When managing finances, it is crucial to differentiate between product cost vs period cost. These expenses affect a company’s bottom line, but they are treated differently in financial reporting. Understanding the distinction between these two types of costs can help you make informed decisions about your business’s finances, which is essential for effective financial management. This article will explore the difference between product cost vs period cost, how they are calculated, and their impact on financial statements.
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What are Product Costs?
Product costs are the costs of manufacturing a product. This includes direct materials and direct labor. Direct labor is the time and effort it takes to make a product, such as when paying someone for an hour’s work. Direct materials, such as wood, metal, or plastic, are the raw materials needed to make your product.
Product costs are typically categorized as either variable or fixed. Variable costs change based on the quantity of products that are produced, as discussed in the context of mobile app development cost estimation. For example, if you produce 100 units of a product, the cost per unit will be lower than if you produce 1 million units.
Following are the example of product costs:
- Raw materials
- Direct labor costs
- Manufacturing overhead
- Depreciation on production equipment
- Shipping and handling costs
How to Calculate Product Costs
The following are instances of how you can calculate product costs:
Direct Materials:
Materials that go directly into the production of a product. An example is wood used in making furniture.
Direct Labor:
The cost of labor required to convert raw materials into finished goods is considered direct labor. This comprises wages, benefits, and payroll taxes for employees who work directly on the production line or in supporting areas such as maintenance or quality control.
Factory Overhead:
Factory overhead includes indirect materials, indirect labor, and manufacturing support services that support the production department’s activities but cannot be easily traced to specific products or services produced by the company’s operations.
How Product Costs Affect Financial Statements
Product costs affect financial statements differently than period costs because they can be traced directly to specific products or services. For example, if you manufacture widgets for sale, each widget has its direct material and direct labor cost on your income statement. When you sell one widget, these two costs show up as expenses on your income statement with a corresponding debit to inventory for each widget sold. This allows you to see at any point in time how much inventory you have on hand based on your sales figures for that product.
What is a period cost?
A period cost is a cost that the company incurs during a specific period. It is also known as a variable cost. The cost of resources used in manufacturing, service production, and distribution can be considered period costs.
How to Calculate Period Costs
Period costs are incurred for direct material, direct labor, and variable overhead costs, which are integral to understanding B2B SaaS and its advantages.
Period Cost Example:
The following example will help you understand how to recognize a period cost in the accounting records:
Let’s say that you manufacture pens that sell for $5 each. You use $1 of raw material and $1 worth of labor to make each pen. In addition, you incur $2 worth of overhead costs each day. These overhead costs include utilities, rent, etc., which are not related to any specific unit produced but are incurred based on the number of pens produced over a given period (monthly). Suppose you produce 100 pens per month after incurring all these expenses. The total cost you incur each month is $3 ($2 + $1 + $1).
Types of Period Cost.
Period costs can be classified into three types:
Fixed period cost:
A fixed period cost does not change based on the output level produced by a company. For example, rent is a fixed period cost because it does not change even though more or fewer products may be manufactured during a given period.
Variable period cost:
A variable period cost changes based on the company’s output level. For example, raw materials and labor are variable period costs because they fluctuate depending on how many products are manufactured during a given period.
Semivariable period cost:
A semivariable cost has both fixed and variable components. For example, payroll taxes paid to state and federal governments would be considered semivariable because they vary based on how many people work during each pay period and have fixed portions that do not change regardless of sales volume.
How to calculate Period costs?
Period costs are all the costs incurred during a specific period. These may be variable or fixed costs, including labor, materials, and overhead. You can calculate period costs by using the following formula:
- Period cost = Total Fixed Costs + Variable Costs
- Total Fixed Costs = Total Fixed Costs from Previous Period + New Fixed Costs
- New Fixed Costs = Total Fixed Costs from Previous Period – Total Variable Cost from Previous Period
- Variable Costs = (Sales – Sales from Previous Period) x 1/Sales Goal / 100%
If you want to calculate period costs in a more simplified way, there is another formula for you:
Period Cost = Total Variable Cost + Total Fixed Cost.
How Period Costs Affect Financial Statements
Period costs are expenses recorded on the current period’s income statement. They include items such as salaries, rent, and taxes. A business cannot avoid incurring these costs but can delay paying them until the end of an accounting period. Understanding how these costs affect financial statements is important because they can make a big difference in your company’s bottom line.
For example, suppose your company pays $1 million in salaries and $100,000 in monthly rent. The total of those two expenses is $1.1 million each month, so you should expect to see that amount on your balance sheet and in your income statement. That means if you add up all the expenses listed in your income statement, they should equal your total assets on your balance sheet (assuming there are no other accounts). The apps designed by The App Founders can assist you in calculating the expense of the period.
Difference Between product cost vs period cost
Following are the difference between product cost vs period cost
Timing of Expenses
One of the main differences between product and period costs is the timing of when they are incurred. Product costs are incurred during production, while period costs are incurred over time.
Relationship to Production
Another difference between product costs and period costs is their relationship to production. Product costs are directly tied to the production of goods, while period costs are not.
Treatment in Financial Reporting
product cost vs period cost is treated differently in financial reporting. Product prices are part of the cost of goods sold and the inventory on the balance sheet. Costs for a certain period are deducted from the income statement during the period in which they were paid.
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Crucial Insights Unveiled
| Aspect | Product Costs | Period Costs |
| Definition | Costs related to manufacturing a product, including materials and labor. | Costs incurred over a specific period, unrelated to production. |
| Examples | Raw materials, direct labor, manufacturing overhead, shipping costs. | Salaries, rent, utilities, taxes, insurance – not directly tied to production. |
| Calculation | Direct materials + Direct labor + Factory overhead. | Total Fixed Costs + Variable Costs. |
| Timing of Expenses | Incurred during production. | Incurred over a specific period. |
| Relationship to Production | Directly tied to the production of goods. | Not directly tied to production activities. |
| Treatment in Financial Reporting | Part of the cost of goods sold and inventory on the balance sheet. | Deducted from the income statement during the period in which they were paid. |
| Types (Fixed, Variable, Semivariable) | Variable and fixed components. | Fixed, variable, semivariable. |
| Impact on Financial Statements | Shows up on the income statement with a corresponding debit to inventory. | Recorded as expenses on the current period’s income statement. |
Conclusion
understanding the difference between product and period costs is crucial for effective financial management. Product costs are expenses directly related to the production of goods, while period costs are expenses that are not tied to production and are incurred over time. Accurately tracking and reporting product cost vs period cost allows businesses to make informed decisions about pricing, production, and overall financial health.
