Gross value added is an economic measurement used to calculate the productivity of an economy. This measurement works for a specific region, industry, or business sector. It is also used in conjunction with the gross domestic product (GDP) calculation since the gross value added formula includes some of the same basic information. The value added formula is the difference between total economic output and intermediate consumption goods. Private companies can also use the value added formula to determine the benefits from each product line’s profitability.
The first step in this calculation is to understand the basics of gross domestic product. Gross domestic product represents three items: consumer spending, business investment, and government spending. Consumer spending represents all expenditures in a nation by individual consumers; some business purchases may also be in this figure. Business investments are all large purchases of equipment and facilities for production. Items such as asset exchanges, savings, and securities purchases are typically left out of this number. Government spending is comprised of the expenditures on finished goods and services produced by the private sector. Transfer payments are removed from the government spending portion of a nation’s gross domestic product.
Intermediate consumption goods are the second half of the gross value added formula. Because nations produce a wide variety of goods and services, it is possible that the final output includes products another company uses to produce consumer goods and services. For example, automotive manufacturers need alternators in order to manufacture vehicles. Consumers may find little or no use for an alternator on its own; therefore, the alternator represents an intermediate good since its primary use is by automotive manufacturers.
To calculate gross value added, assume the following: $700 US dollars (USD) in consumer spending, $200 USD in business investments, and $100 USD in government spending. Therefore, gross domestic product is $1,000 USD (700 + 200 + 100). Intermediate goods represent $250 USD of the gross domestic product in the above example. Gross value added to the economy is $750 USD (1,000 – 250). The value added figure represents all new production of goods or services to a nation’s economy, which can provide a truer picture of economic wealth.
To convert this formula for use by a private company, a few changes are necessary. Companies can use this formula to determine how much income a product will contribute to the payment of fixed costs and overall profit. Fixed costs represent loan repayments, rent or lease payments, and salaries. Assume the following: $700 USD in sales, $500 USD in variable costs and $250 in fixed costs. The gross value added is $-50 USD, leaving no money to fully pay fixed costs or make a profit. This formula is similar to the cost/volume/profit analysis used by managerial accountants.