Product costs and period costs definition, explanation and examples

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. The product costs for a retailer will be the amount paid to the supplier plus any freight-in. Product costs for a manufacturer will be the direct materials, direct labor, and manufacturing overhead used to manufacture a product. In summary, freight is a product cost if it is incurred as part of purchasing materials for manufacturing. Freight is categorized as a period cost if it relates to delivering finished goods to customers. Proper classification is important for accurate financial reporting and determining true production costs.

What is COGS?

They prepare trading account to record all incomes and expenses related to their manufacturing operations. In order that gross profit and net profit are appropriately reflected, it is important that costs are bifurcated correctly. Classify the following costs as (PRO) product costs or (PER) period costs. In summary, proper classification of costs as either product or period expenses is vital for financial reporting accuracy and strategic business management.

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• Now that we have taken a bird’s eye view of the matching principal, let’s look into the meanings of and difference between product costs and period costs.
• Costs incurred on these other business activities that are not specifically linked to the manufacturing process qualify as period costs.
• These costs are deducted as operating expenses on the income statement.
• Both of these costs are considered period costs because selling and administrative expenses are used up over the same period in which they originate.

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• To illustrate, assume a company pays its sales manager a fixed salary.
• If they do increase, these increases happen only once or twice a year.
• As a general rule, costs are recognized as expenses on the income statement in the period that the benefit was derived from the cost.
• Properly categorizing period vs product costs gives businesses clearer visibility into production efficiency and profitability.
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• They will not be expensed until the finished good are sold and appear on the income statement as cost of goods sold.

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. For example, iron ore is a direct material to a steel company because the iron ore is clearly traceable to the finished product, steel. In turn, steel becomes a direct material to an automobile manufacturer.

Comparison of Direct vs Indirect Costs in Manufacturing

In other words, they are expensed in the period incurred and appear on the income statement. As a general rule, costs are recognized as expenses on the income statement in the period that the benefit was derived from the cost. So if you pay for two years of liability insurance, it wouldn’t be good to claim all of that expense in the period the bill was paid. Since the expense covers a two year period, it should be recognized over both years. Careful analysis of period versus product costs, combined with targeted strategies to control overhead and optimize production, can yield significant cost savings and competitive advantage.

Examples of Product Costs

In general, product cost vs period cost overhead refers to all costs of making the product or providing the service except those classified as direct materials or direct labor. Manufacturing overhead costs are manufacturing costs that must be incurred but that cannot or will not be traced directly to specific units produced. In addition to indirect materials and indirect labor, manufacturing overhead includes depreciation and maintenance on machines and factory utility costs. 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. Understanding these differences helps businesses make sound accounting decisions.

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? In the accounting records, the cost of finished products is accumulated in an inventory account – usually “Finished Goods Inventory”. When goods are sold, the cost is transferred from “Finished Goods Inventory” in the balance sheet to “Cost of Sales” (or Cost of Goods Sold) in the income statement. While direct costs are conveniently traceable per unit, indirect costs require effort to appropriately allocate across departments, processes, and products. Overhead covers indirect production costs like electricity, equipment maintenance, factory supervision, insurance, and more.

Period costs:

The remaining inventory of 200 units would not be transferred to cost of good sold in 2022 but would be listed as current asset in the company’s year-end balance sheet. These unsold units would continue to be treated as asset until they are sold in a following year and their cost transferred from inventory account to cost of goods sold account. Period costs include selling expenses and administrative expenses that are unrelated to the production process in a manufacturing business. Selling expenses are incurred to market products and deliver them to customers.