Methods of Computation

What is National Income? 

In your basic introduction to computation lessons in accounting, you learn the concepts of income, expenditure, profit & loss, along with assets and liabilities. These are the foundational keystones of the introduction to the computation of national income that forms the part of an economy. 

National income is also known as the gross income of the entire country. It is calculated by finding out the total income earned by all the residents of a country over the course of one accounting year. In simpler terms, it is the total value of goods and services made by the residents of the country. There are three methods of computation of income that gives rise to various computation questions. 

Flow of Money

Before moving on to computation questions, we need to know about money flow in an economy. For example, you go to work every day and receive your salary for the work done in a month. Using that money from your salary, you pay for your basic needs and luxury goods and services. You also pay for your rent, groceries, and other small expenses that affect the economy. 

When you purchase groceries with your salary, it creates a demand for household goods. As there is an increase in demand, there is more production of goods and services, which in turn results in more employment in the manufacturing sector. These employees have more disposable income in their hands that they use to increase their purchasing power. As you can see, there is a continuous flow of money from one hand to the next. In accounting terms, it is called the circular flow of income for introduction to computation. 

Circular Flow of Income

The circular flow of income is an economic model that shows how the money moves around from households to industries and vice-versa. There are four factors that affect the circular flow of income – households, industries, government spending, and exports. 

The government injects money into the economy and industries earned by exports. However, if we are importing more goods, then we are reducing our disposable income by paying taxes to the government. The four factors constitute the influx of flow of money into the economy, and taxes along with imports include the total outflow of money. The national income increases when a total influx is a total outflow, and circular flow is balanced when they are equal. 

Methods of Computation of Income

Now that you are familiar with the concept of circular flow, we can move on to the computation of income. It is essential as we can assess the growth of an economy through computation questions. 

Income Method

This method focuses on the total production of goods and services using land, labour, and capital. The Income method also focuses on all the factors of production like rent, wages, salaries, profits, and interest payable. The computation of income through the income method focuses on these factors of production. 

The income method also takes mixed-income into account, which is the income generated in an economy through entrepreneurs and sole proprietors. Thus, the income method is the sum of rent, wages, interest, profit, and mixed income of individuals in a country. 

However, it does not take illegal money, transfer payments, gambling money, and the sale of second-hand goods. 

Expenditure Method

The computation of income through this method focuses only on expenditures made by the residents, government, and business enterprises. 

Just like the income method, the expenditure method has four proponents – purchase of goods and services, government expenditures, expenditure by businesses on stocks and capital markets, and net exports in a country. Thus, the expenditure method is the sum total of all four proponents, excluding expenditure on second-hand goods, share market income, and bonds. 

Value-added Method

This method of computation of income focuses only on value addition at the final stage of production. Here, we first need to calculate the net value added (NVA) that deducts the net indirect taxes. 

The value-added method is considered to be the finest method in the computation of income as it includes all the industries. The NVA is calculated at every stage of production that focuses on the net value added by every component. It subtracts the consumption of raw materials, consumption of capital, and indirect taxes from the output to get the net value added at factor cost for a particular industry. 

Conclusion

When you add the net value added at factor cost for all industries, you get the net domestic product at factor cost, to which we add the net factor income from abroad to get the national income of a country.