What is Value Added and how is it calculated?
What is Value Added and how is it calculated? Discuss the operating ratios that you can use to determine the nature of profit and cash generation (strong or weak) for firms in two different business sectors.
Value-added refers to the additional income made over the original worth of something. It is the wealth generated by a business from using its resources and its employees. Value-added can apply to goods, services, companies and other areas of commerce (Learn the Different Type…, 2020). Value-added can be achieved by enhancing a commodity in a certain way, and then offering it for sale to the buyer. An enterprise buys raw materials, for instance, goods and services and converts them into higher-value products or services. The higher value products and services achieve the value-added (Kenton, 2019). An example is in a carpentry business where the buyer buys timber, nails and other raw materials and converts them into furniture. This is a value addition.
Value added is achieved by getting the difference between the costs incurred when preparing a certain good or service and the total profit that the product makes after being bought by the price the buyer is willing to buy. Generally, value-added is obtained by deducting purchases from sales (Value Adding, 2020). However, companies that have strong branding add value to their products by manipulating their logo or brand name in availing the commodity to the buyer.
There are two methods of calculating the value added; they include the subtractive and additive method. The subtractive method is derived by subtracting the expenses of a commodity or service from the total sale amount of the product. This is the net value of an enterprise. For instance, a processing industry buys raw coffee berries from farmers then processes it for the market. Under the additive method, value added is calculated by adding various kinds of value-added disseminated to the business stakeholders, for instance, taxes, wages, and interest paid to loans (Anamaria, 2010).
The operating ratio of a company is the company’s entity’s expenses as a portion of the total revenue. Companies need to maintain low operational costs in order to have a higher value-added. Companies use the operational ratio to determine the company’s efficiency by comparing it with the net sales. To determine how operation ratio influences profit and cash generation, the paper shall analyse a retail company and a water utility company.
The retail company has a weak value-added due to the little margin between sales and purchases. The company’s operation profit is $1 million after labour and depreciation scoops $ 3 million. The operation ratio in relation to return to sales is at 5% and total cash generation is to sales is at 10%. The total value added to sales is 20%. Labour’s share of the total value added for the retail company is 50%. In contrary, the water utility company has a strong cash generation due to a big positive margin between sales and purchases. The total operation profit for the water utility company is $35 million after deducting $20 and $30 million to depreciation and labour respectively. The total value added to sales is at 71%, whereas the return on sales is 29%. The company has a relatively lower portion of purchases to sales thus a high return on the cash to sales. Labour’s share of value added to internal costs is at 35%.
The rationale for the value added to the sales in the retail company is that the high competition in the marketplace results in the reduction of commodity price, and the market dictates the price range (Berry, 2019). In contrast, the water company lacks stiff competition in the market place thus consistency in price per unit. The purchasing cost to sales is high in the retail company, making little profit per unit. Purchases cost to sales in the water company is low due to negligible amount of input such as little purification. The retail company spends more on labour as compared to the water utility; this is due to the different nature of the industries. Therefore, the cash to sales for the retail company are low as compared to the water utility company, attributing to intensive labour in the retail company.
Conclusion
The water utility company has a strong profit and cash generation rate coupled with high operating costs; this is due to the nature of the industry. The industry benefits from high value-added to the holding ratio, with low labour share of the value-added. In contrast, the retail company has is weak in profit and cash generation rate. High purchases to sales ratio and labour costs results in low value-added.
References
Anamaria, P., Sándor and Augustin (2010) “Analysis Of The Value Added By The Additive Method”, Annals of Faculty of Economics, 1(1), pp. 394-398. Available at: https://ideas.repec.org/a/ora/journl/v1y2010i1p394-398.html (Accessed: 12 May 2020).
John Berry. (2019). Marketing Value Added Products. Available at: https://extension.psu.edu/marketing-value-added-products (Accessed: 11 May 2020)
Lean Manufacturing concept – Value Added – Value Adding. (2020). Available at: http://www.leanmanufacture.net/leanterms/valueadded.aspx (Accessed: 11 May 2020)
Will Kenton. (2019) Why Value-Added Matters Available at: https://www.investopedia.com/terms/v/valueadded.asp (Accessed: 11 May 2020)
Value Added – Learn the Different Types & Ways of Adding Value. (2020). Available at: https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-value-added/ (Accessed: 11 May 2020)