Classification Continued- Product cost and period cost

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.

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:

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.

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.

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.