Costs which are needed to produce a product are referred to as product costs, all other costs are known as period costs.
Product costs are needed to produce the product and are sometimes referred to as inventory costs as they are included in the cost of inventory of the business until the products are sold.
Product costs can be separated into direct and indirect costs.
Direct Product Cost
Direct product costs consist of those which can be easily identified and traced back to the product, they include direct materials and direct labor.
Direct material cost is the cost of all the identifiable materials used in the production of a product. It must be possible to easily identify, track or count the materials to a particular unit of production. So for example, if a business manufactures bicycles, then the metal used to produce the frame would be referred to as a direct material product cost.
Direct labor cost is the gross wage cost of all the labor associated with a particular job. The labor included must relate to those employees who are directly working on the item being produced. In our bicycle manufacturer example, the labor used to produce the frame would be a direct labor product cost.
Indirect Product Cost
Indirect costs or indirect expenses, are costs which cannot be traced directly to a particular cost object. The cost object is usually a product in the manufacturing industry, but can be any object to which the business is seeking to assign costs to such as a department, activity, project, customer, or geographic area. In schools, for example, the cost object might be students or a subject department, in the healthcare industry, the cost object might be a patient or medical department.
It can be seen that the decision as to whether a cost is indirect or direct depends on the definition of the cost object and therefore the type of business and the industry in which the business operates.
Example of Indirect Costs
In a manufacturing business the materials and labor used to manufacture a product can be directly traced to the product (the cost object) and are therefore direct costs, on the other hand insurance and professional fees might not be attributable to the product directly and are therefore classified as indirect costs.
In the case of the bicycle manufacturer for example, oil used in the production process is not easily identified with a particular unit of production but is still a product cost, and is therefore an indirect material product cost, which is allocated across all units of production on a predefined basis. Like wise, the factory supervisor is needed to produce the product and is therefore a product cost but cannot be identified with a particular unit of production and is therefore an indirect labor product cost.
Allocation of Indirect Costs
If appropriate, indirect costs need to be allocated to the cost object using some predefined basis. For example a business with say four departments to which it assigns direct costs, might allocate a quarter of the indirect costs to each department, or as an alternative it might allocate the indirect costs in proportion to the direct costs assigned to a particular department.
In a manufacturing business indirect products costs are often referred to as manufacturing overhead, and are allocated to units of production on an agreed basis such as machine hours or labor hours used in the production of the product.
List of Product Costs
The following are typical examples of product costs.
- Raw materials
- Assembly line workers
- Assembly line supervisors
- Factory janitor costs
- Manufacturing machinery mechanics
- Production plant managers
- Raw materials purchase ordering staff
- Production plant receptionists
- Utilities for production plant buildings and machinery
- Computers for production staff
- Uniforms and protective equipment
- Property tax on production plant
- Insurance for production unit
- Factory cost accountants salary
- Factory cleaner costs
- Depreciation on production machinery and buildings
- Shipping and freight in costs (incurred before the product is produced)
Period Cost Examples
Period costs are any costs which are not product costs. The costs are called period costs as they are included as expenses in the income statement in the period in which they are incurred. Period costs normally include selling, marketing, and administration costs.
Examples of Period Costs
- Sales staff
- Sales commissions
- Website costs
- Distribution and freight out costs (incurred after the product is produced)
- Administration costs
- Executive salaries
- CEO salary
- HR, legal, accounts department staff
- Research and development costs
- Promotion costs
- Market research
Treatment of Product and Period Costs in Financial Statements
It is important to separate costs into product and period costs as their treatment in the financial statements differs.
Product costs become part of the inventory cost of a business and are held on the balance sheet until the product is sold, at which point they are transferred to the income statement as part of the cost of goods sold expense.
Period costs are treated as an expense in the income statement in the period in which they are incurred.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.