The distinction between product costs and period costs is important to:
- Properly measure a company’s net income during the time specified on its income statement, and
- To report the proper cost of inventory on the balance sheet
Definition of Product Costs
Product costs include the costs to manufacture products or to purchase products. If a product is unsold, the product costs will be reported as inventory on the balance sheet. When the product is sold, its cost is removed from inventory and will be included on the income statement as the cost of goods sold. Product costs are also referred to as inventoriable costs.
Examples of Product Costs
The product costs for a retailer will be the amount paid to the supplier plus any freight-in. Product costs for a manufacturer will be the direct materials, direct labor, and manufacturing overhead used to manufacture a product.
Definition of Period Costs
Period costs are expenses that will be reported on the income statement without ever attaching to products. Since they are not product costs, period costs will not be included in the cost of inventory. Instead, period costs will be referred to as period expenses since they will be reported on the income statement as selling, general and administrative (SG&A) or interest expenses.
Example of Period Costs
Selling expenses (such as commissions, salaries of sales employees, advertising), general and administrative (general office salaries, rent, utilities, etc.), and interest expense will be reported on the income statement when they are directly related to sales or when they are used up. For example, the insurance premiums that a company pays for nonmanufacturing protection will be expensed in the period in which the insurance premiums expire. (However, the insurance premiums for the manufacturing operations will become part of the product costs as the insurance premiums expire.)