CH 01 Product vs Period Costs - YouTube

Sometimes we'll need to classify costs as either product or period costs. This

is also referred to as manufacturing or non-manufacturing costs. A product cost

includes any cost that is required to purchase or manufacture inventories. For

a retailer, this would simply be the cost of buying the inventory. So a retailer of

office furniture might buy desks and resell them. If they buy that desk for

$150 that's the product cost of the desk. For a manufacture, this would include

any cost required to manufacture that desk. So that would be wood, someone to

assemble the wood, and a place for this work to take place, and some equipment,

and some tools like saws. So when we think about a manufacturer there are

three broad categories of product costs: direct material, direct labor, and

manufacturing overhead. We'll talk about each of these in turn. Now direct

material becomes an integral part of the finished product, and the costs can be

traced conveniently to that product. So wood for a desk manufacturer would be a

direct material. I will abbreviate this as DM from time to time throughout the

course. Direct material can be natural resources such as wood, or it can simply

be a part that is purchased from another company. If the manufacturer of

elliptical machines purchases motors for those machines, then that would be a

direct materia.l For a t-shirt manufacturer, fabric would be an example

of a direct material.

It is important to note that the term raw material refers to both direct and

indirect material. You will find as we move through the course, it is important

to distinguish between direct and indirect material. Direct labor, this is

the labor cost that can be easily traced to individual units. Sometimes it's

called touched labor because they work hands-on the product. From time to time

throughout the course I will abbreviate this as DL. This would be bottlers at

coca-cola company, or for a t-shirt manufacturer this would be the sewing

machine operators.

Now factory labor includes both direct and indirect labor as well. And you'll

see later in the course, that it is important to distinguish between these

two. Manufacturing overhead includes all other manufacturing costs, so it's an

interesting way to define it. First it has to be a manufacturing cost. And

second it's not direct material or direct labor.

So it's everything else. These cannot be easily traced to the specific units.

They're often called indirect manufacturing cost, factory overhead, or

factory burden. I will abbreviate this as OH or, occasionally MOH, but I'm talking

about manufacturing overhead. When we think of overhead, we need to get the

idea that this would include indirect material. So while it is a material, if

you can't trace it easily to each unit then you will classify it as an overhead

cost. This becomes important later when we start to try to identify how to

assign costs to inventory. Sometimes indirect material is called factory

supplies. For a t-shirt manufacturer this might include thread. If you don't

want to trace that to each unit, then it would be an indirect material. Oil for

the sewing machines would be almost impossible to trace to each t-shirt.

Scissors, Thimbles, other small tools would be considered an indirect material

for a t-shirt manufacturer. Manufacturing overhead also includes indirect labor.

Indirect labor is factory labor but it is difficult to trace it to each unit.

For a T-shirt manufacturer, this would include the factory supervisor salary.

The factory supervisor is going to work in the factory, but they're not going to

have a specific job on each unit that is produced. They're going to oversee

scheduling and the general operations of the factory. The factory janitors would

be included here, they're needed in the factory but they

do not work hands on the product.

Other examples of overhead include maintenance and repairs on production

equipment, heat, light, and power, property taxes, depreciation, insurance, etc. But

this needs to be on manufacturing facilities, on your manufacturing plant

that is. You can think of this in terms of being facilities costs. Just the cost

of owning machinery, or a warehouse, or a manufacturing plant. So when you think of

overhead, this is for a t-shirt manufacturer, think of it in terms of

this would include indirect material, indirect labor (like the factory janitor,

the factory supervisor, or security personnel), and then it would include the

cost of renting a space to manufacture the products, or maintaining the plant, or

maintaining the equipment. Providing heat, light, and power to that facility, those

are the other overhead costs. How do we treat product costs? Think back to your

first accounting course. When you bought inventory, you didn't put it in cost of

goods sold immediately. You recorded it as an asset, called inventory. When the

goods were sold, then you expensed it through cost of

goods sold on the income statement. So it's first an asset and is an expense

when sold. And that of course accommodates the matching principle.

Period costs. These are non-manufacturing costs. Selling and administrative costs

are what we're talking about here. They're often called operating expenses.

All of these terms are synonymous: Period costs, operating expenses, selling and

administrative costs. They will include selling costs, anything to secure the

customer order, and get the finished product to the customer. So examples

would be sales, salaries and commissions, travel expenses, salesman's

auto expenses, delivery to customers, marketing and advertising. You will also

have administrative costs. This would be your executives and your clerical

workers, just the general management of the organization. So administrative

salaries, clerical wages, research and development expenses would fall in under

administrative costs. But it also includes things like rent, insurance,

depreciation, property taxes, utilities, maintenance, etc. You've heard these costs

before, but now if they're on selling and administrative facilities they will be a

period cost. So now when you hear the term that rent cost was incurred, you

will have to ask yourself, rent on what? Before you'll know how to classify it as

a product or a period cost. Period costs are treated very differently from

product costs. They're expensed in the period incurred. They are not recorded as

an asset and expensed when goods are sold. They're expensed immediately.

Now there are a few caveats, like prepaid rent or depreciation. But in general they

are expensed, in full, in the period incurred. Now this product versus period

distinction is necessary in order to prepare financial statements. We will

spend some time on how we do that in this course, but understand that this is

critical for a company to do in order to prepare an income statement and balance

sheet. Two additional terms. Prime costs. That refers to direct material plus

direct labor. That term was coined at the turn of the century when the primary

cost of production were materials and labor. But now of course overhead has

become a major cost of production with automation we have more costs that are

going into equipment, and maintaining, and operating, and powering that equipment.

But the term prime has stuck, so that is direct material plus direct labor.

Conversion costs. That would be direct labor and overhead, the cost of

converting materials. Let's do a short activity to see if you have understood

these terms. Classify the following cost incurred by Abel Furniture Manufacturers

using the following choices: DM for direct material, DL for direct labor, OH

for manufacturing overhead, or P for period cost. Lumber used in production.

Since this is a manufacturer of furniture, we can assume lumber would be

a direct cost of production and we'll call that direct material. Insurance on

building used to house the manufacturing plant. Alright so this is a facilities

cost. Notice that it is on the manufacturing plant,

so this would be overhead. Had that been on administrative offices, it would have

been a period cost. Wages paid to carpenters. We can assume those are the

people who assemble the furniture and that would be direct labor. Rent paid on

administrative headquarters. This is a facilities cost and it's on your selling

and administrative facilities. So we'll call that a period cost. Depreciation on

computers used by sales office clerks. That would be a selling cost, so it will

be classified as period. Glue and sandpaper required in production. Well

that is a product cost because it is required in production. But in all

likelihood, we would not trace how much sandpaper is needed to produce one desk

and we probably would not trace glue to each desk. So while it is a product cost,

it is not direct material. It is not direct labor. So it would be classified

as manufacturing overhead. Now stay tuned, we will talk a little more about cost

classifications and will work a more comprehensive example to make sure you

understand these important concepts.