The difference between product costs and period costs

Discover the key to effective financial management with our straightforward guide on variance reporting. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

So, as they don’t influence inventory valuation, period costs don’t create confusion about the value of unsold goods. Product costs are the expenses directly tied to the creation of goods or services within a business. These costs represent the financial resources invested in the production process. If the cost didn’t pass the traceability test, it is an overhead cost. Allocation is the only way to account for overhead since we can’t pinpoint its direct relationship to products and services.

  1. Imagine you are the owner and co-founder of MealCo, an organic canned meals producer company.
  2. These can include administrative, logistical, financial, distribution, sales and marketing functions etc.
  3. Classification of cost into periods and products is generally for financial accounting purposes.
  4. Understanding how costs flow through the financial statements is an essential concept in managerial accounting and cost analysis.

Product costs are variable and fluctuate as the activity levels within a company increase or decrease. Product costs are sometimes broken out into the variable and fixed subcategories. This additional information is needed when calculating the break even sales level of a business. It is also useful for determining the minimum price at which a product can be sold while still generating a profit.

Those costs would not be accounted for on the income statement until they are sold. However, the general formula would be the sum of selling and administrative salaries, bills, and utilities. Accounting for both types of expenses is key for profitable pricing strategies.

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Administrative activities are the most pure form of period costs, since they must be incurred on an ongoing basis, irrespective of the sales level of a business. Selling costs can vary somewhat with product sales levels, especially if sales commissions are a large part of this expenditure. The type of labor involved will determine whether it is accounted for as a period cost or a product cost. Direct labor that is tied to production can be considered a product cost.

Period costs are on the income statement as expenses in the period they were incurred. Classification of cost into periods and products is generally for financial accounting purposes. Both terms are important in the development of an income statement. A proper determination of revenues and expenses must be based on a well-defined distinction between Period cost and Product cost.

At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. This website is using a security service to protect itself from online attacks. There are several actions that could trigger this block including submitting a certain word or phrase, a SQL command or malformed data. It means that DM and DL increase as production increases, and they decrease if production decreases as well.

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As a non-cash expense, depreciation appears on the income statement but does not directly drain cash flow. While variable costs like materials rise and fall with production volume, fixed expenses like depreciation, rent, insurance, etc. remain unchanged from month to month. In a manufacturing organization, an important distinction exists between product costs and period costs. Both of these costs are considered period costs because selling and administrative expenses are used up over the same period in which they originate. These costs are identified as being either direct materials, direct labor, or factory overheads, and they are traceable or assignable to products.

Also, fixed and variable costs may be calculated differently at different phases in a business’s life cycle or accounting year. Whether the calculation is for forecasting or reporting affects the appropriate methodology as well. Production costs are usually part of the variable costs of business because the amount spent will vary in proportion to the amount produced. 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. Freight would be considered a period cost if it is paid to ship the finished product to customers.

Strategic Management of Period Costs and Product Costs

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. The differences between product and period costs can be summarized in the following areas. Product costs are often treated as inventory and are referred to as “inventoriable costs” because these costs are used to value the inventory. When products are sold, the product costs become part of costs of goods sold as shown in the income statement. For example, the fee for a consulting service offered by external management consultants is a period cost, but it is not mentioned in any of the categories above.

Alternatively, the costs of wood, fabric, nails and other materials that physically go into building a chair are product costs. Only when the finished chair is sold does the product cost hit the income statement through cost of goods sold. An example of a product cost would be the cost of raw materials used in the manufacturing period costs vs product costs process. Product costs also include Depreciation on plant, expired insurance on plant, production supervisor salaries, manufacturing supplies used, and plant maintenance. Period costs are like the backstage crew ensuring the business show runs smoothly. Remenber, they include things like rent, salaries, and advertising costs?

These are items not related to the production or acquisition process directly. Therefore, period costs consist of all items not included as product costs. These costs do not become a part of the capitalized cost of a specific product. Instead, companies expense out period costs each period through the income statement. Overhead or sales, general, and administrative (SG&A) costs are considered period costs.

What are Product Costs?

Period costs are the costs that cannot be directly linked to the production of end-products. Examples of period costs include sales costs and administrative costs. Period costs are always expensed on the income statement during the period in which they are incurred. In sum, product costs are inventoried on the balance sheet before being expensed on the income statement.

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