Difference Between Period Cost and Product CostCost refers to the amount of money, resources, or effort required to acquire or produce something. In business and economics, cost is a crucial concept used to measure the value of goods or services by considering all expenses incurred in their production, acquisition, or operation. Understanding and managing costs effectively is essential for businesses to make informed decisions, set prices, determine profitability, and allocate resources efficiently. Costs can be categorized into various types; in this article, we will discuss Product cost and Period cost. Let us understand both with an example. Imagine you're running a lemonade stand. When you buy lemons, sugar, and cups to make lemonade, those are "product costs" because they directly help you make and sell your lemonade. But let us say you also spend money on things like advertising your lemonade stand, paying for electricity to run your fridge, or renting a table at a fair to sell your lemonade. These costs, like advertising or rent, are "period costs" because they're not directly linked to making the lemonade itself. Instead, they're just regular expenses you have to pay to keep your lemonade stand going. They're called "period costs" because they're expenses that happen over a specific period, like a month or a year, and they show up on your income statement as expenses, not on your balance sheet as assets. Period CostPeriod costs are expenses that are not directly tied to the production of goods or services. Instead, they are incurred during a specific period and are expensed on the income statement in that period. Examples of period costs include selling, general, and administrative expenses (SG&A), marketing expenses, rent, utilities, and salaries for administrative staff. These costs are necessary to keep the business running but do not contribute to the creation of a product or service. Period costs include items like general operating expenses. Because they are not related to the creation of products, they are expensed in the period they are incurred rather than being added to the value of inventory. This distinction is crucial for managerial and cost accounting purposes as it helps businesses understand their total expenses and make informed decisions about pricing, budgeting, and resource allocation. Types of Period CostBasically, there are three types of Period Cost. They are:
Product CostProduct costs are the expenses a company incurs to create its products or provide its services to customers. These costs include purchasing raw materials, paying workers to produce the goods, and covering overhead expenses like factory rent and utilities. Importantly, these costs are reflected on the company's financial statements when they become part of the cost of the goods sold. For instance, if a company sells shoes, the cost of the leather, labor, and factory expenses are considered product costs, and they are recorded on the financial statements when the shoes are sold. Essentially, product costs represent the investment a company makes in producing its goods or services, and they are crucial for understanding the company's financial performance. These costs are vital components of the manufacturing process, including both direct expenses like raw materials and labor wages, as well as indirect expenses like factory overheads. By accounting standards such as GAAP and IFRS, product costs must be capitalized as inventory on the balance sheet rather than immediately expensed on the profit and loss statement. This treatment acknowledges that these expenditures generate value not just in the current period but also in future periods when the goods are sold. Thus, capitalizing product costs ensures that the costs incurred in creating inventory are properly matched with the revenue generated from selling those inventory items, providing a more accurate representation of the company's financial performance over time. Understanding and accurately calculating product costs are crucial for businesses to manage their operations and finances effectively. Knowing the total expenses incurred in producing a specific quantity of products enables businesses to plan their budgets, allocate resources efficiently, and make informed decisions regarding pricing strategies. By comprehensively assessing product costs, businesses can set appropriate selling prices to ensure profitability while remaining competitive in the market. Additionally, having a clear understanding of production-related expenses helps companies avoid potential losses by ensuring that their selling prices cover all costs incurred in the manufacturing process, thereby safeguarding the financial health and sustainability of the business. TypesThe three types of product costs are essential for understanding the breakdown of expenses in manufacturing operations:
Overheads are costs that a business has but aren't directly tied to making a specific product. There are two main types:
Other costs, like electricity bills or rent, are also part of overheads because they're necessary for the factory to work. Still, you can't directly tie them to making a particular product. These costs add up and are important for the business to keep track of, even if they're not directly connected to making stuff. FormulaHere's the product cost formula expressed in mathematical terms:
And for factory overheads:
To calculate the cost per unit, you divide the total product cost by the number of units produced:
These formulas help businesses understand the cost breakdown and determine the cost of producing each unit of their product. Difference TableThis table helps you understand the main differences between product costs (the costs of making stuff) and period costs (the costs of running the business)
ConclusionUnderstanding the distinction between product costs and period costs is vital for businesses to manage their finances and make informed decisions effectively. Product costs represent the expenses directly tied to the production of goods or services, including direct labor, direct material, and factory overheads. These costs are capitalized as inventory and later expensed when the goods are sold, ensuring that the cost of production is matched with the revenue generated. On the other hand, period costs encompass expenses unrelated to production, such as marketing, administrative expenses, and CEO salaries, which are expensed in the period they are incurred. Recognizing the differences between these two types of costs enables businesses to accurately assess their total expenses, determine profitability, and allocate resources efficiently. Furthermore, by calculating product costs on a per-unit basis, businesses can gain insights into the cost-effectiveness of their production processes and make informed decisions about pricing strategies. While product costs directly contribute to the creation of value, period costs are essential for sustaining business operations and maintaining competitiveness in the market. Therefore, by effectively managing both types of costs, businesses can optimize their financial performance, enhance profitability, and ensure long-term sustainability in a competitive business environment. Next TopicDifference Between |
We provides tutorials and interview questions of all technology like java tutorial, android, java frameworks
G-13, 2nd Floor, Sec-3, Noida, UP, 201301, India