Production: Value Added Method: Steps and Precautions!

(a) Method:

In this method two approaches—’Final Product Approach’ and ‘Value Added Approach’—are adopted.

(i) Final Product Approach:

This looks at national income from output side. By this method we measure value of all that is produced in the domestic economy. It is broadly called Gross Domestic Product.

GDP is defined as gross market value of all the final goods and services produced by all producing units located m the domestic economy in an accounting year. It is estimated by multiplying the gross product with market prices. This gives us the value of Gross Domestic Product at market price (GDPMP).

Symbolically:

GDPMP = P (Q) + P (S)

In which P = Market Price, Q = quantity of goods, S = quantity of services.

Being gross, it includes depreciation; being at MP, it includes net indirect taxes and being domestic it includes production by all production units within domestic territory of a country. Mind value of only final goods and services is included to avoid problem of double counting.

The term product refers to the value of output – value of intermediate consumption. GDPMP is estimated by deducting value of intermediate consumption from value of output. If depreciation and net indirect taxes are deducted from GOPMP, we get NDPFC or what is known as Domestic Income. By adding to its net factor income from abroad, we get NNPFC which is called national income.

How far reliable?

Estimates obtained by final product approach (also called output method) are not much reliable due to two reasons. Firstly it is difficult to get data regarding production, prices and costs. Secondly it is difficult to distinguish between final and intermediate goods because every producer treats the good sold by him as final good although the buyer might have used it in production as an intermediate good.

Consequently there is always the possibility of double counting which means a commodity may be counted more than once in estimating national income . To overcome the difficulty of double counting, value added approach is used.

According to this method, domestic income is first calculated by totaling ‘net value added at FC by all the producing units during an accounting year within the domestic territory. This total is called Net Domestic Product at FC or Domestic Income. Then by adding net factor income from abroad to Domestic Income (NDP at FC), we get National Income (NNP at FC). Mind, in value added method, national income is measured at the stage of production (or addition of value).

Clearly, value added method measures the contribution of each producing unit in the domestic economy avoiding any possibility of double counting.

Symbolically:

Net value added at FC = Gross output – intermediate consumption – depreciation – net indirect taxes

(b) Steps involved:

Following steps are involved in estimating national income by Value added method (Production method).

(i) Identify all the producing units in the domestic economy and classify them into three industrial sectors such as primary secondary and tertiary sectors on the basis of similarity of their activities. (Primary sector produces goods by exploiting natural resources like fishing, mining, logging; Secondary sector produces manufactured goods by transforming one type of commodity into another type of commodity like construction, electricity generation and Tertiary sector renders services like educational, medical, banking, etc. only.)

(ii) Estimate net value added at FC by each producing unit by deducting intermediate consumption, depreciation and net indirect taxes from value of output, we get net value added at FC.

(iii) Estimate net value added of each industrial sector by summing up net value added at FC of all producing units falling in each industrial sector.

(iv) Compute Domestic Income (NDP at FC) by adding up NVA at FC of all industrial sectors.

(v) Estimate net factor income from abroad which is added to Domestic Income for deriving National Income (NNP at FC). In short by adding net value added at factor cost by all producing enterprises in the domestic territory of the country as discussed above, we get Net Domestic Product at Factor Cost (NDPFC). When we add to it the net factor income from abroad, we obtain Net National Product at Factor Cost (NNPFC) which is called National Income.

(c) Precautions (Items to be included /excluded):

While calculating national income by value added method, value of the following items should be included:

(i) Imputed rent of owner occupied houses.

(ii) Imputed value of goods and services produced for self-consumption or for free distribution.

(iii) Value of own-account production of fixed assets by enterprises, government and households.

(iv) Only value added and not value of output by production units should be included (i.e., avoid double counting).

(v) Do not include sale of second-hand goods because they are not fresh production activity. However, brokerage or commission paid to facilitate the sale is included as it is a fresh production activity.

Since national income measures reflect the current achievements of an economy during a year, value of the following items should be excluded from its purview:

(i) Sales and purchases of second-hand goods:

They are not a part of production of the current year. Moreover, their value had already been included in the national income of the year in which they were produced. However, if the transaction has been made through a broker, his commission or brokerage should be included because he has rendered productive service.

(ii) Sale of bonds by a company:

This is merely a financial transaction which does not contribute directly to the flow of goods and services. Again, services for self- consumption like those of housewife are not included as it is difficult to estimate their market value.

(iii) Income of a smuggler:

It is an illegal activity and all illegal activities (like smuggling, gambling, black-marketing, etc.) are excluded from the national income.

Let us summarise the concepts of valued added:

(i) Value of output = Sales -f- change in stock (Output is always at MP. Output implies gross output)

(ii) Value added = Value of output-Value of intermediate goods

= Gross product = Gross value added at MP

(iii) NVA at MP = GVA at MP – Depreciation