Period Costs
Costs that are not involved directly in the manufacturing process
What are Period Costs?
Period costs are costs that are not involved directly in the manufacturing process of inventories. In other words, they are the expenses paid on non-manufacturing activities. These costs may include sales, general, and administrative (SG&A) expenses that relate to marketing or sales.
These do not have a fixed formula as they vary depending on each case. Identifying them only requires a little logic. One must decide whether an expense is directly tied to the manufacturing process of inventories or not.
However, the general formula would be the sum of selling and administrative salaries, bills, and utilities.
Some common period costs are:
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Salaries: the salaries and wages of employees who do not participate directly in the production of inventories. These salaries may include the salary of accountants or salespeople.
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Bills and utilities: any utilities required for the sales and administrative side of a manufacturer. These may include depreciation expenses or electricity and insurance bills for non-manufacturing properties, such as offices.
These are the major types of expenses for a manufacturer. However, some period costs may not fit in any of them.
For example, the fee for a consulting service offered by external management consultants is a period cost, but it is not mentioned in any of the categories above. It is a period cost since it is not directly included in the manufacturing process of inventory, and it does not fit in any of the listed titles.
Thus, it is always better to use business logic to identify them by tracing them back to figure out whether they are tied to the manufacturing process of inventories or not.
Key Takeaways
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Period costs are expenses not directly involved in manufacturing processes, including salaries, bills, and utilities for non-manufacturing activities.
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Recognizing period costs involves determining if an expense is directly linked to the manufacturing process of inventories, which may be tricky sometimes.
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They are recognized on the income statement in the period in which they are incurred, usually under selling, general, and administrative (SG&A) expenses.
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Product costs are directly tied to manufacturing, such as raw materials and production-related wages.
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Product costs are recorded as assets under "inventories" on the balance sheet. When inventories are sold, these costs become the cost of goods sold (COGS) on the income statement.
Period costs vs. product costs
Any manufacturer’s expenses can be either categorized as a product cost or a period cost based on whether it can be directly linked to the production process of inventories or not.
Thus, we can conclude that product costs are the opposite of period costs. Product costs can be directly tied to the manufacturing process of inventories.
Following accounting standards, the cost of inventory, or cost of goods sold, is any cost incurred to get inventory ready to be sold. In the case of manufacturers, it is any cost incurred to produce the products to be able to sell them.
Thus, it is the direct manufacturing cost, which we just discovered is the product cost, leading us to an equation:
Cost of inventories = Product Cost = COGS
These costs may include the cost of raw materials used in production, wages of workers who operate in producing goods, or the cost of utilities consumed by manufacturing facilities.
How are product costs reported in financial statements?
Since inventories are considered assets to a manufacturer, they are recorded in the balance sheet under the assets section. Therefore, product costs are recorded as assets on the balance sheet under the title of “inventories.”
The process of turning expenses into assets is done through the following steps:
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When a product cost is incurred, we credit the expense to get rid of it and debit an account called “work in process.”
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When all expenses required to produce the inventories are incurred, we debit finished goods (inventories), and we credit work in process the sum of all accumulated product costs (step 1).
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When inventories are sold, we debit COGS and credit finished goods (inventories).
In other words, manufacturers incur product costs to produce inventories. Therefore, the cost of inventories (Cost of Goods Sold, or COGS) is the same as product costs. Since inventories are recorded as assets for the manufacturers, product costs are recorded on the balance sheet in the assets section under inventories.
Those costs would not be accounted for on the income statement until they are sold.
We know that when we sell inventories, we subtract their value from the company’s assets since they are no longer there. Then, we account for them as COGS on the income statement since they are the cost of producing inventories:
| Db. | COGS +++ |
|---|---|
| Cr. | Inventories +++ |
The bottom line is product costs are recorded as inventories in the balance sheet under assets when the production process is over, and they are not accounted for in the income statement as COGS until they are sold.
Exercise on period and product costs
Now it’s time to practice. We will provide an example of a manufacturer and list all their costs for March 2022. Your task is to categorize their costs as either product or period costs and prepare the income statement for March 2022.
Imagine you are the owner and co-founder of MealCo, an organic canned meals producer company. MealCo operates a small building where 40% of the area is used as offices and 60% as a production facility. 70% of the offices are for administrative employees, and 30% are for production supervisors.
In addition, production machines consume 90% of the total electricity and water used in the building. MealCo sold 10,000 units for $8 each and incurred the following expenses during March:
- Depreciation expenses for the building accounted for $10,000.
- Raw materials used in production accounted for $40,000.
- Cans used in packaging accounted for $5,000.
- Electricity and water bills accounted for $1000.
- Internet and telecommunication bills accounted for $500.
- Salaries expenses for administrative employees accounted for $6,000, for production workers $7,000, and for production supervisors $5,000
- A management consultant offered consulting services for your company’s accounting system and billed you $1,500
- Maintenance of your machines costs $2000
- Insurance on the building costs $3,000
- Depreciation on machines is $3,500.
Task 1 - Categorize the costs between period and product costs
| Item | Product Costs | Period Costs |
|---|---|---|
| Building depreciation | $7,200 | $2,800 |
| Raw materials | 40,000 | - |
| Packaging cans | 5,000 | - |
| Electricity and water | 900 | 100 |
| Internet and telecommunication | - | 500 |
| Salaries | 12,000 | 6,000 |
| Consulting | - | 1,500 |
| Machine maintenance | 2,000 | - |
| Building insurance | 2,160 | 840 |
| Machine depreciation | 3,500 | - |
| Total | $72,760 | $11,740 |
Task 2 - Build the income statement for MealCo for March. (Hint: refer to the product cost equation)
As mentioned above, COGS is going to be the sum of all product costs identified above:
COGS= $72,760
Thus, the income statement will be as follows:
| Revenue | $80,000 |
|---|---|
| Less: COGS | ($72,760) |
| Gross margin | $7,240 |
| Less: Operating expenses | |
| Office depreciation | ($2,800) |
| Electricity bills | ($100) |
| Internet bills | ($500) |
| Admin salaries | ($6,000) |
| Consultant fees | ($1,500) |
| Insurance | ($840) |
| Net loss | ($4,500) |
Period Costs FAQs
Cost of goods sold refers to the cost of production of goods, so it is a period cost.
Even though this cost is directly related to products, it has nothing to do with producing them. Thus, most companies would consider it a period cost and account for it on the income statement directly.
That would depend on whether the depreciation is on property and equipment related to the manufacturing process or not. If yes, it is a product cost. If not, it is a period cost.
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