Segregating Costs: Product vs. Period Costs

THOMAS BUTTROSS: A manner of segregating costs that only applies to manufacturing companies is product, or period, costs. In order to do the segregation of costs, you need to understand the difference between manufacturing, merchandising, and service firms. Then you'll be able to understand the difference between a product cost, which is a cost that goes into inventory on the balance sheet, and a period cost, which is a cost that goes into expenses on the income statement.

This presentation is only for manufacturers. That is, the product cost category only applies to companies that build their inventory. Period costs apply to all companies, since these are primarily the operating expenses on any income statement.

A manufacturing organization is one that buys raw materials and builds its inventory and then sells the inventory that it built. Therefore, these organizations will have three separate inventories among their current assets on the balance sheet. They will have raw materials, which are goods awaiting use in production, that is waiting to be used inside the factory. They will have work in process, an account for the partially completed units inside the factory. And they will have finished goods, which are units that have been completed and are awaiting sale to the customers.

Merchandisers, on the other hand, do not build anything. They buy finished goods and sell them. They add what economists call place utility. By having a Toyota dealership in Harrisburg, Pennsylvania, it saves you from having to make a trip to the factory to pick up a Toyota.

Merchandisers have one inventory, which is the manufacturer's finished goods. But instead of calling it finished goods, it is generally called merchandise inventory.

Since they provide a service and do not sell goods, service companies technically do not have an inventory. However, they might have a parts or supplies inventory, which they might call parts or supplies or they may call inventory. If they do carry parts or supplies, it is not considered an inventory on the level of a merchandiser.

A company can have more than one type of business. For example, an automobile dealer carries a large inventory and sells to the public as well as uses it internally. The parts department is a merchandiser, and the repair shop is a service business. As another example, Sears is a large merchandiser. Several of its stores also have service centers for appliances, equipment, and automobiles.

Product costs only exist in manufacturing, whereas period costs exist outside manufacturing and, therefore, as I said earlier, apply to any organization that incurs costs. Product costs are the cost of items used up inside the factory. Period costs are the cost of items used up outside the factory.

The first thing you need to understand is what is meant by used up. When a company buys a building, it doesn't matter if it's buying a factory building or an office building. It's buying an asset. That building goes into property, plant, and equipment on the balance sheet.

How does the company show that building being used up? Depreciation is the term describing the process of writing off that property, plant, and equipment asset over the years benefited by its use. But as we will see shortly, what the company does with that depreciation is different if it is depreciation of a factory versus depreciation of an office building.

Let's take another example. As you are already aware, you pay your car insurance in advance. A company pays its fire insurance for the next year. At the time the company pays the insurance, it is prepaid insurance, a current asset on the balance sheet. It doesn't matter if the company is pre-paying factory insurance or pre-paying office building insurance. It is prepaid insurance on the balance sheet.

What does the company do as that insurance expires? As we will see shortly, used up insurance goes to a different place if it's on the factory building than if it is on the office building. So it's these used up costs that are of concern here.

The second thing you need to understand is what is meant by product costs. There are three categories of product costs. The first of these is raw materials. Raw materials are sent into the factory. When these raw materials go into the factory, the assembly line workers work on these raw materials to turn them into finished goods.

The labor of the assembly line workers is called direct labor. And that is the second category of product costs.

All the other costs of running that factory, other than direct materials or direct labor, are called factory overhead or manufacturing overhead. Factory or manufacturing overhead is the third category of product costs.

So we have direct materials, which is the materials you can see in the finished product; direct labor, which is the labor of the people who physically work on the assembly line to build the product; and factory, or manufacturing, overhead, which are all the other costs of running the factory that are not direct materials and direct labor.

The third topic you need to understand is what is meant by factory, or manufacturing, overhead. You have factory materials that don't end up in the finished product, such as oil used in the machines that make the product. These are referred to as indirect materials and are included in factory overhead.

