Product vs Period Costs Transcript
Introduction Cost Accounting > Product vs Period Costs
A cost object is anything a manager might want to know the cost of. You can see some common examples on the slide but the most common is the cost of a product. Product costs are one of the most important costs managers need to know. Knowing the cost of a product is a necessity to make sure that its price correctly, or it the company should increase or decrease production or even discontinue the product altogether.
Most companies use two different definitions of costs; total product cost, and inventoriable product cost. The total cost is used for internal decision-making. It includes all the costs of the value chain. Management needs to know total costs so it can price goods high enough to cover these costs and still make a normal profit.
Inventoriable product costs, which are sometimes just called product costs, are only the costs incurred during the production stage of the value chain. Since inventoriable product cost include only cost incurred during production, all costs incurred in other stages of the value chain must be reported in the period in which they are incurred as expenses.
Inventoriable product costs are required by GAAP to be used for the cost of the asset, you know inventory, rather than total product costs. Because GAAP will not allow total product cost to be reported on the balance sheet as an asset the cost incurred in R and D, Design, Marketing, Distribution, and Customer Service, are known as period costs.
Period costs are reported on the income statement as expenses in the period in which they were incurred. They are often known as operating expenses or "Selling, General and Administrative Expenses" or "S, G, and A" for short.
The product costs incurred in the production stage are not expensed when incurred. These costs are debited to an inventory account. The cost will remain as assets until the goods are sold, which could be in subsequent periods and then we would record the cost as Cost of Goods Sold, an expense.
So let's flashback to Financial Accounting for a moment. We learned that the cost of an asset is all of the costs incurred to get the asset ready for its intended purpose.
That definition applies to inventory because it's an asset.
So for merchandisers, the cost of the product plus shipping and handling etc. are included in the cost of the asset and debited to inventory.
Manufacturers have to take raw materials and convert them into finished products. So the inventoriable product cost for manufacturers are direct materials, direct labor, and manufacturing overhead, which is an indirect cost. Direct costs are those that can be easily traced to a product. A car has four tires so the cost of four tires is easily traced to a car. Indirect costs cannot easily be traced to a product. Because of this we allocate indirect costs of products. Depreciation expense on a production facility isn't easily traceable to each finished good so is allocated to all of them. So Direct Materials and Direct Labor are direct costs and Manufacturing Overhead is an indirect cost which needs to be allocated to the products.
Finally, let's conclude this with a couple additional terms that you wanna be familiar with. Prime Costs include direct material and direct labor. Conversion Costs include direct labor and manufacturing overhead. These are the costs incurred to convert materials into finished products.
Make sure you don't make the mistake of adding prime costs plus conversion costs to get product costs. They can't be added together because direct labor would be added twice.