Any business incurs two major types of costs: product and period costs. The company incurs these costs during the production and sale of a product. It can be difficult to determine to which category a particular expense belongs. For instance, salaries of employees working in a factory are product costs, but the salaries of those working in the headquarters offices are period costs.
At first glance, it may be hard to see the distinction between the two types of costs. Expenses belong to either product or period costs, depending on whether the business incurs them in the production or manufacturing process. To get a clearer picture, here are further details of each type of cost.
Product costs are expenses that a business incurs in acquiring raw materials and manufacturing a product. You can also refer to them as production costs. Calculating the cost of a product is critical in determining that product s price point. The business is looking to recoup any expenses it incurred during production through sales.
A paramount thing to understand about product costs is that the production process involves them. In the initial example given, employees working at headquarters are not involved in manufacturing. You, therefore, cannot classify their salaries as product costs. On the other hand, you can consider the wages of factory workers as product costs.
You can divide products into two categories: indirect and direct costs. Direct costs include labor, the cost of materials, the cost of power used in machinery and factory depreciation. Indirect costs are mostly overhead expenses.
While recording in a balance sheet or using online accounting software, an accountant treats product costs as inventory. For this reason, some people refer to them as inventoriable costs.
All other expenses a business incurs that are not product costs are period costs. In a balance sheet, however, you will not find an entry for period costs. This is because the business treats them as any other expenses that arise during a specific accounting period. This is why the general term is period costs.
Unlike product costs, the business does not incur period costs because of the manufacturing process. Any expenses relating to marketing, advertising, sales, office employees, salespersons commissions, legal work and office depreciation are period costs.
Making a Clear Distinction
As mentioned, deciding where you will assign each expense can be a challenging task. For entrepreneurs who cannot afford a professional accountant and lack accounting experience, making the distinction between these two costs is extremely important. This is because it determines how correct your product cost figure is, and in connection, how fair your set prices are.
A good way to decide where to put each expense is to ask yourself the purpose of that expense. Did you incur it during production? If yes, it is a product cost. If no, it is a period cost. The cost of buying raw materials is a product cost. However, the cost of renting a warehouse to put them in is a period cost.