Definition
Period costs are non-manufacturing costs associated with the time period in which they occur. They typically include administrative expenses or marketing costs. On the other hand, product costs are all the direct costs associated with producing a product, including raw materials and labor, and they become expenses only when the product is sold.
Key Takeaways
- Period costs are non-manufacturing costs that are expensed in the period they are incurred. These costs are not tied to production and typically include items such as selling, general and administrative expenses.
- Product costs, on the other hand, are directly tied to the production process. They include direct materials, direct labor, and manufacturing overhead. They are reported as inventory on the balance sheet until the product is sold, at which point they become cost of goods sold.
- The distinction between period costs and product costs is crucial for accurate accounting, pricing decisions, and overall business strategy. Understanding the type and origin of costs plays a key role in cost management and profitability analysis.
Importance
Understanding the distinction between period costs and product costs is crucial in the field of finance and accounting as it directly impacts how businesses track their expenses and ultimately their profitability.
Product costs are directly linked to the manufacturing or procurement of goods and are inventoried until the products are sold; they include direct materials, direct labor, and manufacturing overhead.
On the other hand, period costs are not tied to the production process and include selling, general, and administrative expenses; they are expensed in the period they are incurred.
Therefore, the proper classification of these costs is vital for correct financial reporting, pricing decisions, and profitability analysis.
Misclassification can lead to inaccurate financial statements and impact a company’s strategic decisions.
Explanation
Product costs are associated directly with the production of goods or services for a company. These costs include direct materials, direct labor, and manufacturing overhead costs, and they are used to determine the cost of producing individual units of a given product. Understanding product costs is critical for businesses because it informs pricing decisions, financial reporting, inventory valuation, and performance measurement.
It helps to ensure that the selling price of goods covers all production costs, contributes to profit and improves cost control measures. On the other hand, period costs are the expenses that aren’t directly tied to the production process but are incurred as part of the general operation of a business within a specific period. These costs include marketing expenses, salaries (outside of direct labor), and office expenses.
The primary purpose of period costs is for financial reporting and business analysis. These costs are expensed immediately in the period they incur, which provides a clear picture of the company’s operational expenses over time. By effectively managing period costs, businesses can improve their profitability, as these costs don’t contribute directly to revenues.
Examples of Period Cost vs Product Cost
Manufacturing Company: A factory manufactures shoes, the cost of the raw materials such as leather, laces, and rubber soles and the labor costs to make the shoes would be considered product costs because they are directly tied to the production of the shoes. However, the salary of the company’s marketing manager, rent for the corporate office, and advertising expenses are period costs as they are all costs incurred that aren’t directly tied to the production of the shoes, but rather support overall operations.
Restaurant Business: For a restaurant business, the cost of the food items used to prepare dishes and the labor cost of the chef and servers will be considered product costs. These are all direct costs associated with creating the product that the restaurant sells. However, the rent or mortgage of the restaurant building, utilities, and administrative staff salaries will be considered as period costs as these are indirect costs not directly tied to the preparation of the meals.
Software Development Company: For a software development firm, the costs related to software engineers, program coding, and testing are product costs as they directly relate to the production of the software. However, the rent for the office, salary of the HR team, depreciation of office equipment and spend on promotional activities are considered period costs, as they do not directly contribute to the development of the software, but rather support the general operating of the company.
FAQ: Period Cost vs Product Cost
What is a period cost?
A period cost is an expense that is not directly tied to a product or production process. These costs are usually associated with functions such as selling, administration, or executive tasks. Since period costs are not attached to the production of goods or services, they are immediately charged against revenues in the period in which they are incurred.
What is a product cost?
Product cost, also known as cost of goods manufactured, is everything that goes into producing a product. This includes direct labor, direct materials, and overhead costs associated with the manufacturing process. Unlike period costs, product costs are recorded as inventory on the balance sheet and do not become expenses until the product is sold.
What is the difference between a period cost and a product cost?
The main difference lies in how and when each cost is recorded. Product costs are tied to the production process and are not expensed until the product is sold. On the other hand, period costs are not linked to the production process and are expensed in the period they are incurred. This difference impacts how each cost influences a company’s Income Statement and Balance Sheet.
Why is it important to differentiate between period cost and product cost?
These costs have different implications for a company’s financial reporting and operations. Understanding the difference helps businesses allocate costs appropriately, price their products correctly, guide internal decision-making, and meet financial reporting requirements.
How can a company manage its period and product costs effectively?
To manage period and product costs, a company can implement cost control measures to reduce or eliminate unnecessary expenses. For product costs, this may involve finding ways to streamline the production process. For period costs, it could mean optimizing sales and administration processes. Regular financial reviews and audits can also help identify cost-saving opportunities.
Related Entrepreneurship Terms
- Direct Material Costs: These are costs associated with raw materials used in the production of goods. They are considered product costs.
- Indirect Costs: These costs cannot be directly attributed to production and include expenses like rent, utilities, and salaries. They are known as period costs.
- Cost Accounting: This is the process of tracking, recording, and analyzing costs associated with the activities of an organization, which includes classifying costs as either period costs or product costs.
- Cost of Goods Sold (COGS): This figure includes all costs directly tied to the production of goods, i.e., product costs. It appears on a company’s income statement.
- Operating Expenses (OPEX): These expenses are associated with the day-to-day operations of a business that are not linked to production. They are also known as period costs.
Sources for More Information
- Investopedia: A reliable platform for investment and finance information, it includes several articles and definitions about financial terminologies including Period Vs Product Cost.
- AccountingTools: It provides comprehensive accounting and finance information that can help the user learn more about finance terms.
- AccountingCoach: It provides free educational resources about accounting principles including finance terms like period and product cost.
- Corporate Finance Institute (CFI): An established institution that offers courses and articles about all finance topics, including the differences between period and product costs.
