Describe How Value-Added Is Calculated. to What Extent Are Value Added, Cashflow, and Profit Connected to a Company’s Sales Performance? Essay

According to Gilchrist (Gilchrist, 1971) the value-added is a notion that companies should always be focused on. It can be defined as the measure of the amount of money created by a company. In economics and business languages, it is a term increasingly and wildly used in economic press or in politic speeches for example, especially in European countries concerned about their growth rate needed to maintain their level of living. Somewhat, when we speak about value-added, it is inevitable to address the critical question of labour costs which makes developed countries less competitive than emerging countries.

For example, the idea of a social VAT takes its place here within political programmes designed to reduce the labour costs lying on companies. On one hand, we will describe the several ways to calculate the value added of a company, firstly with the subtractive and the additive perspectives and secondly with the traditional accounting calculation used by most economists. We will also explain how the value added of a country is calculated.On the second hand, we will use the value added framework to try to establish a connection between the value-added, the cashflow and profit in one side, and the company’s sales performance in the other side. To illustrate the point, the examples of Hermes and Nike will be taken throughout this paper. On one hand, we will consider the company’s value-added.

According to Cox (Cox, 1979), there are four constituents of the value-added for a company. Indeed, the deduction of the purchases of materials and services from the gross output (total sales revenue) gives the value-added.Once calculated the value added has to be distributed between wages, depreciation and operating profit.

From this analyze, Cox assumes that it is possible to consider two different ways to calculate a company’s value-added for a given year: the subtractive calculation and the additive one. The subtractive method can be defined as follows: Value added equals to output minus input. The output is the total sales revenue which is calculated as the price of the good multiplied by the quantity sold.

The input represents all the expenses relating to the purchase of materials and services.With the subtractive method, the value-added represents therefore a percentage of the total sales revenue. Otherwise, the additive method focuses on the distribution of the value added. It can be defined as follows: Value-added equals to labour costs plus depreciation plus operating profit.

The labour costs are the cost of wages paid to workers (it includes social charges), those costs are usually the major costs of a business. According to Dodge (Dodge, 1997) the depreciation can be defined as “a decrease in an asset’s value caused by unfavorable market conditions”.The operating profit represents the earnings before interests and taxes.

Those interests and taxes are payable to the bank (interests on loans), the government (several taxes) and mainly to the shareholders (dividends). The other way to calculate the value added of company is the traditional accounting calculation used by most economists: Total sales revenue minus wages and salaries, raw materials and capital costs equals to value added. According to Kay (Kay, 1993), this calculation can measures the competitiveness of a company and gives an index of its profit.Furthermore, it is important to know that a company can produce whether high value-added products or low value-added products: According to the schema, we can understand that a company selling products made by others has a lower value-added than a company who produces and sells its own products. On the other hand, we will consider the countries’ value-added. Thus, the sum of all the values-added made on its territory constitutes the Gross Domestic Product (GDP) of a country. The GDP is therefore used to measure the wealth created in a country for a year given, but also to follow its evolution and then measure its growth.However, the value-added is calculated by currency and then doesn’t enable neither a comparison between the different years (because of the inflation) nor a comparison between countries (because of the currency).

For example, it does not make any sense to compare the GDP of Portugal and the GDP of the United States. This is why, generally, it is preferable to compare the evolution of the GDP which enables to determine the annual growth rate in percentage. Thus, the value-added is an important ndicator because in macroeconomics, it allows for a country to calculate its GDP and then its growth rate; and in microeconomics, it constitutes for a company a tool for its internal control. But does value-added have a connection with the profit a company and with its cashflow? As explained earlier, a company selling products made by others, contenting itself with packaging the goods and putting its brands on those has a lower value-added than a company who produces and sells its own products. But however, does the company with the higher value-added generate more profit than the one with the lower value-added?Does a company sell more easily low value-added products than high value-added products? Do those sales generate systematically more cash flow and profit? For example, Nike sells pairs of sneakers and sportswear manufactured abroad.

Its value-added is really low but however Nike is a very profitable company. In terms of cash flow, the fact that Nike does not manufacture its products itself permits the company to pay its suppliers the latest as possible and to receive to sales profit immediately. Thus, the generated cash flow increases its financial products.In terms of profit and sales performances, according to Gratlon and Taylor (Gratlon and Taylor, 2000) what Nike economizes in costs of manufacturing, it compensates it for an expensive and prestigious advertising which for example involves MBA celebrities, and make people dream.

Therefore, Nike can sell its products for expensive prices and then generate profit. On the opposite, the French family company Hermes manufactures and sells its own luxury, high-end and so high value-added products. The company employs highly skilled artisans who use very expensive raw materials.In terms of cash flow, it is possible to think that Hermes’ situation is less favorable than Nike’s one, insofar as Hermes has to pay its employees immediately and more as well as it can’t defer the payment as Nike does with its subcontractors in emerging countries. However, Hermes is a company that generates huge profits and its sales increase from year to year: it operates on a market where rarity, prestige and quality give the company an inestimable value which more and more wealthy Chinese or Russian people are ready to buy for a lot of money.Moreover, Hermes commercialize its products in a local distribution network which means that its worldwide network of stores only sell Hermes products and so with a minimum of middlemen to pay. However, many European or American companies are facing difficulties and do not meet the same success as Hermes or Nike. We can here take the example of the car industry.

Therefore, this is an industry selling really high value-added products (expensive assembly lines, a lot of research and development in order to improve the comfort and the security for example) on a very competitive market.Thus, the competitiveness comes from both emerging and industrialized countries. In order to continue to sell and to make profit, the companies drop the prices, cut their profit margins or relocate their production. In terms of cash flow, the solution would be to just-in-time distribute in order to keep the minimum level of stock, but here again there is not any general rule For example, the German company OPEL contributes in the German GDP because it creates jobs while Peugeot-Citroen relocate its production and cut jobs.So the difference between the two companies would be that OPEL focuses on the quality (the Deutsche qualitat) and operates on a market where the price is not really taken into account for the buyer while Peugeot-Citroen keeps selling medium range products already really competed by the emerging countries. With those different examples, it is possible to understand that a general rule does not exist: a company can generate a lot of profit on high value-added products as well as on low value-added products.

The companies’ strategy consists in playing on different parameters as the costs, the selling price, the quality or the innovation in order to conquer or lead the market. Nonetheless, when a company manufactures its products abroad, it can generate a lot of profit but the company does not create any wealth nation-wide, so its GDP contribution is really low. In consequence, we can ask ourselves if the GDP is still a pertinent to evaluate the wealth of a country.

Some economists propose to measure the wealth with the Gross National Happiness (GNH) which is a new indicator permitting to evaluate the well-being, the health, and the level of education of a country. The debate stays open. Bibliography: Cox, B. (1979)Value Added, London: Heinemann. Dodge, R. (1997) Foundations of Business Accounting, Thomson Business Press.

Gilchrist, R. R (1971) Managing for profit: The Value Added Concept, London: George Allen. Gratlon, C. and Taylor, P. (2000) Economies of sport and recreation, Taylor and Francis.

Kay, J. (1993) Foundations of Corporate Success , Oxford: OUP.