Instead, they are capitalized as assets on the balance sheet as part of inventory. Only when inventory is sold are these costs transferred to the income statement as COGS. Properly categorizing period vs product costs gives businesses clearer visibility into production efficiency and profitability.
7: Product vs. Period Costs
Period costs and product costs are important concepts in managerial accounting that help businesses track their expenses. Knowing the key differences between these types of costs can have a big impact on financial reporting and decision making. To summarize, product costs are inventoried and then recognized as expense upon sale of the product. Period costs relate to operating the business during an accounting period and are directly expensed on the income statement. Understanding how costs flow through the financial statements is an essential concept in managerial accounting and cost analysis. Instead, they are included in the cost basis of inventory through cost of goods sold as production occurs.
Because period costs immediately impact net income, managing them helps businesses increase profitability. These costs are expensed immediately on the income statement rather than being included in the costs of goods sold. 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. Overhead, or the costs to keep the lights on, so to speak, such as utility bills, insurance, and rent, are not directly related to production. However, these costs are still paid every period, and so are booked as period costs.
- These costs should be monitored closely so managers can find ways to reduce the amount paid when possible.
- Period and product costs play different but important roles in financial reporting.
- They are allocated using cost drivers like machine hours, square footage, labor hours, etc.
- Careful analysis of period versus product costs, combined with targeted strategies to control overhead and optimize production, can yield significant cost savings and competitive advantage.
- If that reporting period is over a fiscal quarter, then the period cost would also be three months.
- Period costs relate to operating the business during an accounting period and are directly expensed on the income statement.
Items That are Not Period Costs
However, if these costs become excessive they can add significantly to total expenses and they should be monitored closely so managers can take action to reduce them when possible. 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. Operating expenses are costs that businesses expect to incur in their attempts to generate revenue. Knowing how much money a business spends on periods of expenses helps its owners and managers understand where their cash flows from operations come from and where they go when operations end up with cash deficits. Period expenses are costs that help a business or other entity generate revenue, but aren’t part of the cost of goods sold. Careful analysis of cost behavior is key to proper accounting classification and supporting smart management of margins and profits.
The difference between product costs and period costs
Understanding these differences helps businesses make sound accounting decisions. In summary, period costs like rent and advertising are expensed immediately each accounting period on the income statement. Product costs like materials are included is rent a period cost in inventory valuation through cost of goods sold when production occurs.
The costs that are not classified as product costs are known as period costs. These costs are not part of the manufacturing process and are, therefore, treated as expense for the period in which they arise. Period costs are not attached to products and the company does not need to wait for the sale of its products to recognize them as expense on income statement. According to generally accepted accounting principles (GAAPs), all selling and administrative costs are treated as period costs.
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. The remaining inventory of 200 units would not be transferred to cost of good sold in 2022 but would be listed as current asset in the company’s year-end balance sheet. These unsold units would continue to be treated as asset until they are sold in a following year and their cost transferred from inventory account to cost of goods sold account.
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