For financial reporting purposes, costs are classified as product costs or period costs.
1. Product costs consist of manufacturing costs: direct materials, direct labor, and factory overhead.
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2. Period costs consist of selling and administrative expenses. Selling expenses are incurred in marketing the product and delivering the product to customers. Administrative expenses are incurred in managing the company and are not directly related to the manufacturing or selling functions.
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The key difference between product costs and period costs is that product costs are only incurred if products are acquired or produced, and period costs are associated with the passage of time. Thus, a business that has no production or inventory purchasing activities will incur no product costs, but will still incur period costs.
Product costs are initially recorded within the inventory asset. Once the related goods are sold, these capitalized costs are charged to expense. This accounting is used to match the revenue from a product sale with the associated cost of goods sold, so that the entire effect of a sale transaction appears within one income statement.
Examples of product costs are direct materials, direct labor, and allocated factory overhead. Examples of period costs are general and administrative expenses, such as rent, office depreciation, office supplies, and utilities.
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Period costs are sometimes broken out into additional subcategories for selling activities and administrative activities. Administrative activities are the most pure form of period costs, since they must be incurred on an ongoing basis, irrespective of the sales level of a business. Selling costs can vary somewhat with product sales levels, especially if sales commissions are a large part of this expenditure.
Product costs are sometimes broken out into the variable and fixed subcategories. This additional information is needed when calculating the break even sales level of a business. It is also useful for determining the minimum price at which a product can be sold while still generating a profit.
The impact on the financial statements of product and period costs. As product costs are incurred, they are recorded and reported on the balance sheet as inventory. When the inventory is sold, the cost of the manufactured product sold is reported as cost of goods sold on the income statement. Period costs are reported as expenses on the income statement in the period in which they are incurred and, thus, never appear on the balance sheet.
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