What is Value-Added?

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Definition:

Value-added is the difference between the cost of a finished product and the cost of the materials and services that went into making it.

🤔 Understanding value-added

Companies that manufacture goods often buy raw materials, capital goods (meaning man-made goods that go into making something else), and labor to craft their products. Companies aim to add value to the product so that the finished good is worth more than the cost of the parts and materials that went into it. The more value a company adds to a product, the more it can charge for the product. Value-added occurs at each step in the manufacturing supply chain, when companies purchase raw materials or capital goods and turn them into a finished product. It doesn’t just refer to tangible improvements a company makes to a product — value-added can also refer to the perceived value created through marketing.

Example

Consider the example of a pizza you buy from your local pizza joint. You could just go to the grocery store and buy all of the ingredients yourself. In fact, it’s probably cheaper to make your own pizza at home. But when the pizza place makes the pizza, it adds value with the particular method it uses to cook the sauce and bake the crust. Not only that, but the restaurant adds value through the customer service it gives and the atmosphere it creates. The difference between the cost of the ingredients and labor that went into the pizza and the value of the final product is the value-added.

Takeaway

Value-added is like the difference between a blank book and a best-selling novel...

A book without words isn’t worth much more than the paper and binding within it. A company adds a bit of value by putting the pieces together. But it’s not until the author puts the words on the pages that consumers see value in the book. The author of the book is just like companies that add value to products before selling them to the buyers.

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What is value-added?

Value-added refers to the difference between what a company pays to produce a good and the cost at which the company sells that good. Adding more value to a product often means more money for the company. Companies can add value to products in many ways. It’s not just tangible improvements to a product that count as value-added — It can also refer to the perceived value-added as a result of intangible factors such as brand recognition and customer service.

Suppose there were two coffee shops near each other selling the same high-quality coffee. One of the coffee shops has really excellent customer service, while the service at the other shop is subpar. There are plenty of people who would choose to visit the shop with superior customer service. In fact, they might even be willing to pay more for that coffee. That excellent customer service is a value-add for the company. Starbucks has been able to master this exact business model — Even if the coffee isn’t better, customers perceive the product to have more value than at other coffee chains.

What is value-added in the economy?

Value-added isn’t just important when it comes to determining the profit margin for a particular company. It’s also an important factor for the economy and the nation’s gross domestic product (GDP), which is the value of all the goods and services a country produces in a year.

In the United States, the Bureau of Economic Analysis (BEA) collects data on the value-added of each industry. An industry value-added, also known as an industry GDP, is the difference between the gross output and the costs of the whole industry. The gross output consists of total revenue, commodity taxes, and inventory changes. Costs include energy, raw materials, and unfinished goods (aka work in progress). Not only does an industry GDP give you an idea of what’s happening in a particular sector, but the BEA also uses that value-added number as that industry’s contribution to the nation’s overall GDP.

What is value-added through marketing?

Value-added doesn’t necessarily have to be a tangible improvement to a product (though it often is). Instead, companies can also create value-added through their marketing efforts. Consider the difference between Coca-Cola and Pepsi. Both companies pay a lot of money for their marketing efforts to create brand-loyal customers. In fact, most people probably feel strongly about preferring to drink one or the other.

It’s not just soda companies that create this value-added through marketing. Most people can think of a company, whether it be a favorite restaurant, a tech brand, or a clothing line, that they buy because of the brand name. People spend money at those companies because of the feeling and the perception that the name creates.

What is value-added pricing?

When it comes down to pricing a particular product, companies largely have to follow consumer demand. But what if a company wants to charge more for a product than the market will currently allow? One way that companies can charge more for a product, without losing demand, is to use a value-added pricing strategy. When you use value-added pricing, you find a way to add value to a product for which people will pay more money.

Consider the value-added example of companies that practice corporate social responsibility, which is when they aim to have a positive impact on the environment or their community. It might be through their environmentally friendly production or packaging, or that they donate some of their revenue to charity. Even though this factor may not change the product itself in any way, it instantly adds value to the company in the eyes of many consumers. As a result, people are often willing to pay more for the products that those companies sell.

How do you calculate value-added?

Value-added refers to the economic profit that a company gets from its products. To calculate value-added, a company first has to figure out its net operating profit after taxes. For that calculation, simply take a company’s operating income (which is its profit after deducting operating expenses from revenue) and multiply by the company’s tax rate. Suppose that a company’s net profit were $100,000. If we assume that the company paid the standard corporate tax rate of 21%, then the net operating profit after taxes would be $79,000.

Next, figure out the amount of capital a company has. You can do this by looking at its book value, meaning the amount of the equity and debt on the company’s balance sheet. You’ll also have to figure out the cost of the capital, which is the expected rate of return for the debt and equity. Finally, subtract the total cost of capital from the net operating profit after tax. So if our company with the $79,000 net operating profit after tax had $30,000 of capital costs, then its total value-added is $49,000.

Why is value-added important?

Value-added is the difference between the cost of the materials and labor to produce a certain good and the price at which the company sells the product. In other words, the value-added represents the profit a company gets for each individual item. The more value a company can add to a product, either through tangible improvements or those that consumers perceive, the greater the profit margins for the company.

Value-added is also important on a greater economic scale. The Bureau of Economic Analysis (BEA) uses the value-added of an entire industry to figure out what that industry has contributed to the nation’s gross domestic product (GDP).

How can you add value?

There are many ways that companies can add value to their products. In some cases companies add value by reducing the cost of production of a particular good. Other times they add value by increasing the amount that customers will pay for something. Here are some of the most common sources of value-added:

  • Economies of scale: It’s often the case that the more of something that a company produces, the less it costs to make each individual item. Like buying the larger size of something at the grocery store to save a bit of money per ounce, companies can save money by mass-producing. As a result, they widen the gap between what they pay for a product and what they sell it for, creating value-added.
  • Economies of scope: In some cases, producing a greater variety of goods allows a company to bring down the average cost to produce each good. Increased economies of scope serve as value-added for a company.
  • Cost advantages: Anytime companies can produce something at a lower cost than a competitor, they have a cost advantage. This competitive advantage can help companies to increase the difference between their cost to produce a good and the price at which they sell it.
  • Product differentiation: There are tangible and intangible ways that companies can differentiate themselves from their competitors that serve as added value. Consider the example of Apple — For many people, simply the Apple logo on a product is enough of a value-add to get them to buy.
  • Access to distribution channels: A distribution channel is the supply chain a company uses to get its products to the consumers. When a company has access to a more efficient distribution channel, it can add value to its product by widening the profit margin.
  • Government policy: While government policy isn’t necessarily something that a company does to add value to its products, it’s still a factor that can increase a company’s profit margins. When governments carry out policies that make it difficult for new companies to enter the market, those already in the market can charge a higher price for their products.
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