Transmitting economic ideas

The table below demonstrates how a nation’s GDP is determined. The table contains specimen transactions. Not all of a nation’s transactions relevant to GDP determination are included, just a sample. The table reveals the logic behind GDP determination and the role of the actors. It’s worth noting immediately that the government is a producer of goods and services and that government produced goods and services are included in GDP at cost. Household income is derived from wages and self-employment. Rentier income is derived solely from ownership of financial capital or property; rentiers do not produce anything.

The advantages of setting out GDP determination in tabular format are several.

Firstly , for those wishing to learn the basics it demonstrates the logic underpinning GDP determination. Included in this group could be first year undergraduates in economics, accountancy, business studies, and cognate subjects. As a former teacher myself, demonstration is vastly superior to presenting equations or relying on words to convey knowledge. In my experience, students will thank you for providing demonstrations to accompany words and to explain equations.

Secondly, it provides a format whereby students’ understanding can be tested. It should be fairly straigtforward to provide pre-printed tables with appropriately headed columns for students to use to enter a list of transactions under examination conditions.

Thirdly, the quantum of saving for each of the actors drops out of a completed table as shown in the savings table below. It demonstrates how Keynes’s “saving equals investment” postulate is arrived at. The saving figures also permit an introduction to sectoral balance analyses, as well as capital flows in a balance of payments context.

Fourthly, from the same table, the three approaches to GDP determination can be obtained. This is shown below.

Finally, the approach is not limited to demonstrating national income determination. It can be applied to other topics in economics, eg the banking system. Try it!

Value Added Statements

Introduction

Being slightly nerdy and having a background in accountancy and an amateur interest in some of the current economic controversies, the topic of value added statements and national income accounting interests me. Hence this post. I hope those with an interest in accounting and bookkeeping for national income will find this interesting and useful.

What is value added?

Value added is a measure of wealth creation. At an individual firm level, value added is measured as sales revenue minus the cost of all goods and services purchased from outside the firm. At an individual firm level, a value added statement provides a useful and interesting alternative to a traditional income statement.

Value added is used in accounting for national income because a nation’s value added is the same as a nation’s GDP. Value added statements can assist in evaluating government spending projects.

Illustration

The government proposes to spend £100 m on a much needed public housing programme. It will borrow funds from wealthy private sector savers to finance the project.

Of the additional GDP created by the project, 10% will be paid to government by way of taxation and 10% will be saved by the private sector. The remaining 80% of additional GDP will be spent on wages and salaries. The recipients of wages and salaries will spend their entire incomes on consumption. This consumption expenditure will be spent 3 parts on imported goods and 5 parts on domestically produced goods and services.

The multiplier effect

The spending in shops, restaurants, cinemas, and on other consumables by workers becomes the income of those supplying the goods and services to the workers. These suppliers will then pay their labour force, who in turn will then spend their wages on consumable goods and services in shops, restaurants etc. However, at each turn of the cycle, the value of transactions will shrink by 50% because the 10% saving rate, the 10% tax rate, and the 30% import rate removes 50% of income received from circulation by the time wages are next paid. This  process will continue until all the additional demand generated by the £100 m initial government injection has disappeared. This will occur when the additional GDP has reached £200m. It stops at this point because the multiplier value used in the illustration is 2*. Had the multiplier value been 1.5 then the process would stop when the additional GDP (value added) reached £150 m (1.5 x £100m)

The following statement reports the additional GDP once all transactions have completed.

Value Added Statement

Some final points

The statement is in two parts. The top part shows how value has been created. The lower part shows how the value has been distributed among the stakeholders. In the above example, providers of finance capital have not been shown as stakeholders. This is a deliberate omission, made to aid exposition

The above example is a simple one. For example, we have assumed that all wages have been spent on consumption. In reality, this is unlikely to be the case because workers may save, just as the firms have done in this example.

Secondly, we are not showing how much of the value added has been distributed to finance creditors and shareholders as interest and dividends respectively. Their share of valued added has been subsumed under savings instead of itemising their respective share of value added .To keep the illustration simple, all consumption expenditure has been assumed to derive from wages and salaries. In reality, dividends and interest payments will impact consumption expenditure.

Another simplification is that all consumption expenditure has been paid for out of income. This is nowadays an unrealistic assumption since it is common for workers to borrow to fund their consumption expenditure. A simplifying assumption has been made in the illustration that workers do not spend more than they have earned.

More elaborate value added statement to incorporate more complex and realistic scenarios are relatively easy to prepare.

