As the name suggests, period costs are those costs which are incurred due to the passage of time. They don’t form part of the cost of inventory and thus are expensed to the profit and loss account as and when they are incurred by the entity. Such a treatment of period costs is in accordance with the accrual concept of financial accounting. Grasping the difference between product and period costs serves as a financial compass for businesses. Moreover, this understanding empowers businesses to manage costs effectively, making informed decisions about product pricing, production efficiency, and overall operational strategies. Unlike product costs, period costs don’t depend on the production volume.

Understanding Period Costs

• Period cost refers to the passage of time incurred by the businesses even if there is no production of goods or inventory purchase.
• It’s only when the product is sold that these costs are transferred to the Cost of Goods Sold (COGS) category on the income statement.
• To grasp the concept of what a period cost encompasses, think of any expense that is necessary to maintain business operations but does not directly contribute to the creation of products.
• This depends on whether the labor is directly related to production or not – a factory worker’s wages would be product costs, while a company secretary’s wages would be period costs.
• For businesses, especially for small enterprises and startups, understanding how to classify expenses like sales commissions is crucial.
• Product costs are directly related to the production of goods or services and are recorded as inventory until sold.

Failing to distinguish between product vs period costs could result in an overstatement or understatement of assets and net income. Salaries of administrative employees are considered fixed and period costs as well. Since admin employees aren’t directly involved in production, their salaries are period costs. Read our article about managerial accounting to learn more about how it can help your business manage costs.

For businesses, especially for small enterprises and startups, understanding how to classify expenses like sales commissions is crucial. Proper accounting practices involve ensuring that commissions are recognized when incurred. This may require robust internal controls and accounting software to track and record transactions accurately.

According to the Matching Principle, all expenses are matched with the revenue of a particular period. So, if the revenues are recognised for an accounting period, then the expenses are also taken into consideration irrespective of the actual movement of cash. By virtue of this concept, period costs are also recorded and reported as actual expenses for the financial year.

Product Cost vs. Period Cost

Because of the different nature of product and period costs, they receive different accounting treatments. Product costs form part of inventory and the balance sheet, making them inventoriable cost. They only affect the income statement when inventory is sold, and the cost of inventory becomes COGS. Moreover, period costs are expenses in the income statement of the period in which they were incurred. Product and period costs are the two major classifications of costs that have different accounting treatments. Product costs are related to the cost of purchasing inventory for sale or performing a service.

Examples of Product Costs and Period Costs

When costs are traceable to products and services, they are undeniably product costs. Being traceable means that you won’t have a hard time determining the physical quantity and its cost equivalent. So, let’s get started on our journey to unravel the complexities of product vs period costs. Let’s say you’re considering hiring more staff to handle the increasing number of orders. By looking at period costs, you can evaluate the impact of such decisions on the bakery’s overall financial health. To make a profit and keep your bakery thriving, you’ll likely set a price for your cakes that’s higher than $10.

Allocable to Products & Services

Businesses should also seek professional financial advice or use specialized consulting services to navigate complex categorizations. A meticulous approach to accounting ensures compliance and enhances overall financial oversight. Both types of costs are an important component of your business’s financial statements, so it’s helpful to set up a real-time reporting system using accounting software. GoCardless blends seamlessly with numerous accounting partners, including Xero.

Operating expenses are the funds a business pays regularly to stay in business – rent, salaries, and advertising costs, to name a few. They play what is a general ledger account a significant role in shaping the overall profitability of a business because they directly impact how much money it gets to keep after covering all these ongoing expenses. This means they accumulate as the business transforms raw materials into finished products. This timing is crucial for accurately determining the total cost of producing each unit.

Period costs:

These two cost categories are critical for allocating expenses between production-related activities and general business operations. This means that these costs directly impact the income statement for the specific time frame. For example, if a company owns a building that is used for both production and administrative purposes, the cost of the building could be considered a mix of product and period costs.

• If there is no production of any goods, the business will incur no product cost.
• While commissions are motivational tools that drive revenue growth, they also represent significant expenses.
• Overall, understanding the difference between product and period costs is crucial in cost accounting.
• Both types of costs are an important component of your business’s financial statements, so it’s helpful to set up a real-time reporting system using accounting software.
• In summary, product costs are recognized in the balance sheet before being expensed in the income statement.
• A business can go through periods where it doesn’t have any product costs, but there will still be period costs as these are unrelated to the ebb and flow of production.
• People often confuse product and period costs due to the complexity of accounting terminology and the different ways these costs are treated in financial reporting.

Now that we have taken a bird’s eye view of the matching principal, let’s look into the meanings of and difference between product costs and period costs. Balancing product and period costs is important for your business performance efficiency. Product costs help you fine-tune the price of each item you sell, ensuring profitability. Period costs guide decisions about how to efficiently rule your small business realm to stay afloat, impacting staffing, advertising, and day-to-day operations.

On the other hand, costs of goods sold related to product costs are expensed on the income statement when the inventory is sold. 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, nine steps in the accounting cycle especially if sales commissions are a large part of this expenditure.

The direct materials, direct labor and manufacturing overhead costs incurred to manufacture these 500 units would be initially recorded as inventory (i.e., an asset). 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.

Example of Period Costs

These costs are not included as part of the cost of either purchased or manufactured goods, but are recorded as expenses on the income statement in the period they are incurred. If advertising happens in June, you will receive an invoice, and record the expense in June, even if you have terms that allow you to actually pay the expense in July. The cash may actually be spent on an item that will be incurred later, like insurance. It is important to understand through the accrual method of accounting, that expenses and income should be recognized when incurred, not necessarily when they are paid or cash received. Understanding the distinction between product costs and period costs is fundamental in cost accounting, as it helps businesses accurately track expenses and evaluate financial performance.

Therefore, a period cost is generally recorded in the books of accounts with inventory assets. In a nutshell, we can say that all the costs which are not product costs are period costs. The simple difference between the two is that Product Cost is a part of Cost of Production (COP) because it can be attributable to the products. On the other hand Period, the cost is not a part of the manufacturing process, and that is why the cost cannot be assigned to the products. Accurate measurement of product and period costs helps you report the correct amount of expense in the income statement and assets in the balance sheet.

Product costs are also often termed as inventoriable costs and manufacturing costs. These costs include direct materials, direct labor, and factory overhead. If the related products are sold at once, then these costs are charged to exploring the relevance and reliability of fair value accounting the cost of goods sold immediately. If the products are not sold right away, then these costs are instead capitalized into the cost of inventory, and will be charged to expense later, when the products are eventually sold.

Under different costing system, product cost is also different, as in absorption costing both fixed cost and variable cost are considered as Product Cost. On the other hand, in Marginal Costing only the variable cost is regarded as product cost. An example of such cost is the cost of material, labour, and overheads employed in manufacturing a table. Period costs are costs that cannot be capitalized on a company’s balance sheet. In other words, they are expensed in the period incurred and appear on the income statement. Integrate financial data from all your sales channels in your accounting to have always accurate records ready for reporting, analysis, and taxation.

The Financial Modeling Certification

The $10 direct materials would be a debit to cost of goods sold (increasing) and a credit to inventory (decreasing). The  $10 direct materials would be a debit to cost of goods sold (increasing) and a credit to inventory (decreasing). Product cost comprises of direct materials, direct labour and direct overheads. Period costs are based on time and mainly includes selling and administration costs like salary, rent etc. These two type of costs are significant in cost accounting, that most people don’t understand easily.