Overview of Period Costs
In the world of accounting, businesses incur various costs throughout their operations. These costs can be classified into two main categories: period costs and product costs.
In this article, we will focus on period costs and delve into their definition, types, and how they appear on the income statement. By the end of this article, you will have a comprehensive understanding of period costs and their significance in financial reporting.
Definition of Period Costs
Period costs, also referred to as expenses, are costs that are not directly tied to the production of goods or services. Unlike product costs, which are incurred when goods are manufactured or services are delivered, period costs are expensed on the income statement in the period in which they are incurred.
There are several types of period costs that companies encounter during their operations. Let’s take a closer look at some of the common ones:
1.
Prepaid Expenses: These are costs that a company pays in advance for goods or services that will be used at a later date. For example, if a company pays rent for the next six months upfront, the portion applicable to the current period will be recorded as a period cost.
2. Inventory: Period costs associated with inventory include expenses incurred to store, maintain, and protect inventory.
This can include costs such as warehousing, insurance, and inventory counting. 3.
Fixed Assets: Costs related to fixed assets, such as buildings and equipment, are considered period costs. These costs include depreciation, repairs, and maintenance expenses.
Types of Costs Incurred by a Company When Producing Goods
While period costs are not directly tied to the production of goods or services, it’s essential to understand the costs incurred when producing goods. These costs are critical in determining the cost of goods sold (COGS) and ultimately, the company’s profitability.
Let’s explore some of the costs associated with producing goods:
1. Product Costs: Product costs, also known as manufacturing costs, include all costs incurred to manufacture a good or service.
These costs typically fall into three main categories: direct materials, direct labor, and manufacturing overhead. 2.
Office Expenses: Office expenses are costs associated with running the day-to-day operations of the business. This can include rent, utilities, office supplies, and insurance.
3. Administration Expenses: Administration expenses cover the costs of managing and overseeing the company’s operations.
This includes salaries of administrative staff, office rent, legal fees, and travel expenses. 4.
Marketing Expenses: Marketing expenses are incurred to promote products or services and attract customers. These costs can include advertising, sales commissions, market research, and public relations.
Understanding Period Costs According to the Corporate Finance Institute
According to the Corporate Finance Institute (CFI), period costs are “costs that are matched with the revenue of a specific time period rather than included as a cost of products or inventory on hand.” Period costs are expensed as soon as they are incurred, rather than being capitalized and recorded on the balance sheet. On the income statement, period costs are deducted from revenue to arrive at the net income.
Net income represents the profit or loss generated by a company during a specific period. Period costs include expenses such as salaries, rent, utilities, and advertising costs.
By deducting these costs from revenue, the income statement provides a clear picture of the company’s financial performance.
The appearance of Period Costs on the Income Statement
When reviewing an income statement, you will find period costs reported as separate expense items. These expenses are deducted from revenue to determine the company’s net income.
Some common expense line items associated with period costs include:
1. Salaries and Wages: This line item captures the cost of employee compensation during a specific period, including salaries, wages, bonuses, and payroll taxes.
2. Rent and Utilities: Rent and utilities expenses include the cost of leasing office space, as well as electricity, water, and other utility expenses.
3. Advertising and Marketing: This line item encompasses expenses associated with promoting the company’s products or services, such as advertising campaigns, digital marketing, and sponsorships.
4. Office Supplies: Office supplies expenses account for the cost of everyday supplies necessary to run the business, including paper, pens, and other office materials.
5. Depreciation and Amortization: Depreciation and amortization expenses reflect the wear and tear on the company’s fixed assets and the expiration of intangible assets’ useful lives.
Conclusion
Period costs are an important aspect of financial reporting, as they capture the expenses incurred by a company that are not directly tied to the production of goods or services. By understanding period costs and how they appear on the income statement, businesses can accurately assess their financial performance and make informed decisions.
Whether it’s prepaid expenses, rent, marketing, or depreciation costs, period costs play a significant role in determining a company’s profitability. By mastering period costs, companies can improve their financial management and ultimately thrive in today’s competitive business environment.
