Why is the distinction between product costs and period costs important?
Because of the different nature of product and period costs, they receive different accounting treatments. Product costs form part of inventory and the balance sheet, making them inventoriable cost. They only affect the income statement when inventory is sold, and the product cost vs period cost cost of inventory becomes COGS. Moreover, period costs are expenses in the income statement of the period in which they were incurred. Both product costs and period costs directly affect your balance sheet and income statement, but they are handled in different ways.
Product costs include the costs to manufacture products or to purchase products. If a product is unsold, the product costs will be reported as inventory on the balance sheet. When the product is sold, its cost is removed from inventory and will be included on the income statement as the cost of goods sold. In cost accounting, costs are categorized based on their relationship with the production process or the time when they are charged to expense.
- Instead, period costs will be referred to as period expenses since they will be reported on the income statement as selling, general and administrative (SG&A) or interest expenses.
- Speaking of financial statements, it’s important that you take the time to review your financial statements on a regular basis.
- Grasping the difference between product and period costs serves as a financial compass for businesses.
- Product costs are always considered variable costs, as they rise and fall according to production levels.
- As an owner, you rely on their accuracy to make key management decisions.
Under different costing system, product cost is also different, as in absorption costing both fixed cost and variable cost are considered as Product Cost. On the other hand, in Marginal Costing only the variable cost is regarded as product cost. An example of such cost is the cost of material, labour, and overheads employed in manufacturing a table.
Product costs are applied to the products the company produces and sells. Product costs refer to all costs incurred to obtain or produce the end-products. Examples of product costs include the cost of raw materials, direct labor, and overhead. Before the products are sold, these costs are recorded in inventory accounts on the balance sheet. Product costs are sometimes referred to as “inventoriable costs.” When the products are sold, these costs are expensed as costs of goods sold on the income statement. Product costs are initially attached to product inventory and do not appear on income statement as expense until the product for which they have been incurred is sold and generates revenue for the business.
We still include MOH as part of product costs even if we can’t trace them directly. Product and period costs are the two major classifications of costs that have different accounting treatments. Product costs are related to the cost of purchasing inventory for sale or performing a service. Meanwhile, period costs are costs that are not related to production but are essential to the business as a whole.
Definition of Period Cost
Examples of period costs include rent and utilities of admin offices, finance charges, marketing and advertising, commissions, and bookkeeping fees. Unlike product costs, period costs don’t depend on the production volume. They occur consistently over a specific time period, like a month or a year, and are incurred regardless of how much or how little the business produces during that time. Product costs (also known as inventoriable costs) are those costs that are incurred to acquire, manufacture or construct a product. In manufacturing companies, theses costs usually consist of direct materials, direct labor, and manufacturing overhead cost. So, in this example, you can see how product costs and period costs are recorded differently and appear in different places on the financial statements.
Classification of cost into periods and products is generally for financial accounting purposes. A proper determination of revenues and expenses must be based on a well-defined distinction between Period cost and Product cost. Period costs are like the backstage crew ensuring the business https://business-accounting.net/ show runs smoothly. Remenber, they include things like rent, salaries, and advertising costs? But they’re ongoing expenses necessary for the daily operation of the entire bakery. Product cost and period cost are accounting concepts used to categorize and allocate expenses in a business.
Period Costs vs. Product Costs: What’s the Difference?
The cost of labor is unique in that it can be both a product and period cost. This depends on whether the labor is directly related to production or not – a factory worker’s wages would be product costs, while a company secretary’s wages would be period costs. A business can go through periods where it doesn’t have any product costs, but there will still be period costs as these are unrelated to the ebb and flow of production. Instead, they’re related to the passing of time and any time-based expenses like utility bills and rent. The cost of production is an essential component of basic business accounting. Breaking down your business’s costs can help you calculate profit more accurately as well as assist with financial forecasting.
Product and period costs are incurred in the production and selling of a product. All expenses incurred in the factory or manufacturing unit for producing the assets are product or manufacturing costs. Many employees receive fringe benefits paid for by employers, such as payroll taxes, pension costs, and paid vacations. These fringe benefit costs can significantly increase the direct labor hourly wage rate. Other companies include fringe benefit costs in overhead if they can be traced to the product only with great difficulty and effort. Direct materials are those materials used only in making the product and there is a clear, easily traceable connection between the material and the product.
At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. It means that DM and DL increase as production increases, and they decrease if production decreases as well. You’ll also be able to spot trouble spots or overspending in administrative areas or if overhead has ballooned in recent months.
For example, if Company A is a toy manufacturer, an example of a direct material cost would be the plastic used to make the toys. The concept of product vs period costs is a subset of cost accounting. Read our article about managerial accounting to learn more about how it can help your business manage costs. When costs are traceable to products and services, they are undeniably product costs. Being traceable means that you won’t have a hard time determining the physical quantity and its cost equivalent. Though it may be tempting to just lump your expenses together, there are three great reasons why you need to separate product and period costs for your business.
Key Differences Between Period Cost vs Product Cost
Easily traceable costs are product costs, but some product costs require allocation since they can’t be traced. Otherwise, costs that can’t be traced or allocated to products and services are classified as period costs or costs that are attributed to the period in which they were incurred. Grasping the difference between product and period costs serves as a financial compass for businesses. It’s like having a roadmap that guides accurate financial reporting, ensuring that the numbers on the balance sheet and income statement tell a clear and truthful story about the business’s health. Moreover, this understanding empowers businesses to manage costs effectively, making informed decisions about product pricing, production efficiency, and overall operational strategies. Unlike product costs, period costs don’t linger in the inventory valuation storyline.
Product costs are one of the most important costs managers need to know. Knowing the cost of a product is necessary to ensure its price is correct, or the company should increase or decrease production or even discontinue the product altogether. To understand the concept of traceability further, see our comparison of direct vs indirect costs, which discusses the nature of the costs and provides some examples. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.