Product vs. Period Costs Defined

 

Product (Manufacturing) vs. Period (Non-manufacturing) Costs

Product costs only exist in manufacturing, whereas period costs exist outside manufacturing and therefore, as said earlier, apply to any organization that incurs costs.

Product costs are the cost of items used up inside the factory where the manufacturing takes place.

Period costs are the cost of items used up outside the factory and are expenses on the income statement.

There are four things you need to understand here.

Used-up Costs

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 plant and equipment assets over the years benefited by their use. Depreciation is the amount considered used up. 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 prepaying factory insurance or prepaying office building insurance—it is prepaid insurance on the balance sheet. What does the company do when that insurance expires? As we will see shortly, used-up insurance goes to a different place if it's on the factory building versus on the office building.

It is the used-up costs that are of concern in our discussion here.

Product Costs

The second thing you need to understand is the three categories of product costs. Raw materials are sent into the factory. When those raw materials go into the factory, the assembly-line workers work on those raw materials to turn them into finished goods. The labor of the assembly-line workers is called direct labor. All the other costs of running that factory, other than direct materials or direct labor, are called factory overhead or manufacturing overhead.

So, we have three categories

• 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.

Factory or Manufacturing Overhead

The third thing 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 will 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 a factory other than the direct materials and direct labor, and they are all lumped together in manufacturing or factory overhead.

Period Costs

The fourth and last thing 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.

In financial accounting, we break the operating expenses into two basic sub-categories; selling expenses and general and administrative expenses. In cost accounting, we don't concern ourselves with the breakdown of operating expenses. We leave that to financial accounting. It's enough for you to know when a cost is an operating expense, which is a period expense. On the product costs though, you do need to know the categories, i.e.., be able to distinguish raw materials, direct labor, and manufacturing overhead.

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