Intermediate consumption: Meaning, Criticisms & Real-World Uses

What Is Intermediate Consumption?

Intermediate consumption, a core concept in national accounts and macroeconomics, measures the value of goods and services used as inputs in a production process to create other goods and services. It represents the value of inputs that are transformed or entirely used up during production, excluding fixed assets whose consumption is accounted for as depreciation or consumption of fixed capital. These inputs can include raw materials, energy, and various services purchased by businesses.¹⁵, ¹⁶

History and Origin

The concept of intermediate consumption is integral to the development of national accounts, a statistical framework for summarizing and analyzing economic activity. Early attempts to quantify a nation's economic output can be traced back to the 17th century with works by Sir William Petty and Gregory King in England, who sought to estimate national income.¹³, ¹⁴ These pioneering efforts laid the groundwork for modern systems of accounting for economic flows. The formalization of intermediate consumption as a distinct concept gained prominence with the evolution of national accounting systems in the 20th century. The Great Depression of the 1930s spurred economists to develop more comprehensive statistical models of economies, leading to the establishment of national accounting frameworks.¹¹, ¹² Richard Stone's work, which contributed to the first United Nations System of National Accounts (SNA) published in 1953, was particularly significant in establishing a systematic framework for recording production, consumption, and accumulation, including the precise definition and measurement of intermediate consumption.¹⁰

Key Takeaways

Intermediate consumption represents the value of goods and services consumed as inputs in a production process.
It is a crucial component in calculating gross value added (GVA) and subsequently, Gross Domestic Product (GDP).
Examples include raw materials, energy, and services like accounting or legal fees used by businesses.
It excludes the consumption of fixed assets, which is recorded as depreciation or consumption of fixed capital.
Understanding intermediate consumption helps in analyzing an industry's efficiency and its contribution to the overall economy.

Formula and Calculation

Intermediate consumption is a key component in calculating gross value added (GVA), which is derived from an industry's gross output. The formula is:

\text{Gross Value Added (GVA)} = \text{Gross Output} - \text{Intermediate Consumption}

Where:

Gross Output: The total value of goods and services produced by an industry.
Intermediate Consumption: The value of goods and services used up as inputs in the production process.

This formula highlights that GVA measures the value added at each stage of production by subtracting the cost of inputs already produced by other entities.

Interpreting the Intermediate Consumption

The interpretation of intermediate consumption is critical for understanding the structure and efficiency of an economy. A higher level of intermediate consumption relative to gross output in an industry might indicate lower efficiency, as more inputs are required to produce a certain output. Conversely, a lower ratio could suggest improved efficiency.⁹ It also reveals the interconnectedness of different industries, as the output of one industry often becomes the intermediate consumption for another. For example, the steel produced by a metal manufacturing company serves as an intermediate input for an automobile manufacturer. This inter-industry relationship is often visualized through input-output tables, which detail the flow of goods and services between various sectors of an economy.

Hypothetical Example

Consider "EcoFurniture," a company that manufactures wooden chairs. To produce these chairs, EcoFurniture incurs several costs. They purchase lumber, screws, wood glue, and varnish. They also pay for electricity to power their machinery, rent for their workshop, and a professional service for designing their product catalog.

In this scenario:

The lumber, screws, wood glue, and varnish are raw materials directly transformed into the finished product.
The electricity consumed, the workshop rent, and the catalog design service are all inputs used up or consumed in the production process of the chairs.

All these costs collectively represent EcoFurniture's intermediate consumption. Payments to their carpenters (compensation of employees) or the purchase of new woodworking machinery (a fixed asset) would not be considered intermediate consumption, as the former is labor cost and the latter is a capital expenditure.

Practical Applications

Intermediate consumption data is vital for a wide array of economic analysis and policy-making. In national accounts, it is a fundamental component for calculating gross domestic product (GDP) using the production approach, where it is deducted from gross output to arrive at gross value added. This helps economists and policymakers understand the value created at each stage of production within an economy.

Businesses utilize intermediate consumption data to analyze their cost structures and improve efficiency. By examining the types and values of intermediate inputs, companies can identify opportunities for cost reduction or supply chain optimization. For government entities, understanding trends in intermediate consumption across different sectors can inform industrial policies, trade negotiations, and tax policies. For instance, the U.S. Bureau of Economic Analysis (BEA) collects and publishes data on intermediate goods and services purchased by various sectors, including government consumption expenditures, which are key inputs for their economic reports.⁷, ⁸

Limitations and Criticisms

While essential for national accounting, the measurement and interpretation of intermediate consumption come with certain limitations and criticisms. One challenge lies in precisely defining the boundary between intermediate consumption and other economic flows, particularly capital formation or final consumption expenditure. For instance, durable goods that are small, inexpensive, and used for ongoing operations might be classified as intermediate consumption, while larger, more expensive durable goods are considered fixed assets subject to depreciation. This distinction can sometimes be ambiguous and vary across different accounting standards or statistical agencies.

Another point of contention can arise from the statistical boundary between intermediate consumption and value-added, which can be influenced by ownership structures. If a company chooses to outsource services (e.g., accounting or cleaning) rather than producing them in-house, its intermediate consumption will increase, and its own gross value added will decrease. This highlights that changes in business organization can impact reported intermediate consumption figures, even if the underlying economic activity remains similar. Furthermore, the valuation of intermediate consumption, typically at purchaser prices, can be complex, especially when dealing with non-market transactions or goods produced for own-use.

Intermediate Consumption vs. Final Consumption Expenditure

Intermediate consumption and final consumption expenditure are distinct but related concepts within national accounts, both dealing with the use of goods and services. The key difference lies in their ultimate purpose:

Intermediate Consumption: Refers to goods and services used as inputs in the production of other goods and services. These inputs are transformed or entirely used up during the production process. Examples include flour for a bakery, steel for a car manufacturer, or electricity used by a factory.⁵, ⁶
Final Consumption Expenditure: Represents the spending on goods and services that are used to directly satisfy individual or collective needs and wants, without further transformation in a production process. This includes purchases by households (e.g., groceries, haircuts), non-profit institutions serving households (NPISHs), and government (e.g., public services, defense).⁴

Confusion often arises because both involve "consumption." However, intermediate consumption is a business cost incurred to generate output, whereas final consumption is the ultimate end-use of goods and services by consumers.

FAQs

What is the main difference between intermediate consumption and capital formation?

Intermediate consumption refers to goods and services used up or transformed in a single production process, such as raw materials or energy.³ Capital formation, also known as investment, involves the acquisition of fixed assets like machinery, buildings, or infrastructure, which are used repeatedly over a long period to produce goods and services.

Is labor cost considered intermediate consumption?

No, labor costs, or compensation of employees, are not considered intermediate consumption. Intermediate consumption accounts for goods and services purchased from other businesses. Labor is a factor of production, and its cost is part of the value added by the producing unit.²

How does intermediate consumption affect GDP?

Intermediate consumption directly impacts the calculation of gross domestic product (GDP) when using the production approach. GDP is derived by summing the gross value added of all industries, and gross value added is calculated by subtracting intermediate consumption from gross output. Therefore, higher intermediate consumption for a given gross output results in lower value added and, consequently, lower GDP from that sector.

What are some examples of intermediate services?

Intermediate services include various services purchased by businesses that are used up in their production process. Examples include accounting services, legal fees, advertising services, transportation services for moving goods, cleaning services for an office building, and IT support.¹ These services facilitate the main economic activity of the business but are not directly incorporated into the final product.