Product or Value Added Method of calculating National Income

• Difficulty Level : Easy
• Last Updated : 16 Jun, 2022

National income refers to the value of goods & services produced by a nation during a particular financial year. Therefore, it is the net result of all the economic activities that take place during a financial year and is valued in monetary terms. It includes payments made to various resources either in form of rents, wages, interests and profits. A country’s progress can be estimated by the growth of its national income.

According to Marshall, “The labor and capital of a country acting on its natural resources produce annually a certain net aggregate of commodities, material and immaterial including services of all kinds. This is the true net annual income or revenue of the country or national dividend.”

Gross Domestic Product

The total value of all the goods & services produced in a country during a particular year is known as its gross domestic product.

Further, GDP is determined at market price and is termed GDP at market prices. Various constituents of GDP are:

• Interest
• Rents
• Wages & salaries
• Undistributed profits
• Dividends
• Mixed-income
• Depreciation
• Direct taxes

Gross National Product

For GNP calculation, data of all productive activities like agriculture produce, minerals, woods, commodities, transport contribution to production, insurance companies and all professions ( lawyers, teachers, doctors, etc.) must be at market prices.

It also includes the country’s net income arising from abroad. Four primary constituents of GNP are:

• Consumer goods and services
• Goods produced or services rendered
• Income arising from abroad
• Gross private domestic income.

Value Added Method

The most commonly used methods for calculating national income are the Income Method, Expenditure Method and Value Added Method. The value-added method is used to calculate national income at different stages of the production process in a circular flow. It represents the value-added for each unit produced in the production process. Every organization adds value to the product, which it buys from other firms as an intermediate good. The sum total of value added by every organization is the value of national income.

What is Value Added?

Value-added refers to the addition in the value of a raw material or intermediate good by an organization during the production process. To calculate the national income through the value-added method, the difference between the value of output and the value of intermediate goods is taken. The value-added method is the most commonly used method to estimate national income as it avoids double counting, which is a major error while calculating national income.

Value Added = Value of Output – Intermediate Consumption

For example, A baker needs only flour to produce the goods. He purchases the flour from a miller as an intermediate good worth  ₹30 and converts the flour into bread with the help of production activities, and sells the bread for ₹50.
Here, flour is an Intermediate Good whose value is ₹30 and is termed the value of Intermediate Consumption.

Bread sold to the baker is the final good whose value is ₹50 and is termed Value of Output. It shows that the baker has added a value of ₹20 to the flow of final goods & services in the economy.

As discussed above, the difference between the value of output and the value of intermediate goods is known as value added.

Value Added = Value of Output – Intermediate Consumption

= 50 – 30

= ₹ 20

The value added by each production company is also called Gross Value Added at Market Price (GVAMP). Also, the sum total of all the Gross Value Added at Market Price of all the enterprises of a country within its domestic territory during one year is equal to GDPMP or Gross Domestic Product at Market Price.

∑GVAMP = GDPMP

1. Intermediate Consumption

The use of intermediate goods during the production process to create the final product is termed Intermediate Consumption, and the expenses occurred on intermediate goods are known as Intermediate Consumption Expenditure.
In the above example, Flour is represented as an intermediate good, as it is used as a raw material for the production of the bread. However, any kind of machinery purchased for baking bread will not be considered an intermediate consumption, as its value will not be merged with the value of final goods.

Imports are not separately included:

If the value of a product’s intermediate consumption is already given, then the value of imports is not included separately in the calculation of national income. It is because the value of intermediate consumption already includes the value of imports. However, if the question specifies the domestic purchases separately, then the value of imports will be added.

The value of intermediate consumption can be calculated in the given below cases:

Case 1:
Imports = ₹400 and Intermediate Consumption = ₹1,600

Solution:

As the imports of the country are already included in the value of intermediate consumption, for calculation of the national income intermediate consumption will be ₹1,600.

Case 2:

Purchase of raw material = ₹800 and Imports = ₹100

Solution:

In this case also, as the value of the purchase of raw material is given, imports will not be included.

Therefore, Intermediate Consumption = ₹800

Case 3:

Imports = ₹200 and Purchase of raw material from domestic firm = ₹1,000

Solution:

In this case, the imports will be included in the value of intermediate consumption because the value of purchase of raw material from domestic firm is mentioned separately.

Therefore, Intermediate Consumption = 200 + 1,000 = ₹1,200

2. Value of Output

The market value of all goods and services produced within a country during a period of one year is known as the Value of Output.

Different ways of calculating the value of output are as follows:

• When the whole output is sold in a financial year, then the value of output will be equal to the total sales of the output.
Value of Output = Sales
• When the whole output is not sold in a financial year, then the value of output will be equal to the sum of sold output and the unsold stock of output. Here, the unsold stock is the difference between closing stock and opening stock and is also known as Change in Stock.
Value of Output = Sales + Change in Stock
Change in Stock = Closing Stock – Opening Stock
• When the value of output sold is not given directly, then the value of output will be calculated by first determining the sales value.
Value of Output = (Quantity × Price) + Change in Stock

Exports are not separately included:

If the value of Sales is already given, then the value of exports are not included separately in the value of output. However, in the case of an open economy, the value of sales includes both exports and domestic sales.

