What it means
The idea is easiest to see in a chain. A sawmill buys timber, cuts it and sells boards; the value added is the gap between the price of the boards and the cost of the logs, energy and outside services consumed in making them.
That gap is what the business has to share out among everyone with a claim on it. Wages, depreciation on equipment, interest to lenders, tax to government and retained profit for the owners are all funded from value added, which is why it is sometimes presented as a statement of value added and its distribution.
Value added is not the same as gross profit, although the two are related. Gross profit deducts the cost of goods sold as defined by accounting policy, while value added deducts every bought-in good and service, including externally purchased utilities, subcontracting and professional fees.
Expressed as a percentage of revenue, it tells you what kind of business you are looking at. A distributor that buys finished goods and ships them may add only a slim percentage, while a design consultancy that buys almost nothing but a few software licences adds most of its revenue itself.
The measure is also the basis for value added tax, which charges tax at each stage of the chain on the value each business adds rather than on the full sale price. The same idea underpins national accounts, where the gross domestic product of a country is essentially the sum of value added by everyone in it.
In practice
Real-world examples.
Example
A neighbourhood bakery sells $900,000 of bread and cakes a year and spends $360,000 on flour, other ingredients, packaging and energy. Its value added of $540,000 is 60% of revenue, most of which goes on the wages of the bakers and counter staff.
Example
An electrical wholesaler turns over $12,000,000 but pays manufacturers $10,200,000 for the goods it resells. Value added of $1,800,000 is only 15% of revenue, which is why the business lives or dies on volume, stock turn and tight overheads rather than on margin per item.
Example
A management consultancy bills $2,400,000 and buys in $400,000 of subcontractor time, software and travel. Value added of $2,000,000 is around 83% of revenue, reflecting a business whose output is almost entirely the work of its own people.
Formula
Calculation
Value Added = Sales Revenue - Cost of Bought-In Goods and Services. It can also be checked from the other direction, since value added must equal wages plus depreciation plus interest plus tax plus retained profit.
A furniture maker records sales revenue of $5,000,000. It buys in raw materials of $1,900,000, subcontracted finishing services of $600,000 and external utilities and professional services of $500,000, a total of $3,000,000 of bought-in goods and services. Value added is $5,000,000 - $3,000,000 = $2,000,000, which is 40% of revenue. Checking the distribution: wages of $1,300,000 plus depreciation of $200,000 plus interest of $100,000 plus tax of $120,000 plus retained profit of $280,000 also comes to $2,000,000. With 40 employees, value added per employee is $2,000,000 / 40 = $50,000.Case study
Seen in the real world.
Kestrel Joinery is an invented staircase and door manufacturer used here purely as an illustrative example. Revenue had been flat at about $3,000,000 for three years and the owner assumed the problem was pricing, since gross margin looked reasonable and the order book was full.
His accountant reframed the numbers around value added instead. Bought-in goods and services came to $1,500,000, so value added was $3,000,000 - $1,500,000 = $1,500,000, exactly 50% of revenue, and a growing share of that spend was subcontracted machining and bought-in ironmongery that the workshop used to make itself.
Over the following two years the company brought machining back in house on a second-hand CNC router and started fabricating its own hardware fittings. Revenue rose modestly to $3,200,000, but bought-in costs fell to $1,280,000, lifting value added to $1,920,000, or 60% of revenue. The extra $420,000 of value added funded three new joiners and a pay rise, on a revenue increase of only $200,000.
Watch out
Common mistakes.
- Treating value added as another name for profit, when it is the pool from which wages, depreciation, interest, tax and profit are all paid.
- Assuming a high value added percentage always means a better business, when capital-intensive and labour-intensive models simply distribute the same pool differently.
- Confusing the accounting measure with value added tax, which uses the same underlying idea but follows detailed statutory rules on what counts.
Questions
People also ask.
How does value added differ from gross profit?
Gross profit deducts only the cost of goods sold under accounting policy, while value added deducts every bought-in good and service including utilities and outsourced work.
Why is value added per employee useful?
It shows how much wealth each person in the business helps create, which is a fairer productivity comparison than revenue per employee across different business models.
Can a business increase value added without growing sales?
Yes, by bringing bought-in work in house or by reducing dependence on external suppliers, which raises the share of each sales dollar the business creates itself.
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