How Period Costs Work
When it comes to understanding the financial performance of a business, it is crucial to have a clear understanding of period costs. Period costs are expenses incurred by a company that are not directly associated with the production of goods or services.
In this section, we will dive deeper into how period costs work by exploring the factors that influence their determination and discussing the distinction between period costs and product costs.
Factors to Consider in Determining Period Costs
Several factors come into play when determining period costs for a specific accounting period. Let’s take a closer look at some of these factors:
1.
Accounting Period: Period costs are typically associated with a specific accounting period, which can be a month, quarter, or year. Costs are recognized in the period in which they are incurred, regardless of when the actual payment is made.
This means that even if an expense is paid in advance, it is recorded as a period cost when it is incurred, not when the payment is made. 2.
Product Costs: To determine period costs accurately, it is essential to identify the costs that are directly tied to the production of goods. These costs, known as product costs, include direct materials, direct labor, and manufacturing overhead.
Product costs are capitalized and recorded as part of the inventory until the products are sold. Once the products are sold, the associated costs are recognized as expenses and recorded as cost of goods sold (COGS).
3. Expense Account: Period costs are typically recorded in expense accounts on the income statement.
These accounts are used to track and report the costs incurred during a specific accounting period. Some common expense accounts associated with period costs include salaries and wages, rent and utilities, advertising and marketing, office supplies, and depreciation and amortization.
Identifying Period Costs and Product Costs
Differentiating between period costs and product costs is crucial for accurate financial reporting. While both types of costs impact a company’s profitability, they are treated differently and appear in different sections of the financial statements.
Let’s explore how to identify period costs and product costs:
1. Cost Incurred: Period costs are expenses incurred in a specific accounting period, regardless of whether the company is engaged in production or not.
These costs are expensed immediately and do not contribute to the acquisition or production of goods. On the other hand, product costs are costs incurred in the acquisition or production of goods.
These costs are capitalized and become part of the inventory until the products are sold. 2.
Inventory vs. Expense: Product costs are associated with the production process and are assigned to the inventory account.
These costs include the cost of raw materials, direct labor, and manufacturing overhead. In contrast, period costs are not related to the production process and are recorded as expenses on the income statement in the period they are incurred.
Examples of Period Costs and Product Costs
To further illustrate the distinction between period costs and product costs, let’s explore some examples:
1. Period Costs:
– Selling, General, and Administrative Expenses (SG&A): This includes expenses related to sales, marketing, and general administration.
Examples of SG&A expenses include salaries and commissions for sales personnel, marketing campaigns, executive salaries, rent expenses for office space, and utilities.
– Marketing Expenses: Costs associated with promoting products or services, such as advertising, public relations, and market research, fall under marketing expenses.
2. Product Costs:
– Labor Costs: The wages and benefits associated with the direct labor involved in manufacturing a product are considered product costs.
– Raw Materials: The cost of materials used in the production process, such as wood, metal, or plastic, is also classified as a product cost. – Overhead Expenses: Costs indirectly related to the production process, such as factory utilities, factory rent, and equipment depreciation, are classified as overhead expenses.
Understanding the distinction between period costs and product costs is crucial for accurate financial reporting. It ensures that expenses are properly categorized and recorded, providing stakeholders with an accurate assessment of a company’s financial performance.
Conclusion
Period costs are expenses incurred by a company in a specific accounting period, not directly related to the production of goods or services. Understanding how period costs work, including the factors influencing their determination and the distinction between period costs and product costs, is crucial for accurate financial reporting.
By properly identifying and recording period costs, businesses can assess their profitability and make informed decisions to drive success.
Period Cost Examples
Understanding the various types of period costs is essential for businesses to accurately track and report their expenses. In this section, we will explore some common examples of period costs and delve into a hypothetical scenario to categorize costs as either period costs or product costs.
Examples of Common Period Costs
1. Marketing and Advertising Expenses: Businesses often allocate a significant portion of their budget to marketing and advertising.
These costs can include advertising campaigns, social media promotions, print advertisements, and digital marketing efforts. Such expenses are essential for reaching customers, creating brand awareness, and driving sales.
