Costs may be classified as product costs and period costs. This classification is usually used for financial accounting purposes. A brief explanation of product costs and period costs is given below:
Product costs (also known as inventoriable costs) are those costs that are incurred to acquire or manufacture a product. For a manufacturing company, theses costs usually consist of direct materials, direct labor, and manufacturing overhead.
Product costs are initially treated as inventory and do not appear on income statement until the product for which they are incurred is sold. When the product is sold, these costs are transferred to cost of goods sold account. For example, John & Muller company manufactures 50 units of product X in year 2020. Out of these 50 units manufactured, the company sells only 30 units during the year and 20 unsold units remain as ending inventory. The direct materials, direct labor and manufacturing overhead costs incurred to manufacture these 50 units will be initially treated as inventory (i.e., an asset). The inventory of 30 units will be transferred to cost of goods sold during the year 2020 and appear on the income statement of 2020. The remaining inventory of 20 units will not be transferred to cost of good sold in 2020 but will be listed as current asset in the John & Muller’s balance sheet. These unsold units will continue to be treated as asset until they are sold next year and their cost is transferred to cost of goods sold account.
The costs that are not included in product costs are known as period costs. Usually, these costs are not part of the manufacturing process and are therefore treated as expense for the period in which they arise.
Period costs are not attached to products and company does not need to wait for the sale of its products to recognize them as expense. According to generally accepted accounting principles (GAAP), all marketing, selling and administration costs are treated as period costs. Examples of these costs include office rent, interest, depreciation of office building, sales commission and advertising expenses etc.