Difference Between Product Costs and Period Costs Examples

When the raw materials are brought in they will sit on the balance sheet. When the product is manufactured and then sold a corresponding amount from the inventory account will be moved to the income statement. So if you sell a widget for $20 that had $10 worth of raw materials, you would record the sale as a credit (increasing) to sales and a debit (increasing) either cash or accounts receivable. The  $10 direct materials would be a debit to cost of goods sold (increasing) and a credit to inventory (decreasing).

Both product costs and period costs may be either fixed or variable in nature. In this post, you’ll learn the key differences between period and product costs along with real-world examples to clearly illustrate the implications of proper classification. Most business owners would agree that properly classifying costs as either “period” or “product” expenses is critical for accurate financial reporting and strategic decision making. In a manufacturing organization, an important distinction exists between product costs and period costs. Both of these costs are considered period costs because selling and administrative expenses are used up over the same period in which they originate. Examples of period costs include selling costs and administrative costs.

This freight cost reflects a selling/distribution expense rather than a production expense. In a nutshell, COGS is the bill for creating or buying the stuff a business sells. Imagine your favorite bakery – the cost of flour, sugar, and the baker’s time to make those croissants you’re so fond of.

  1. Period costs are sometimes broken out into additional subcategories for selling activities and administrative activities.
  2. Eric is an accounting and bookkeeping expert for Fit Small Business.
  3. 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?
  4. Being traceable means that you won’t have a hard time determining the physical quantity and its cost equivalent.

They only affect the income statement when inventory is sold, and the cost of inventory becomes COGS. Moreover, period costs are expenses in the income statement of the period in which they were incurred. Finally, managing product and period costs will help you establish more accurate pricing levels for your products. If a company’s management understands both https://simple-accounting.org/ product and period costs, they can use it in improving decision-making. Product costs help businesses figure out how much it truly costs to make each item they sell, helping set prices for profit. Period costs guide decisions on running the whole business efficiently, like deciding on staffing or advertising, ensuring everything works well financially.

Examples of period costs include rent and utilities of admin offices, finance charges, marketing and advertising, commissions, and bookkeeping fees. 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. Because of the different nature of product and period costs, they receive different accounting treatments. Product costs form part of inventory and the balance sheet, making them inventoriable cost.

When the product is sold, these costs are transferred from inventory account to cost of goods sold account and appear as such on the income statement of the relevant period. For example, John & Muller company manufactures 500 units of product X in year 2022. Out of these 500 units manufactured, the company sells only 300 units during the year 2022 and 200 unsold units remain in ending inventory. The direct materials, direct labor and manufacturing overhead costs incurred to manufacture these 500 units would be initially recorded as inventory (i.e., an asset). The cost of 300 units would be transferred to cost of goods sold during the year 2022 which would appear on the income statement of 2022.

What are period costs?

Allocable but nontraceable costs to products and services—like our electricity example above—are called manufacturing overhead (MOH). We still include MOH as part of product costs even if we can’t trace them directly. Product and period costs are the two major classifications of costs that have different accounting treatments. Product costs are related to the cost of purchasing inventory for sale or performing a service. Meanwhile, period costs are costs that are not related to production but are essential to the business as a whole. It’s important to distinguish between product vs period costs because the former must be deducted when a good or service is sold, whereas the latter is deducted in the period it is incurred.

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As a non-cash expense, depreciation appears on the income statement but does not directly drain cash flow. While variable costs like materials rise and fall with production volume, fixed expenses like depreciation, rent, insurance, etc. remain unchanged from month to month. Rent falls under operating expenses, while product costs like labor and materials are used to calculate COGS. Tracking the difference helps with managerial decision making and financial reporting. People often confuse product and period costs due to the complexity of accounting terminology and the different ways these costs are treated in financial reporting.

If you manufacture a product, these costs would include direct materials and labor along with manufacturing overhead. Most of the components of a manufactured item will be raw materials that, when received, are recorded as inventory on the balance sheet. Only when they are used to produce and sell goods are they moved to cost of goods sold, which is located on the income statement.

Product costs contribute to the valuation of Ending inventory on the balance sheet

Failing to distinguish between product vs period costs could result in an overstatement or understatement of assets and net income. All components are added together and recorded as part of inventory. In other words, product costs are expenses that are initially “parked” in the balance sheet and recorded only as an expense (COGS) upon sale.

What are product costs?

To understand the concept of traceability further, see our comparison of direct vs indirect costs, which discusses the nature of the costs and provides some examples. Product costs only become an expense when the products to which they are attached are sold. However, you’ll still have to pay the rent on the building, pay your insurance and property taxes, and pay salespeople that sell the products currently in inventory. If you’re currently in business, you need a good way to manage costs.

There is little difference between a retailer and a manufacturer in this regard, except that the manufacturer is acquiring its inventory via a series of expenditures (for material, labor, etc.). What what are retained earnings and how to calculate them is important to note about these product costs is that they attach to inventory and are thus said to be inventoriable costs. Tracking product costs accurately impacts inventory valuation and COGS.

Product vs. Period Costs

But they’re ongoing expenses necessary for the daily operation of the entire bakery. When we talk about product costs, we’re diving into the nitty-gritty of how much it takes to make the things a business sells. So, in the financial statements, it’s a key player in the Cost of Goods Sold (COGS) section on the income statement. Accurate measurement of product and period costs helps you report the correct amount of expense in the income statement and assets in the balance sheet.