The coding shown on the value added statement illustration denotes the item corresponding to the expenditure method of measuring national income, eg G = Government expenditure, C = Consumption, M = Imports and Y = National Income, T = Taxation and S = Savings.

* A multiplier value is calculated as the reciprocal of the sum of leakages. In the illustration, the leakages were tax = 10% + saving  = 10% + imports = 30% = 50%.  The reciprocal of 50% = 2, which is the value of the multiplier used in the illustration

In praise of value added statements

Introduction

In this post I express my long standing enthusiasm for the value added statement and my disappointment that they are currently unfashionable. I am enthusiastic because of their relevance to a wider group of users than are traditional income statements. They can be  particularly relevant and useful to employees. Value added statements possess simplicity and elegance and are underpinned by a co-operative philosophy  between workers and capitalists. Along with employee representation on corporate boards of directors, value added statements can contribute to the enfranchisement / empowerment of workers. I believe such an outcome is a good thing.

The traditional income statement

All firms will (or should) produce an income statement. An income statement looks at a firm’s performance from the point of view of the owners. Owners may be sole traders, partners, or a company’s shareholders.  An income statement’s purpose is to report how much profit has been made by a firm in an accounting period and how this profit was achieved. Clearly, such statements with profit as their primary focus are orientated towards business owners. Of course, in countries where profits and income are taxed, the traditional income statement is useful for taxation purposes too.

Labour costs

In income statements, wages and salaries are not seen as payments to contributors towards wealth creation. Instead, labour costs are seen and treated as a cost burden that reduces owner profit. Labour costs are often subsumed within cost of sales, administration costs and distribution costs and so may not be visible on the face of the income statement.

Taxation

Although tax is accounted for differently, it too is viewed negatively. Instead of tax being seen as a contribution to wider society, it is seen and treated as a deduction from owner profit. In short, it is seen as a burden that reduces the disposable income of owners.

The treatment of wage costs and taxation charges in the traditional income statement reflects and promotes the interests of the dominant capitalist class, that is, the object of economic activity is to enrich the owners of firms. Benefits received by labour and by wider society are seen as incidental  to the firm’s activities, to be minimised, where possible, so as to maximise owner disposable income

Here is Tesco PLC’s group income statement for 2012. This can be contrasted with Tesco’s value added statement shown in the next section.

Tesco income statement processed

Value added statements

The traditional income statement is not the only way of presenting a firm’s results. Items of cost in an income statement can be unpacked, rearranged and recast for the benefit of a wider group of people – the stakeholders. The new information is reported in a value added statement.

Stakeholders

Stakeholders consist of a firm’s workers, its providers of loan capital, its owners, the government, and society at large.  Each stakeholder contributes to the wealth creation of a firm. The government is included in the list of wealth creators because of its role in providing the transport, legal and financial infrastructures, education, health, and other services. Without these services business activity would not thrive.  In a value added statement, none of the stakeholders are given primacy.

Value added: an alternative metric

In a value added statement profit does not feature as the primary metric. Instead, value added, a measure of wealth creation, replaces the profit metric. The value added metric changes the implied orientation of a firm from owners to stakeholders. Value added is measured as the difference between a firm’s sales revenue and the costs of materials, goods and services bought-in from outside the firm. Where a firm has other sources of income, it is convenient to add these into sales revenue, as demonstrated in the statement below.

Tesco Value Added Statements

Postscript

Financial reports have political and social significance The financial reports prepared by accountants are not neutral – they reflect the perspective and interests of the dominant social class – capitalists.

Capital increasingly has gained the upper hand over labour in recent times.  Accounting practice reflects capital’s dominance, and financial statements may seem quite opaque and irrelevant to workers and to society at large. Of course, worker incomprehension of financial reports suits the purpose of capital. Opaque financial reports create information assymetry which favours capitalists over workers in wage and related negotiations.

Value added statements go some way to redressing this information assymetry and power imbalance. It is probably too optimistic to hope that legislatures around the world will legislate to require companies to include a value added statement in their corporate reports. This is a predictable consequence of capital’s dominance and its hold over governments.

Despite this, it is usually feasible to convert a firm’s income statement into a value added statement, although this depends on using information that is found elsewhere in a company’s corporate report, most notably in the notes to the accounts.

In the above example, I was able to produce Tesco’s group value added statement, but not a value added statement for Tesco UK. This is because Tesco’s financial statements have not segmented labour costs by country. I was hence unable to identify the UK specific element from the published consolidated figure for Tesco’s  labour costs..

I shall continue to extol the virtues of value added statements, despite their being out of fashion. I hope you and others will do the same