2. Travel Expenses: When businesses send employees on business trips, expenses such as airfare, accommodation, meals, and transportation fall under the category of period costs.
Travel expenses are incurred to attend conferences, meet clients, or conduct site visits, all of which contribute to the overall operation of the business. 3.
Rent: One of the most common period costs for businesses is rent. Whether it’s an office space, retail store, or warehouse, rental expenses are incurred to provide a location for conducting business operations.
The rent paid for these spaces is recorded as a period cost and contributes to the ongoing expenses of the business. 4.
Interest Expenses: If a business has loans or borrowed funds, the interest paid on these loans is considered a period cost. Interest expenses are incurred over time as the business pays off its debt obligations and are an essential part of financial management.
5. Selling Expenses: Selling expenses are costs associated with the sales process.
This can include salaries and commissions for sales personnel, advertising expenses, packaging costs, and sales promotion activities. These costs are necessary to generate revenue and drive sales growth.
6. Depreciation Expenses: Depreciation is the gradual decrease in the value of assets over time.
Companies need to allocate depreciation expenses over the useful life of their fixed assets (such as buildings, machinery, or vehicles). These expenses are recorded as period costs because they relate to the ongoing use and wear and tear of the assets.
7. Sales, General, and Administrative Expenses (SG&A): SG&A expenses cover the day-to-day operational costs of running a business.
This category includes salaries and benefits for administrative employees, office supplies, utilities, legal expenses, and insurance. These expenses do not directly contribute to the production process but are necessary for the overall operations of the company.
Hypothetical Example of Categorizing Costs
To further understand the distinction between period costs and product costs, let’s consider a hypothetical scenario of a manufacturing company.
1.
Raw Materials: The cost of raw materials, such as wood, metal, or plastic, used in the production process, falls under product costs. These costs are directly linked to the creation of the goods and are initially capitalized as part of the inventory.
2. Labor Costs: The wages paid to workers involved in the production process are also classified as product costs.
This includes both direct labor (workers directly involved in manufacturing the goods) and indirect labor (workers who support the production process, such as supervisors or maintenance personnel). 3.
Office Rent: Office rent is an example of a period cost. It is an expense that supports the general operation of the business rather than being directly tied to the production process.
4. Marketing Expenses: Marketing expenses, such as advertising campaigns or promotional initiatives, are period costs.
These costs are crucial for generating awareness and driving sales, but they do not relate directly to the production of goods. 5.
Sales and Administrative Expenses: Costs associated with sales and general administration, such as salaries of sales personnel, office supplies, and utilities, are classified as period costs. These expenses support the ongoing operation of the business but are not attributable to the production process.
6. Production Costs: Costs directly related to the production process, such as raw materials and labor, are categorized as product costs.
These costs are capitalized when the goods are produced and become expenses when the goods are sold. By appropriately categorizing costs as period costs or product costs, businesses can accurately assess their expenses and determine their true profitability.
Conclusion
Period costs encompass a range of expenses incurred by businesses that are not directly linked to the production of goods or services. Marketing and advertising expenses, rent, travel expenses, interest expenses, selling expenses, depreciation expenses, and sales, general, and administrative expenses are all common examples of period costs.
It is crucial for businesses to distinguish between period costs and product costs to accurately report and analyze their financial performance. By understanding and properly categorizing costs, businesses can make informed decisions and effectively manage their expenses.
In conclusion, an understanding of period costs is crucial for businesses to accurately track and report their expenses. By differentiating between period costs and product costs, businesses can assess their financial performance and make informed decisions.
Period costs such as marketing and advertising expenses, rent, travel expenses, interest expenses, selling expenses, depreciation expenses, and sales, general, and administrative expenses play a significant role in determining a company’s profitability. It is vital for businesses to properly categorize these costs to provide stakeholders with an accurate assessment of their financial health.
By mastering period costs, businesses can improve financial management and make informed decisions for future success. Remember, period costs are not directly tied to the production process but are essential for the overall operations.
So, accurately tracking and understanding period costs is key to financial success.