Relationship Between Sum of Value Added and Sum of Factor Incomes!
Value added is the same as income generated. How? Production actually means addition of value (value added) to intermediate inputs by collective efforts of factors of production (land, labour, capital, enterprise).
Naturally, the factors of production are claimants to the output of a firm. Since they have produced output collectively, therefore, every factor has a right to get back a share as a reward for its contribution in the production process.
Actually, whatever is produced by the four factors is their real income (in terms of goods and services) which ought to be distributed among them. But it is difficult, rather impossible in the modern economy to distribute in kind the produced goods and services among four factors of production.
They are, therefore, rewarded in the form of money income out of value added (or income generated). Incomes accruing to primary inputs (also called factors of production) are known as primary incomes. Since factors are paid their remuneration (reward) out of what they have produced by way of value added, it is said that production generates income.
Mind, it is net value added at FC of the firm which is distributed among factors of production as factor income. A firm sells its output in the market. By deducting intermediate consumption, depreciation and net indirect taxes from the value of output (sale proceeds), we get firm’s net value added at FC. Out of this, land owner gets rent which is income for him. Labour and capitalist get wages and interest, respectively, which are incomes to them.
The balance is the income of entrepreneur who gets in the form of profit. Obviously, firm’s net value added at FC is distributed among factors as factor income for rendering productive services in the production process. Briefly, value is added by factors of production and the same is distributed among them in the form of money income. In this way, income is generated in the production process.
This can be further illustrated with the help of an example. Let us take the case of an imaginary cloth mill which manufactures 1,000 metres of cloth in a month and sells the same @ Rs 50 per metre. This price includes indirect tax (say, sale tax) @10%. Further, suppose that firm’s intermediate consumption (expenditure on raw material, fuel, power, etc.) is to the tune of Rs 20,000 and value of depreciation of machinery is Rs 2,000.
In this case firm’s net value added at FC will be Rs 23,000 (= Value of output 50,000 – intermediate consumption Rs 20,000 – net indirect tax 5,000 – depreciation 2,000). The firm’s real contribution to the flow of goods and services by virtue of its productive activities is worth Rs. 23,000 which will be distributed among factors as reward (income) for their contribution in the production of cloth. Clearly, income of Rs 23,000 has been generated by the firm in the production process.