The value of output can be calculated in the given below cases:

Case 1:

Exports = ₹500 and Sales = ₹1000

Solution:

As the value of sales is already given, the value of exports will not be included in the value of output.

Therefore, Value of Output = ₹1,000

Case 2:

Exports = ₹100 and Domestic Sales = ₹800

Solution:

In this case, the domestic sales is given separately; therefore, the value of exports will be added in the value of output.

Value of Output = 100 + 800 = ₹900

Steps of Value Added Method

Steps for calculating national income through Value Added Method are as follows:

Step 1

The first step is to recognize and group all the producing units of an economy into primary, secondary, and tertiary sectors.

Step 2

The second step is to calculate the Gross Domestic Product at Market Price (GDPMP). For (GDPMP) calculation, determine the Gross Value Added at Market Price (GVAMP) of each sector, and the total of each sector’s (GVAMP)  gives GDPMP; i.e. ∑GVAMP = GDPMP

Step 3

Now, calculate Domestic Income (NDPFC). For the calculation of domestic income, the value of depreciation and net indirect tax is subtracted from the Gross Domestic Product at Market Price (GDPMP).

NDPFC  = GDPMP – Depreciation – Net Indirect Taxes

Step 4

The final step is to calculate Net Factor Income from Abroad (NFIA) to get national income.  NFIA is added with the domestic income of the country.

National Income or NNPFC = Domestic Income or NDPFC + NFIA

Precautions of Value Added Method

1. Intermediate goods should not be added to National Income: As the value of intermediate goods is already added to the value of final products, they should not be added to national income. The inclusion of the value of intermediate goods again to national income will result in double counting

2. Transactions (sale and purchase) of second-hand goods must not be included: The value of second-hand goods should not be included in national income, as these goods are already counted in the year they were produced. Adding the value of these goods again will disrupt the current flow of goods and services. However, any kind of brokerage fee or commission paid on any transaction of such products should be included in the calculation of national income, as it is a productive service.

3. Self-consumption Services or Domestic Services production should not be included: It is difficult to find out the market value of domestic services like housewives, etc. Therefore, the production of domestic services is not included in the calculation of national income. These types of services are produced and used within a household and do not enter the marketplace; therefore, are considered non-market transactions. However, paid services like maids, drivers, etc. should be mentioned clearly in the national income, as their market value can be easily determined.

4. Self-consumption goods should be included: The production of self-consumption goods contributes to the output of a financial year; therefore, these are added to the national income of an economy. However, these products are never sold in the open market; hence, their value is estimated.

5. Estimated value of houses owned by people should be included: People living in their own houses do not pay rent, but enjoy the same housing services as received by people living in houses on rent. Therefore, the value of the houses owned by people is included in the national income. For this, the value is determined on the basis of an estimation of the rent of a similar house or accommodation in the market. This estimated rent is also known as imputed rent.

6. Change in the stock or inventory must be included: The change in the value of opening and closing stock or inventory of an economy is also included in the calculation of national income. In other words, the net increase in the inventory of an economy is included as a part of capital formation in the National Income.

Double Counting Problem

A situation in which the value of an output when passing through its production stages, is counted more than once, is known as Double Counting. A product passes through various stages of production before reaching the final stage. When the value of a product is calculated at each stage of production, it is more likely to add the cost of input more than once. This situation leads to double counting.

While calculating national income, the problem of double counting occurs when the value of intermediate goods is also included with the value of final products.

For example, A farmer produces wheat in his fields and sells it for ₹200 to a flour mill. The miller, then converts the wheat into flour and sells it to a baker for ₹500. Ultimately, the baker prepares biscuits from that flour and sells them to the consumers for final consumption at a price of ₹700.

For Farmer, wheat is the final product (₹200), and he has not spent any intermediate cost. Therefore, the value added at this stage is ₹200 (₹200-₹0).

For Miller, flour is the final product (₹500), and he has spent ₹200 on wheat as an intermediate good. Therefore, the value added at this stage is ₹300 (₹500-₹200).

For the Baker, the biscuit is the final product (₹700), and he has spent ₹500 on flour as an intermediate good. Therefore, the value added at this stage is ₹200 (₹700-₹500).

By adding the value of outputs of the farmer, miller, and baker, the Value of Output = 200+500+700 = ₹1,400.

However, these values of output consist of the value of an intermediate good.

The value of flour (₹500) consists of the value of wheat (₹200). Similarly, the value of biscuits (₹700) consists of the value of flour (₹500). It shows that the value of wheat and flour are counted twice. Once as the value of output and the other time as an intermediate good. This leads to the problem of Double Counting.

How to Avoid Double Counting?

There are two alternates available for avoiding double counting.

1. Final Output Method: The method of Final Output says that only the value of the final goods should be added in the determination of national income.

In the above example, using the method of final output, only the value of Biscuit, i.e., ₹700 at which these are sold to the final consumers will be taken during the calculation of national income.

2. Value Added Method: The method of Value Added says that the sum of value added at each stage of production of the final good should be added in the determination of national income.

In the above example, the sum of value added at each producing unit by the farmer, miller, and baker worth ₹200, ₹300, and ₹200, respectively should be added. Therefore, the value to be taken for the determination of national income will be ₹700 (₹200+₹300+₹200).

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