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How Are Period Expenses Calculated?
Accounting for both types of expenses is key for profitable pricing strategies. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs.
Freight costs can be categorized as either a product cost or a period cost, depending on the context. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path. Period expenses are important to know about because they can have a direct impact on both reducing costs and increasing revenue.
If a manufacturer rents its manufacturing facilities and equipment, the rent is a product cost (as opposed to an expense of the period). That is, the rents will be included in the manufacturing overhead which is allocated to the goods produced. (Think of the manufacturing rents as clinging to the goods produced.) As a result, the manufacturing rents will be part of the products that are in inventory and will be part of the cost of the products sold. When the items in inventory are sold, the manufacturing rent allocated to those products will be expensed as part of the cost of goods sold. These rents are not allocated to products for its external financial statements.
Exploring Period Costs
- Period expenses are usually calculated by adding together all expected payments for a period, then subtracting any amounts that were paid early.
- Period costs and product costs are two important concepts in managerial accounting that classify costs to analyze financial performance.
- When the items in inventory are sold, the manufacturing rent allocated to those products will be expensed as part of the cost of goods sold.
- Direct Materials include the raw materials and components that go directly into a finished product, such as wood, fabric, electronics, etc.
When preparing financial statements, companies need to classify costs as either product costs or period costs. We need to first revisit the concept of the matching principle from financial accounting. In addition to categorizing costs as manufacturing and nonmanufacturing, they can also be categorized as either product costs or period costs. This classification relates to the matching principle of financial accounting. Therefore, before talking about how a product cost differs from a period cost, we need to look at what the matching principle says about the recognition of costs.
Introduction to Period Costs vs Product Costs
Other examples of period costs include marketing expenses, rent (not directly tied to a production facility), office depreciation, and indirect labor. Also, interest expense on a company’s debt would be classified as a period cost. If you manufacture a product, these costs would include direct materials and labor along with manufacturing overhead. Most of the components of a manufactured item will be raw materials that, when received, are recorded as inventory on the balance sheet.
However, other labor, such as secretarial or janitorial staff, would instead be period costs. 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. 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. For example, reducing monthly rent expenses by $1,000 would increase net income by $12,000 per year.
The difference between product costs and period costs
A period cost is any cost consumed during a reporting period that has not been capitalized into inventory, fixed assets, or prepaid expenses. These costs tend to be clustered into the selling, general and administrative classifications of expenses, and appear in the lower half of a reporting entity’s income statement. Freight costs would be considered a product cost if the freight is to ship direct materials to the factory for production. For example, if a furniture manufacturer pays freight to transport lumber from a supplier to their factory, that freight cost gets included in the total cost to manufacture the furniture. Product costs (also known as inventoriable costs) are those costs that are incurred to acquire, manufacture or construct a product.