You've got people who do things in the factory other than the assembly line workers, such as janitors that sweep up the factory and maintenance workers who maintain the machines. These are referred to as indirect labor and are included in factory overhead.

If you own the factory building, factory overhead would include depreciation on the factory building. If you rent the factory equipment, factory overhead would include rent on the factory equipment. It would include factory building insurance, insurance covering the factory employees, and factory gas, electricity, water, and telephone.

There are many costs of running that factory other than the direct materials and direct labor. And they are all lumped together in manufacturing, or factory, overhead.

The last topic you need to understand is period costs. As stated earlier, period costs are items used up outside the factory. And these costs primarily go into operating expenses on the income statement. Office supplies, office labor, office building depreciation, office equipment rent, office building insurance, insurance covering the office employees, and office gas, electricity, water, and telephone are examples.

We break these operating expenses into two basic subcategories. One is selling expenses, which are expenses directly connected to the sales effort. This includes things like advertising, delivery expense, and sales salaries. The other is general and administrative expenses, which are operating expenses not directly related to the sales effort.

So when something is used up outside the factory, you ask yourself, is it directly related to the sales effort? If yes, it's a selling expense. If no, then by process of elimination, it is a general and administrative expense.

In cost accounting, we don't concern ourselves with the breakdown of operating expenses very much. We leave that to financial accounting. It's enough for you to know it's an operating expense, which is a period expense. On the product costs, though, you do need to know the categories.

Now comes an opportunity to make sure you clearly understand the distinction between product and period costs. Classify each of the following merchandising-- excuse me-- classify each of the following manufacturing company used-up cost items as a product or a period cost.

Office building depreciation, is it product or period cost? Pause the presentation until you have a solution.

It's outside the factory, so it must be a period cost and operating experience. It will be in depreciation expense.

Factory assembly line wages, is it a product or period cost? Pause the presentation until you have an answer.

It's inside the factory, so it must be a product cost. And in this case, it's direct labor.

Factory janitorial salaries, is it a product or a period cost? Pause until you have a solution.

It's inside the factory, so it must be a product cost. And in this case, it's manufacturing overhead.

You might be thinking, what does sweeping the factory floor have to do with building the product? Well, one of the necessary costs incurred to build a product is a need to have the factory cleaned periodically. So factory janitorial salaries are a legitimate part of the cost of building a product.

Office property taxes, is it product or period cost? Pause the presentation until you're ready.

It's outside the factory, so it must be a period cost in operating expense, in this case, property tax expense or office property tax expense.

Office supplies used, is it a product or period cost? Pause the presentation until you're ready.

It's outside the factory, so it must be a period cost in operating expense. In this case, it's office supplies expense or supplies expense.

Factory building depreciation, is it product or period cost? Pause the presentation until you're ready.

It's inside the factory, so it must be product cost. And in this case, it's manufacturing overhead.

Factory property taxes, is it product or period cost?

It's inside the factory, so it must be a product cost. It's inside the factory, so it must be a product cost. And in this case, it's manufacturing overhead.

Office janitorial salaries, is it product or period cost?

It's outside the factory, so it must be a period cost in operating expense.

Factory supplies used, is it product or period cost?

Factory supplies are not direct materials, or it would be called raw materials or direct materials. Factory supplies are indirect materials. It's inside the factory, so it must be a product cost. And in this case, it's manufacturing overhead.

Advertising costs for ads already run, is it product or period cost? Pause until you're ready.

The reason for saying ads already run is because advertising costs for ads to be run in the future would be prepaid advertising, a current asset. After the ads are run, it's used up. It's outside the factory, so it must be a period cost in operating expense. In this case, it would be advertising expense.

In summary, the distinction between product and period costs is very clear. If the cost is incurred to run the factory, it is a product cost and will go into the inventory asset account. If it is incurred outside the factory, it is a period cost and will go into expenses on the income statement. This is the end of product versus period cost.