Value added: what a firm really creates
A firm does not create the value of everything it sells. Part of the price pays for things it bought from other firms: raw material, electricity, transport, services. These are called bought-in goods and services (also intermediate consumption).
Value added = sales - bought-in goods and services.
It is the new value created by the firm's own work and capital. Adding the value added of every firm in a country gives that country's output (GDP).
Example: sales 100, bought-in 60, value added 40.
Sharing the value added between the actors
Everyone who helped the firm gets a share of the value added:
- Employees: wages and social contributions.
- The state: taxes and duties.
- Lenders: interest on loans.
- Owners (shareholders): profit, the remainder.
- The firm itself keeps some for depreciation and growth.
The share of each actor = amount / value added. In the 3D: 12/40 = 30% to staff, 5/40 = 12.5% to the state, 3/40 = 7.5% to lenders, 20/40 = 50% to owners.
Financial, shareholder and stakeholder value
Financial value is what accounts show in money: profit, assets, cash. Shareholder value looks only at the owners: dividends and the rising price of shares.
Stakeholder value looks at everyone with a stake: staff, customers, suppliers, lenders, the state and the local community. A firm that treats staff badly may show a high profit this year but lose in the long run.
Perceived value is what the customer feels a product is worth: brand, reputation, reviews, service. Two identical shirts can sell for different prices because one brand is trusted. Perceived value is not directly on the balance sheet, but it lets a firm charge more.
Price, cost and margin
Cost is what the firm spends to make and sell a product. Price is what the customer pays. Margin = price - cost (the gain on each unit). Margin rate = margin / cost, and the margin on sales = margin / price.
Example: cost 60, price 100: margin 40; margin on cost 66.7%; margin on price 40%. Moving the price slider in the 3D changes the margin straight away.
Allocating profit: reserves, dividends, retained earnings
At year end the profit belongs to the company, and the owners decide its use:
- Legal reserve: many countries force companies to put a small part (often 5-10%) of profit aside until it reaches a set share of capital. It protects lenders.
- Optional (free) reserves: kept by choice, for future needs.
- Dividends: the part paid out to shareholders.
- Retained earnings / profit carried forward: what stays in the business to fund growth.
Rule: profit available = profit of the year + earlier retained profit - losses brought forward - legal reserve. Dividends can only be paid from this amount, never from capital.
The accounting information system and digital tools
The accounting information system (AIS) collects, records, processes and reports the money facts of a firm.
Flow: source document (invoice, receipt, bank statement) -> journal (record in order of date) -> ledger (group by account) -> trial balance -> financial statements (income statement, balance sheet).
ERP (enterprise resource planning) software joins accounts, sales, purchases, stock and payroll in one database. A sale entered once updates stock, customer account and the ledger at once.
Paperless documents (e-invoices, scanned bills) save space and speed search. Data security needs: user passwords and roles, backups, encryption, an audit trail of who changed what, and privacy rules for personal data.
Key formulas and definitions
- Value added = Sales - Bought-in goods and services
- Share of an actor = amount received / value added x 100
- Margin = Price - Cost; margin rate = margin / cost
- Profit = Value added - wages - taxes - interest (- depreciation)
- Profit to allocate = profit + retained profit brought forward - losses - legal reserve
Worked examples
1. A bakery sells bread worth 5,000 and bought flour, gas and packing worth 3,000. Find its value added.
Value added = 5,000 - 3,000 = 2,000.
2. The bakery pays wages 900, taxes 150 and interest 100. Find the profit and each actor's share of value added.
Profit = 2,000 - 900 - 150 - 100 = 850. Shares: staff 900/2,000 = 45%, state 7.5%, lender 5%, owners 42.5%. Together 100%.
3. Profit is 850. The firm keeps 10% as legal reserve, pays 50% of the profit as dividends and retains the rest. Find each amount.
Legal reserve = 85. Dividends = 425. Retained = 850 - 85 - 425 = 340.
4. A shirt costs 400 to make and is sold at 700. Find the margin, the margin rate on cost and the share of margin in price.
Margin = 700 - 400 = 300. Margin rate on cost = 300/400 = 75%. Margin in price = 300/700 = 42.9%.
5. In a year a firm makes a profit of 200. Last year's retained profit is 50 and it still has a loss of 30 brought forward. The legal reserve is 10% of the year's profit. What can be distributed as dividends at most?
Legal reserve = 20. Available = 200 + 50 - 30 - 20 = 200. Dividends cannot exceed 200.
6. Put these in order: ledger, source document, financial statements, journal.
Source document -> journal -> ledger -> financial statements (with the trial balance before the statements).
Common mistakes
- Using total sales as 'value created'. Sales include goods bought from others; only sales minus bought-in is value added.
- Counting wages as part of bought-in goods. Wages go to the firm's own staff, so they are a share of value added, not a cost bought from outside.
- Thinking all profit is paid as dividends. Part goes to reserves and retained earnings.
- Mixing margin on cost with margin on price: 40 on a cost of 60 is 66.7% of cost but 40% of price.