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In addition to classifying costs as manufacturing or nonmanufacturing costs, there are other ways to look at costs. For instance, they can also be classified as either product costs or period costs. To understand the difference between product costs and period costs, we must first discuss the matching principle from financial accounting. Generally, costs are recognized as expenses on the income statement in the period that benefits from the cost. For example, if a company pays for liability insurance in advance for two years, the entire amount is not considered an expense of the year in which the payment is made. Instead, one-half of the cost would be recognized as an expense each year. The reason is that both years—not just the first year—benefit from the insurance payment. The unexpensed portion of the insurance payment is carried on the balance sheet as an asset called prepaid insurance. The matching principle is based on the accrual concept that costs incurred to generate a particular revenue should be recognized as expenses in the same period that the revenue is recognized. This means that if a cost is incurred to acquire or make something that will eventually be sold, then the cost should be recognized as an expense only when the sale takes place—that is, when the benefit occurs. Such costs are called product costs. Product CostsFor financial accounting purposes, product costsAll costs that are involved in acquiring or making a product. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. Also see Inventoriable costs. include all costs involved in acquiring or making a product. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. Product costs “attach” to units of product as the goods are purchased or manufactured, and they remain attached as the goods go into inventory awaiting sale. Product costs are initially assigned to an inventory account on the balance sheet. When the goods are sold, the costs are released from inventory as expenses (typically called cost of goods sold) and matched against sales revenue. Since product costs are initially assigned to inventories, they are also known as inventoriable costsSynonym for product costs.. We want to emphasize that product costs are not necessarily treated as expenses in the period in which they are incurred. Rather, as explained above, they are treated as expenses in the period in which the related products are sold. This means that a product cost such as direct materials or direct labor might be incurred during one period but not recorded as an expense until a following period when the completed product is sold. Period CostsPeriod costsCosts that are taken directly to the income statement as expenses in the period in which they are incurred or accrued. are all the costs that are not product costs. For example, sales commissions and the rental costs of administrative offices are period costs. Period costs are not included as part of the cost of either purchased or manufactured goods; instead, period costs are expensed on the income statement in the period in which they are incurred using the usual rules of accrual accounting. Keep in mind that the period in which a cost is incurred is not necessarily the period in which cash changes hands. For example, as discussed earlier, the costs of liability insurance are spread across the periods that benefit from the insurance—regardless of the period in which the insurance premium is paid. As suggested above, all selling and administrative expenses are considered to be period costs. Advertising, executive salaries, sales commissions, public relations, and other nonmanufacturing costs discussed earlier are all examples of period costs. They appear on the income statement as expenses in the period in which they are incurred. Prime Cost and Conversion CostTwo more cost categories are often used in discussions of manufacturing costs—prime cost and conversion cost. These terms are quite easy to define. Prime costDirect materials cost plus direct labor cost. is the sum of direct materials cost and direct labor cost. Conversion costDirect labor cost plus manufacturing overhead cost. is the sum of direct labor cost and manufacturing overhead cost. The term conversion cost is used to describe direct labor and manufacturing overhead because these costs are incurred to convert materials into the finished product. Exhibit 1-3 contains a summary of the cost terms that we have introduced so far.
Manufacturing Companies: Classifications of Inventory
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