Product vs Period Cost
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When preparing financial statements, companies need to classify costs as either product costs or period costs. We need to first revisit the concept of the matching principle from financial accounting.
According to FreshBooks, the rent paid for the factory building is part of manufacturing overhead and should be recorded as a product expense. If a building is used for both administrative and manufacturing purposes, you may allocate the rent to each. There are many costs businesses incur that are not related directly to product manufacturing. The most common of these costs are sales and marketing costs and administrative costs. Sales and marketing costs may be commission for the sales team, salary for the marketing team, advertising costs to boost brand awareness, market research, and product design. For example, the cost of raw materials that a company purchases will be a period cost, as it will vary with the level of production.
Is Labor a Period Cost or Product Cost?
Business owners who do their small business bookkeeping need to know period cost accounting in order to write off their business expenses correctly. Bringing an understanding of period and product costs to a value chain or break-even analysis helps you quickly identify what types of expenses are hampering your business’s profitability. Product costs, on the other hand, are expenses that are incurred to manufacture a good and can typically be traced back to a specific product.
Note that prepaid rent and other prepaid expenses, as well as the costs included in fixed assets, are not period costs. Looking at these expenses the utilities for the manufacturing facility and the production worker’s wages are both product costs because these are manufacturing overhead costs and direct labor costs.
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Rent on a company’s office space will be a fixed cost, as it will not vary with the level of production. There are several different product costs in manufacturing, which can include direct materials, direct labor, and overhead costs. There are types of period costs that may not be included in What are Period Costs? thefinancial statementsbut are still monitored by the management. These costs include items that are not related directly to the primary function of a business, such as paying utility bills or filing legal suits. The cost of labor is unique in that it can be both a product and period cost.
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For example, if a business rents space to house its accounting function, then it will incur the cost of rent whether it produces goods or not. Some of the expenses that a business incurs have nothing to do with the production https://online-accounting.net/ of goods at all. The point is that a business will incur expenses in the process of making profits. The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters.
Understanding Period Costs
Companies must understand both types of costs to make informed decisions about pricing, production, and resource allocation. By understanding the difference between product and period costs, companies can make choices that will help them stay competitive and profitable.
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- Outsourcing non-core activities– If a business is not core to its operations, then outsourcing those responsibilities could help it reduce period expenses.
- The administrative costs can grow very quickly and should be reviewed with benefits professionals annually.
- There are the salaries and wages of executive officers, office workers, and other employees not involved in the production process.
- On the other hand, period costs are considered indirect costs or overhead costs, and while they play an important role in your business, they are not directly tied to production levels.
The total cost of a product will encompass all of these different types of costs. Knowing the specific product costs can help managers make better decisions about how to price their product, how to reduce costs, and where to allocate resources.
Period Costs
While they still form part of the overall cost of running a business, they aren’t directly related to manufacturing a specific good or service. Product costs may appear on the balance sheet or income statement depending on whether their related goods are sold or unsold at the end of the period. To start, only businesses that produce or acquire and eventually sell goods incur product costs. This is why we sometimes refer to product costs as inventoriable costs. These costs that are directly involved in the production or acquisition of goods are what we refer to as product costs.
Loan interest payments and depreciation are also periodic expenses. Product costs, on the other hand, arecapitalizedas inventory on the balance sheet. Manufacturers debit their raw materials inventory account when the purchase is made and credit their cash account. Period costs are expensed on the income statement when they are incurred. When a company spends money on an advertising campaign, it debits advertising expense and credits cash.