Value Added – Concept, Definition and Uses

Meaning and Definitions of Value Added

The traditional basic financial statements are balance sheet and Profit & Loss account. These statements generate and provide data related to financial performance only. They do not provide any information which shows the extent of the value or the wealth created by the company for a particular period. Hence, there arose a need to modify the existing accounting and financial reporting system so that the business unit is able to give importance to judge its performance by indicating the value or wealth created by it. To this direction inclusion of Value Added statement in financial reporting system is useful. The Value Added concept is now a recognized part of the accountant’s repertoire.

However, the concept of Value Added (VA) is not new. Value Added is a basic and broad measure of performance of an  enterprise. It is a basic measure because it indicates the net output produced or wealth created by an enterprise. The Value Added of an enterprise may be described as the difference between the revenues received from the sale of its output, and the costs which are incurred in producing the output after making necessary stock adjustments.

Some definitions of Value Added are following;

  • E.S.Hendriksen has defined Value-added as: “The market price of the output of an enterprise less the price of the goods and services acquired by transfer from other firms.”
  • Morely has defined Value-added as:”The value, which the entity has added in a period that equals its sales less bought-in-goods and services.” i.e. This definition can be expressed in terms of equation as follows: Value-added = (Sales) – (bought-in-goods &services)
  • The annual service of industries (ASI,1964) defines Value Added as: “Value Added (VA) = (gross ex factory value of output)-(gross value of input) “. The term Value Added may simply be defined in economics as the difference between the value of output produced by a firm in a period, and the value of the inputs purchased from other firms.
  • According to John Sizer “Value Added is the wealth the company has been able to create by its own and its employees efforts during a period. “
  • According to E.F.L Berch, “The added value of a firm or for any other organization is the Value Added to materials by the process of production. It also includes the gross margin on any merchanted or factored goods sold. “
  • According to Kohler, Value Added has been defined as: “That part of the costs of a manufactured or semi manufactured product attributable to work performed on constituent raw material. The value is arrived by deducting from the total value of the output of a firm and other incomes, the cost of raw materials, power and fuel, water, etc, which are bought from other firms.” i.e, Value Added = (value of output + income from other sources) – (cost of material and services purchased from outside)
  • According to Evraert and Riahi Belkaoui, “Value Added is said to represent the total wealth of the firm that could be distributed to all capital providers, employees and the government.”
  • According to Central Statistical Organization (CSO), India “Value Added represents the part of the value of the products which are created in the factory and is computed by deducting from the gross ex factory value of output, the gross value of input”

Concept of Value Added

The concept of value addition has been derived out from the very manufacturing process in which the firm’s raw materials are converted into  finished goods. A company can add value by the efficient use of the resources available to it. These resources can be in the form of manual skills, technical skills, know-how, special purpose machines, factory lay-out, etc. The process of manufacturing begins with a certain quantum of raw material and goes through a conversion process to yield an output. This output is a product with new utility and market value which is different from the original cost of materials. The excess of such market value over the cost of materials is defined as Value Added.

The concept of Value Added is considerably old. It originated in the US treasury in the 18th century and periodically accountants have deliberated upon whether the concept should be incorporated in financial accounting practices. The preparation, presentation and disclosure of Value Added statements (VAS) have come to be seen with greater frequency in most countries of Europe more particularly in Britain.

Value Added is the wealth created by the business during a particular period of time and the wealth or the value so created or added is distributed amongst different stake holders who created it. The discussion paper `corporate report’ published in 1975 by the then Accounting Standards Steering Committee (now known as Accounting Standards Board) of UK advocated the publication of Value Added statement along with the conventional annual corporate report.

Value Added indicates the `new value’ or `wealth’ created by the enterprise during a specified period. No enterprise can grow if it fails to generate wealth. Thus, Value Added is a form of wealth. However, things like land, minerals, metals, coal, oil, timber, water and similar sort of things are wealth but they are provided by nature. Value Added is the kind of wealth that is generated by the efforts and ingenuity of mankind. This can be understood from following examples:

  • At the primitive level a man goes into the forest and cuts down a tree. He converts it into a house, furniture and other articles for his own use. In doing so he `adds value’ to the raw material provided by nature.
  • In the complex industrial society, a manufacturing business buys raw materials, components, fuel and other services. It converts these into products which can be sold for more than the cost of the raw materials and other purchases. In doing so, the business `adds value’ to the materials by the process of production.
  • A farmer generated wealth by growing crops and breeding animals, then selling them for more than the cost of seeds, fertilizers, food stuffs and other materials used.

Value Added may be generated even when little or no material is involved. The gap between what the consumer pays and what the manufacturer or supplier has to pay for the raw material, and other bought in items, is the Value Added that has been generated.

