Rs. 150 on inputs like fertilizers, seeds etc. The value added by the farmer is Rs. 250. 

➤Now, the factory buys the tomatoes at Rs. 400 and converts the raw material into ketchup and sells it to the retailer at Rs 700. So, the value added by the factory is Rs. 300

➤ The retailer buys the ketchup from the factory at Rs. 700 and lets say sells the ketchup to the customers at Rs. 900. Thus, adding a value of Rs. 200. 

➤The total value added therefore, is the total of value added at every level i.e 250 by the farmer, 300 by the factory and 200 by the retailer, which gives us Rs. 750.

Producing Unit	Value of Output (Rs.)	Value of Intermediate consumption (Rs.)	Value Added (Rs.)
1. Farmer	400	150	250
2. Factory	700	400	300
3. Retailer	900	700	200
Total	2000	1250	750

The difference between Value of Output and Intermediate Consumption gives value added or GDPMP . National Income can be derived by doing some adjustments as shown below. 

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Points to Keep in mind while estimating National Income by Value Added Method 

1. Sale and purchase of second-hand goods:

Many of the goods may be sold and purchased in the current year but may have been produced in the previous years, like second hand cars. 

The sale of a second hand goods represents just a transfer of the good from one hand to the other and not the increase in the nation's output in that year. In such a case the value of the second hand goods is not added in the current years' GDP because the value of these goods was included in the GDP in the year in which they were manufactured. 

However, any commission or brokerage earned by the people after selling the used goods is included in the estimation of GDP as this is their income which they earn after rendering their service.

2. Intermediate goods

Value of intermediate goods should not be included in the estimation of GDP as their value is already included in the value of final goods and services. 

Including the value of the intermediate goods will lead to the problem of double counting, which means the value of the good is included more than once in the estimation of GDP.

3. Goods for self-consumption

Some goods are also produced for self-consumption and may not enter the market example, farmers keep a part of their produce for their own consumption and do not sell it in the market. These goods are included in the national income because their has been an addition in the stock of goods and services in a nation. Imputed value. 

4. Services for Self-consumption: 

The value of services for self- consumption is not included in the GDP as their estimation is difficult. Moreover, these services are produced and consumed within the household and do not enter the market, hence their value is not estimated. Examples can be housewife, parents tutoring their children, driving. 

However, services which are hired for the household like a maid, tutor, driver, babysitter are included in the GDP as their value can be estimated.

5. Imputed Rent: 

There are some goods and services which may not be sold in the market but still have a rental value, like a house. If it is lent out to tenants, it generates rent. But many people live in their own houses and give no rent. Still, that house is giving services like it would to a person who rents it. 

The value of self owned houses is included in the GDP. The government determines an estimate of what would the market rent be of such a house if it were rented and includes its value in the GDP. Such an estimate is known as imputed value or imputed rent.