Value added is an important element in a company since it is instrumental in measuring the wealth created by a company which can in turn be used to analyze the contribution of the company to the economy of its country. According to Cox (1979), value added is defined as “the wealth the reporting entity has been able to create by its own and its employee’s efforts”. In Simple terms, value added is the difference between sales and the cost of purchasing goods or bought-in-goods and services. Two approaches are used to calculate value added.
The first methodology is by simply subtracting the purchases from the sales or turnover based on the definition of value added. This means that Value Added = Sales – Purchases or Bought-in-good.
Furthermore, value added can be looked at as a net figure that presents the value an individual, industry or company and contributes to the goods it has purchased. Therefore, value added can be calculated through the method of addition. This means that Value Added = Operating Profit + Labor Costs + Depreciation. It can be calculated through the addition of employee costs, operating profit, amortization/impairment of charges and depreciation even though company accounts do not always provide the cost of bought-in-items.
The above quantities that cumulatively constitute value added are calculated and defined as follows (Department for Business Innovation and Skills, 2010):
Employee costs- This is the total amount of money paid to an employee including social security, death benefit plans, pension & wages and salaries.
Operating profit- This is the measuring of a company’s ability to earn from day-today operations and is equal to pre-deduction of income taxes and interest payments of earnings.
Amortization/impairment- This is the impairment of goodwill, depreciation of capitalized development and impairment/amortization of other intangibles.
Depreciation- This is the impairment charges on assets held under finance leases and owned assets.
Link between value added, profit and cash flow
As much as value added is the best indicator of a company’s wealth, the success of the company may also be contingent to the profitability of the business entity. A strong correlation between the performance of a company’s sales and its profit exist.
For instance, a company making profit may be recording a good sales performance in that they are selling the quantity of goods that they intended to or even surpassing their prospects. However, it is imperative to note that the profitability of the company in question does not translate to an increase in the sales. A wholesaler’s pricing of goods to the company may be very good. The company will in turn gives the goods a market value that ensures profit but does but not sell the expected quantity of goods. On the other hand, the inability of a company to make profit would result into a loss thus affecting the performance of sales. This loss may be contributed by a lack of a company selling the intended quantity of goods thus interfering with the prospects of value added.
Moreover, cash flow is another aspect that is correlated with the sales performance. It is defined as a record of a company’s income and expenditure. Cash flow is vital for the success of business in that the if a company had a good sales performance, their cash inflow will be higher thus boosting the sales performance. This may eventually result into the value addition of the company. On the contrary, a company that records a low amount of sales will add little money to the cash flow hence limiting the chances of profitability and value addition