Every business entity has many costs that need to be recognized, recorded, and given a financial statement. As a small business owner, keeping track of all costs might become a difficult task. However, cost management is a comparatively easy task for a large corporation due to the systematic approach and automation in place.
Many options in accounting software help you record and keep track of costs involved in business operations. Regardless of the business size, it is essential to understand the different product, operational, and non-operational costs involved in your business to differentiate each one from the other.
Cost management is an even more critical job when running a manufacturing business that involves dozens of costs. The costs are classified as direct, indirect, product, process, operational, and non-operational costs. After the expenses have been recognized and recorded, the next step is to use them to prepare the financial statements.
All types of costs are used to prepare the income statement, cash flow, and balance sheet. However, the handling of all costs in each financial statement is different. In this article, we will differentiate between the product costs and period costs for any business entity.
What Is Product Cost?
Product cost, as the name suggests, is related to the direct costs of products. We can formally define the product costs as,
Product cost is a variable cost incurred by a company or business entity to procure the merchandise or manufacture the finished goods. The retail company will record the cost of acquiring merchandise as the product cost. However, a manufacturing company’s material, labor, and FOH cost will be treated as the product cost.
The product costs measured and recorded in the company’s records are also used to prepare the financial statements. Adding product costs to the financial statement is required in both IFRS(International Financial Reporting Standards) and GAAP(Generally Accepted Accounting Principles).
The product costs also include the factory overhead cost that goes into manufacturing or procuring the products. Often, managers focus on the bottleneck operation, which means that their main focus is on including the direct material cost and time the product spends in the bottleneck operation. However, the managers also modify the overhead costs for short-term production or price determination.
What is included?
It is an important consideration when calculating the product costs that what is included in it. Most commonly, product costs include the following costs:
- Direct material costs
- Direct labor
- Manufacturing supplies
- Manufacturing overhead, for instance, utility expenses of manufacturing plant
How Are Product Costs Calculated?
The product cost can be calculated per unit or total production cost. Most commonly, unit product cost is calculated. The product costs are associated with a specific batch in which a certain number of products are manufactured. The per-unit product cost can be calculated by dividing the total production costs of a batch by the total number of products produced in a batch.
The formula for product costs is as follow:
Total Production Cost of a Batch = Total direct labor + Total direct material cost + Consumable supplies + Manufacturing Overhead.
The per-unit product costs can be calculated as follow:
Product Cost Per Unit/ Product Unit Cost = Total Production Cost Of A Batch
Total Number Of Units Produced
We’ve already discussed the examples of product costs above. However, let’s explain the examples in a more elaborative way.
Product costs are recorded as inventory in the financial statements until the product has been sold. Therefore, the product costs are often called inventoriable costs.
Let’s understand with an example. Mike & Muller company has manufactured 100 units of product in the year 2019. Eighty units have been sold out of the 100 manufactured units, and 20 units are still in the closing inventory at the year-end.
When the financial statements are prepared, all the product costs will be transferred to inventories held by the company. The cost of 80 units will be transferred to the income statement and will be recorded as the cost of goods sold. The cost of the sold units can also be segregated as separate costs of material, labor, and overhead.
Recognition and Financial Treatment
All the product costs are transferred to inventories before recording as the cost of goods sold in the income statement. The units that remain in the closing inventory are treated as the asset of the company. These assets are recorded in the current assets of the balance sheet at the end of the year.
Job costing is used when a specific order with special requirements or one client is placed. All costs for completing the job are recorded and recognized.
On the other hand, process costing uses an approach in which all the costs of material, labor, supplies and overhead during the batch production process are summed up. Later on, the total cost is divided by the number of units produced.
What Is Period Cost?
Let’s discuss the period costs now.
Period costs or period expenses are also very elaborative by just looking at the name. The name gives a clear idea that these costs are related to an entire period or financial year. Period costs are also an essential part of the cost and managerial accounting in any business entity.
The simplest definition of period costs is as follow,
All the costs incurred by a business entity or company that do not directly relate to the manufacturing or procurement of the products sold are treated as period costs. The period costs for both manufacturing and merchandising concerns are almost the same.
Just like the product costs, the period costs of a business entity are also required to be recognized and recorded in financial statements as per GAAP and IFRS. All the periodic costs of a business entity are recorded in the income statement under the head of operational costs. The operational costs are usually subtracted from the gross profit. The gross profit is calculated by subtracting the product costs from total revenues generated in a financial period.
The period costs are not tied to the manufacturing or purchase of an individual product. Instead, these expenses are incurred and recorded in a lump sum for the whole business entity. Some companies have a regulation to transfer some periodic costs to the product costs as a percentage of each period cost.
The purpose of doing so is a more accurate representation of information. However, in most cases, there is a tradition of transferring period costs to operational costs.
What is included?
The period costs of any business entity include the following costs:
- Sales, General, and Administrative costs
If we further segregate these costs, it includes:
- Selling and promotion costs
- Office rent
- Salaries of employees
- Overall administration expenses
- Office supplies
- Transportation expenses
- Indirect material and labor costs
- Interest expense
And the list goes on depending on the size, nature, and type of the business entity.
The administration of the business entity is working throughout the year. The marketing, promotion, and sales budget is also allocated for a specific period. The other costs are also incurred on a regular basis. Therefore, these costs are included in the period costs.
For instance, the remuneration of employees, rent expense, interest expense, depreciation, audit fees, insurance expense, etc., are recurring, fixed, and related to a whole financial period.
Recognition and Financial Treatment
All the period costs are recorded in the income statement and cash flow statement of the company. These costs are recorded in accounting books as incurred with the same name. Later on, all the expenses are transferred to the income statement and subtracted from the gross profit to find the operating income or EBT of the business entity.
Difference Between Product Costs and Period Costs
We’ve understood the product and period costs. Let’s highlight the differences between the two types of costs.
|Product Costs||Period Costs|
|Product costs are based on the volume of production.||Period costs are based on the time or a specific financial period.|
|The product costs include direct material, direct labor, manufacturing overhead, etc.||The period costs include sales, general, & administrative expenses, depreciation, interest expense, etc.|
|Most part or the whole product costs are recorded as a part of the cost of goods sold.||Period costs are subtracted from the gross profit to find operating income. They are recorded as the operational costs of the business entity.|
|The product costs are usually variable costs as they change with the level of production.||The period costs are fixed as they remain the same irrespective of the number of units produced.|
|Product cost per unit increases with an increased level of production.||Period costs per unit decrease with an increase in production|
|The product costs are recorded as an inventory in the balance sheet.||The period costs are just recorded in the income statement of the company.|
|The product costs are related to the manufacturing or purchase operations of a business entity.||The period costs are related to sales, administrative, and general operations of a business entity.|
|The product costs can be calculated by using job costing or process costing.||The period costs are recorded as it is.|
In this article, we have discussed what the product cost and the period costs are. The product costs can be calculated by using different approaches as job costing and process costing. This article was all about explaining both types of costs and comparing. Regardless of differences, both types are significant in the cost accounting and profit appropriation of a business entity.