To quickly identify if a cost is a period cost or product cost, ask the question, “Is the cost directly or indirectly related to the production of products? What a company expects to pay during a particular accounting period is included is rent a period cost in an expense account while what it pays during the period goes into a prepaid expense account. In general, period expenses include items such as rent, utilities, insurance, and property taxes. They can also include legal fees and loan interest if these amounts are paid in advance.
A summary of the concept of product cost and period cost
While direct costs are conveniently traceable per unit, indirect costs require effort to appropriately allocate across departments, processes, and products. Direct Labor refers to the wages paid to production workers who are directly involved in making the product, such as assembly line workers, woodworkers, tailors, etc. Examples include production materials consumed in making a product and commissions paid to salespeople. What is paid during that period was $100,000 in rent and utilities, but only $10,000 in insurance and property taxes because a storm damaged the roof of one of its properties. Proper classification of costs is thus essential for businesses to improve profitability. Product costs are used to calculate cost of goods sold and inventory value.
- If the related products are sold at once, then these costs are charged to the cost of goods sold immediately.
- By understanding the key components of period costs, managers can better control overhead spending and analyze expense trends over time.
- We need to first revisit the concept of the matching principle from financial accounting.
- Direct Labor refers to the wages paid to production workers who are directly involved in making the product, such as assembly line workers, woodworkers, tailors, etc.
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. When the product is sold, these costs are transferred from inventory account to cost of goods sold account and appear as such on the income statement of the relevant period. For example, John & Muller company manufactures 500 units of product X in year 2022. Out of these 500 units manufactured, the company sells only 300 units during the year 2022 and 200 unsold units remain in ending inventory. The direct materials, direct labor and manufacturing overhead costs incurred to manufacture these 500 units would be initially recorded as inventory (i.e., an asset).
The $10 direct materials would be a debit to cost of goods sold (increasing) and a credit to inventory (decreasing). Proper classification and monitoring of period versus product costs are vital for accurate financial reporting. While period costs directly hit the income statement, product costs impact inventory valuation and flow through to COGS.
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In managerial and cost accounting, period costs refer to costs that are not tied to or related to the production of inventory. Examples include selling, general and administrative (SG&A) expenses, marketing expenses, CEO salary, and rent expense relating to a corporate office. The costs are not related to the production of inventory and are therefore expensed in the period incurred. In short, all costs that are not involved in the production of a product (product costs) are period costs.
If advertising happens in June, you will receive an invoice, and record the expense in June, even if you have terms that allow you to actually pay the expense in July. The cash may actually be spent on an item that will be incurred later, like insurance. It is important to understand through the accrual method of accounting, that expenses and income should be recognized when incurred, not necessarily when they are paid or cash received.
7: Product vs. Period Costs
Rent falls under operating expenses, while product costs like labor and materials are used to calculate COGS. Tracking the difference helps with managerial decision making and financial reporting. Period costs are not assigned to one particular product or the cost of inventory like product costs. Therefore, period costs are listed as an expense in the accounting period in which they occurred.
Operating expenses are expenses related to daily operations, whereas period expenses are those costs that have been paid during the current accounting period but will benefit future periods. Depreciation represents the loss in value of fixed assets like machinery and equipment as they wear down over time. Depreciation is considered a fixed cost since the same amount is expensed every period based on an asset’s useful lifespan – changes in production do not impact the depreciation amount. There are types of period costs that may not be included in the financial statements but are still monitored by the management. For example, understating product costs decreases COGS and increases net income.
Overhead covers indirect production costs like electricity, equipment maintenance, factory supervision, insurance, and more. Overhead cannot be directly linked to individual units and is allocated based on an appropriate cost driver. Direct Materials include the raw materials and components that go directly into a finished product, such as wood, fabric, electronics, etc. Freight would be considered a period cost if it is paid to ship the finished product to customers. This freight cost reflects a selling/distribution expense rather than a production expense.