Value Added = Gross value of output – gross value of input

Where,

  • Output = Aggregate value of product*+ work done for customers + sale value of goods sold in the same condition as bought + stock of semi finished goods (i.e. closing and opening).
  • *Value of Products= value of product manufactured for sale during a year where value is ex-factory, exclusive of any incidental expenses on sale.
  • Input= Gross value of materials, fuels, etc + work done by other concerns for the firms+ non industrial services done + depreciation + purchase value of goods sold in the same condition as bought.

Thus,

Value Added = value of production – cost of materials, power, etc

Where, the value of production = sales value + value of increase or decrease in finished and semi finished goods.

Beneficiaries of Value Added

There are four main beneficiaries of the net value added created by an enterprise. These beneficiaries are workers, providers of capital, government and the owners. As a matter of principle, the beneficiaries are the persons contributing or providing their efforts or facilities directly or indirectly.

  1. Workers: Labour is one of the major claimants of value added. The value added statement shows the amount of value added that goes to the human resources. The payments to the workers can be in the form of :
  2. Providers of capital: Banks, Financing institutions, public and the owners provide capital to the enterprise, but under this caption, providers of only interest-bearing funds are taken into consideration.
  3. Government: The government which provides not only infrastructural facilities but also conditions conducive for carrying out operational activities has also its claim in the value added. The payment to the government goes in the form of :
  4. Owners: Last but not the least owners or shareholders are the ultimate claimants of the value added. The transfer to owners may be in the form of transfer to various non-statutory reserves or profits distributed (which should be disclosed separately).

Uses of Value Added

Till recently, the yardstick to judge the efficiency and profitability was Return on Investment (ROI) but, now-a-days too much interest has been shown on `value added’ and it is considered as another approach to measure operational efficiency and profitability of a business enterprise. The reason behind this is that the performance of an enterprise is now judged from the `social obligation point of view’. The profit is a test for shareholders to measure the performance of an enterprise while `value added’ is a measure useful to all those of the society who have contributed in the process of generating value such as employees, investors of capital, government, etc. No enterprise can survive and grow if it fails to generate sufficient value.

Value added reflects the performance of a team, which is, employees, managers, shareholders, creditors. Value added statement helps the employees to perceive them as responsible participators in a team effort with management and thus may motivate them to work harder. Value added statement provides a better measure of the size and importance of a company. VA based ratios are interpreted as mere indicative of and predictive of the strength of the company than conventional ratios.

  1. VA can be used as a basis for wage and salary policies. The index for value added per employee is a vital figure because it sets a limit to the average wage per employee. No company pay out more in wages per  employee than it is generating in value added per employee. The higher the value added per employee, the higher can be the average wage per employee. The creation of value added depends not on the level of capital expenditure but on good marketing strategy, sound investment policy, effective management and employee co-operation to maximize the value added per employee.
  2. VA can be used as a basis of bonus schemes.The conventional bonus incentive schemes which are either based on time or on piece work system have a limitation that they apply only to production workers or individuals or small group of employees. Since, a better measure of output is value added, a bonus scheme can link the payroll to value added. This is known as value added based bonus scheme. The technical design of value added based bonus scheme can vary quite circumstances. The traditional measure of business performance is profitability i.e. a ratio of profit to capital employed. The concept of profitability has some merits but it also has some serious defects. First, as a measure of performance, it can be very misleading. Second, in the modem climate of public opinion it takes somewhat narrow view. Third, it cannot be applied to non-profit organizations. Value added is more useful than the profitability ratio.
  3. VA can be used as a measure of business performance.
  4. VA can be used in formulation of business policies. Value added is used in the formulation of various business policies. It includes (1) product analysis (2) pricing policies (3) capital investment decision, (4) marketing strategy, etc.
  5. Another use of VA is that it links the company’s financial accounts to national income. The sum of the value added by each company will equal national income.
  6. VAS are said to improve the attitude of employees towards their employing company because the value added statements reflect a broader view of the company’s objectives and responsibilities. When fully informed about value added they should be better motivated to work, be more co-operative and more identified with their company.
  7. Acts as an excellent measure of the size and importance of the company. VAS is used to construct VA based ratios that are considered as important diagnostic and predictive tools for making comparison of company’s performance with other national and multi-national companies.
  8. At present, both central and state governments use VAS to determine and collect tax on value addition by an enterprise in its process of production.
  9. VAS also provides important accounting and other information that facilitates better communication from concerned to a variety of users who are related or unrelated. Thus, it is more transparent in nature.

From the above mentioned uses of VAS it is worthwhile to note that an organization may survive without earning profit but cannot survive without adding value. An organization, even if it is sick, especially non-profit making in nature, would remain useful so long as it generates value.