Product Cost Versus Period Cost:
Learning Objectives of this
article:
In addition to the distinction
between manufacturing and non-manufacturing costs, there are other ways to look
at costs. Costs can also be classified as either
product cost or period cost. To
understand the difference between product costs and period costs, we must first
refresh our understanding of the matching principle from financial accounting. Generally costs are recognized as expenses on the
income statement in the
period that benefits from the cost. For example, if a company pays for liability
insurance in advance for two years, the entire amount is not considered an
expense of the year in which the payment is made. Instead, one half of the cost
would be recognized as an expense each year. The reason is that both years-not
just the first year-benefit from the insurance payment. The un-expensed portion
of the insurance payment is carried on the balance sheet as an asset called
prepaid insurance. You should be familiar with this type of accrual from your
financial accounting coursework.
The matching
principle is based on the accrual concept and states that costs incurred to
generate a particular revenue should be recognized as expense in the same period
that the revenue is recognized. This means that if a cost
is incurred to acquire or make some thing that will eventually be sold, then the
cost should be recognized as an expense only when the sale takes place-that is,
when the benefit occurs. Such costs are called product costs.
Product Costs:
Definition and Explanation of Product Cost:
For financial accounting purposes,
product costs include all the costs that are involved in acquiring or making
product. In the case of manufactured goods, these costs consist of
direct
materials,
direct labor, and manufacturing overhead. Product costs are viewed as
"attaching" to units of product as the goods are purchased or manufactured, and
they remain attached as the goods go into inventory awaiting sale. So initially,
product costs are assigned to an inventory account on the balance sheet. When
the goods are sold, the costs are released from inventory as expense (typically
called
Cost of Goods Sold) and matched against sales revenue. Since product
costs are initially assigned to inventories, they are also known as inventoriable costs. The purpose is to emphasize
that product costs are not necessarily treated as
expense in the period in which they are incurred. Rather, as explained above,
they are treated as expenses in the period in which the related products are
sold. This means that a product cost such as
direct materials or
direct labor
might be incurred during one period but not treated as an expense until a
following period when the completed product is sold.
Period Costs:
Definition and Explanation of Period Costs:
Period costs are all the costs that are not included in
product costs. These
costs are expensed on the
income statement in the period in which they are
incurred, using the usual rules of accrual accounting that we learn in financial accounting.
Period costs are not included as part of the cost of either purchased or
manufactured goods. Sales commissions and office rent are good examples of
period costs. Both items are expensed on the
income statement in the period in
which they are incurred. Thus they are said to be period costs. Other examples
of period costs are selling and administrative expenses.
Summary of Product and
Period Costs:
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PRODUCT
COSTS OR INVENTORIABLE COSTS
Direct Materials:
Materials that can be physically and conveniently traced to a product, such
as wood in a table. Direct Labor:
Labor costs that can be physically and conveniently traced to a product such
as assembly line workers in a plant. Direct labor is also called touch labor
cost. Manufacturing
Overhead:
All costs of manufacturing a product other than direct materials and direct
labor, such as indirect materials, indirect labor, factory utilities, and
depreciation of factory equipment.
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PERIOD COSTS OR
NON-MANUFACTURING COSTS
Marketing or selling
costs:
All costs necessary to secure customer orders and get the finished product
or service into the hands of the customer, such as sales commission,
advertising, and depreciation of delivery equipment and finished goods
warehouse. Administrative
Costs:
All costs associated with the general management of the company as a whole,
such as executive compensation, executive travel costs, secretarial
salaries, and depreciation of office building and equipment.
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Product Costs - A Closer Look
We have already defined product
costs as those costs that are involved in either the purchase or the manufacture
of goods. For
manufactured goods, these costs consist of direct materials, direct labor, and
manufacturing overhead. It will be helpful at this point to look briefly at the
flow of costs in a manufacturing company. This will help us understand how
product costs move through the various accounts and how they affect the balance
sheet and the income statement.
Exhibit 1.1
illustrates the flow of costs in a manufacturing company. Raw materials
purchases are recorded in the Raw materials inventory account. When raw
materials are used in production, their costs are transferred to the work in
process inventory account as direct materials. Not that direct labor cost and
manufacturing overhead costs are directly added to work in process. Work in
process account can be viewed most simply as an assembly line where workers are
stationed and where products slowly take shape as they move from one end of the
assembly line to the other. The direct materials, direct labor, and
manufacturing overhead costs added to work in process in
Exhibit 1.1 are the costs needed to complete these products as they move
along this assembly line.
Notice from the exhibit that as
goods are completed, their costs are transferred from work in process to
finished goods. Here the goods await sale to customers. As goods are sold, their
costs are transferred from finished goods to cost of goods sold. At this point
the various material, labor, and overhead costs required to make the product are
finally treated as expenses. Until that point, these costs are in inventory
accounts on the balance sheet.
Exhibit 1.1 Cost Flows
and Classifications in a Manufacturing Company
Inventoriable Costs:
As stated earlier products costs are
often called inventoriable costs. The reason is that these costs go directly
into inventory accounts as they are incurred (first into work in process WIP and
then into finished goods), rather than going into expense accounts. Thus, they
are termed inventoriable costs. This is a key concept since such costs can end
up on the balance sheet as assets if goods are only partially completed or are
unsold at the end of a period. To illustrate this point, refer again to
Exhibit 1.1. At the end of the period, the
materials, labor, and overhead costs that are associated with the units in the
work in process and finished goods inventory accounts will appear on the balance
sheet as part of the company's assets. These costs will not become expenses
until later when the goods are completed and sold.
Selling and administrative expenses
are not involved in the manufacturing of a product. For this reason, they are
not treated as product costs but rather as period costs that go directly into
expense accounts as they are incurred, as shown by the
Exhibit 1.1.
An Example of Cost Flows:
To provide an example of cost flows
in a manufacturing company, assume that company's annual insurance cost is
$2,000. Three fourth of this amount ($1,500) applies to factory operations, and
one fourth ($500) applies to selling and administrative activities. Therefore,
$1,500 of the $2,000 insurance cost would be a product (inventoriable) cost and
would be added to the cost of goods produced during the year. This concept is
illustrated in the Exhibit 1.2. Where $1,500 of
insurance cost is added into work in process. This portion of the year's
insurance will not become an expense until the goods that are produced during
the year are sold--which may not happen until the following year or even later.
Until the goods are sold, the $1,500 will remain as part of the asset, inventory
(either as part of work in process or as a part of finished goods), along with
other costs of producing goods.
By contrast, the $500 of insurance
cost that applies to the company's selling and administrative activities will be
expensed immediately.
Thus far, we have been mainly
concerned with classifications of manufacturing costs for the purpose of
determining inventory valuations on the balance sheet and cost of goods sold on
the income statement of external financial reports. However, costs are used for
many other purposes, and each purpose requires a different classification of
costs.
Exhibit 1.2 an example of cost
flows in a manufacturing company
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