In your basic accounts lessons, you must have learned the concepts of income and expenditure, assets and liabilities, profit and loss, and so on. Now, these concepts are important because they set the financial foundations for a successful business. However, it doesn’t stop there. These concepts are equally important for an economy as a whole. Let’s look at Income method and Expenditure Method of calculating National Income.
National income or the gross national income is the total income earned by all residents and enterprises of a country over a specific period. You can also define national income as the total value of all goods and services produced over a specific period of time. Now, there are several methods of calculating national income.
The three most common methods are the value-added method, the income method, and the expenditure method. The value-added method focuses on the value added to a product at each stage of its production.
Next, the income method focuses on the income received on the factors of production such as land and labor. And finally, the expenditure method focuses on the various types of expenditure based on consumption and investment. Let’s look at the income and expenditure methods in detail.
The income method of calculating national income takes into account the income generated from the basic factors of production. These include the land, labor, capital, and organization. And in addition to income accrued from these factors of production, another important component of income is mixed income. Now let’s discuss all these components in detail.
Rent from Land
Rent is the money you pay for the use of land. While calculating income, rent refers only to the income earned from using any land. Rent paid for the use of machinery and other equipment is not accounted for as rent.
Now in addition to rent, another form of income is royalty. Royalty is the amount you pay to an individual or a company in exchange for the use of assets such as coal or gas.
Compensation for Labor
Compensation includes salaries and wages that you earn in exchange for the services and skills that you provide for producing goods and services. It also includes travel allowances, bonuses, accommodation allowances, and medical reimbursements.
In addition to wages and salaries, another important component of compensation is remuneration in the form of social security schemes such as insurance, pensions, provident funds.
Interest on Capital
Interest refers to the charges you pay for using borrowed capital. Now, this includes the interest paid when a company takes a loan for an investment. Similarly, when a family invests in a property or a house, they take a loan from a bank and pay an interest for the same while repaying the loan over a period of time. However, while calculating national income, economists consider only the interest paid by production units.
Profits by Organizations
Profits refer to the money that organizations make while producing goods and services. Now companies distribute the profits they make by paying income tax to the government and dividends to shareholders. And the amount that is left over after paying tax and dividends is called undistributed profit.
Mixed income refers to the income of the self-employed individuals, farming units, and sole proprietorships. Now, if you consider all these components of income, national income can be represented as follows:
National Income = Rent + Compensation + Interest + Profit + Mixed income
When economists calculated national income, they divide the production units into different sectors. Then they calculate the income for each sector and then derive the total national income. However, while computing national income using the income approach, economists exclude transfer payments such as gifts and donations and profits from the sale of pre-owned goods. They also exclude income from the sale of shares and debentures.
Now that you are familiar with the income approach of calculating national income, let’s understand the expenditure approach. The final expenditure approach focuses on the expenditure involved in the production of goods and services. Now you can classify expenditure based on consumption and investment.
Consumption expenditure includes household consumption of goods and services (C). It also includes government’s expenditure on goods and services to fulfill social welfare needs (G). Investment expenditure refers to the expenditure made by companies and production units for raising capital (I). For instance, investment expenditure includes the purchase of fixed capital assets such as buildings and equipment. Expenditure also includes an addition to the stock of raw materials.
Investment expenditure also includes an acquisition of valuables such as precious metals or jewelry. Expenditure also includes imports and exports made by companies and the government. And while calculating national income, you need to calculate the net exports (NX). That is the total exports minus total imports.
Now while calculating national income using the expenditure approach, you need to also deduct depreciation on capital assets and indirect taxes. Using the expenditure approach, national income can be represented as follows:
National Income = C (household consumption) + G (government expenditure) + I (investment expense) + NX (net exports).
Again, you while determining income using the expenditure approach, you need to exclude expenditure on second-hand goods, purchase of shares and bonds, expenditure of transfer payments (unemployment benefits, pension), and purchase of intermediate products.
Solved Question for You
Question: Identify whether the following statement is true or false.
“Royalty received by an organization for the use of its coal mines can be considered as a source of income while computing national income using the income approach.”
Correct Answer: True. Royalty is a form of income and it should be accounted for while calculating national income using the income approach.