Product Costs vs. Period Costs

Introduction

Understanding the difference between product costs and period costs is crucial for accurate financial reporting and decision-making in a trading business. The correct classification impacts the Income Statement and Balance Sheet.

Product Costs

Definition

Product costs are costs directly associated with acquiring or producing inventory and getting it ready for sale. These costs are included in the cost of inventory and are expensed as Cost of Goods Sold (COGS) when the inventory is sold.

a cost incurred to get inventory ready for sale and can be allocated to individual units on a logical basis

Examples

• Supplier’s price of inventory
• Cartage inwards (if allocable to individual units)
• Modification costs (if allocable to individual units)
• Import duties
• Insurance during transit

Recording

Product costs are initially recorded in the Inventory account (an asset) in the General Ledger. When the inventory is sold, the cost is transferred from the Inventory account to the Cost of Goods Sold account (an expense).

Impact on Financial Statements

• Balance Sheet: Product costs increase the value of inventory (an asset).
• Income Statement: Product costs are expensed as Cost of Goods Sold only when the inventory is sold, impacting Gross Profit.

Multiple Suppliers

If inventory is purchased from multiple suppliers, product costs like cartage inwards must be allocated fairly across all inventory items, if possible.

Example:

MacEvoy Golf Gear purchased golf clothing from Nickwell Clothing (Invoice 67):

• Golf shirts: \$460
• Golf hats: \$80
• Cartage in: \$50
• Total before GST: \$590
• GST (10%): \$59
• Total: \$649

In this case, cartage in can be treated as a product cost because it is incurred to bring inventory into a condition and location ready for sale.

KEY TAKEAWAY: Product costs are directly tied to inventory and expensed only when the inventory is sold.

Period Costs

Definition

Period costs are costs that are not directly associated with acquiring or producing inventory. They are expensed in the period in which they are incurred, regardless of when the inventory is sold and cannot be allocated to individual units of inventory because there is no logical basis to do so.

a cost incurred in order to bring inventory into a condition and location ready for sale that cannot be allocated to individual units of inventory because there is no logical basis to do so.

Examples

• Rent
• Advertising
• Salaries and wages (excluding direct labor in production)
• Depreciation on office equipment
• Cartage inwards (if not allocable to individual units)

Recording

Period costs are recorded directly as expenses in the General Journal and General Ledger in the period they are incurred.

Impact on Financial Statements

• Balance Sheet: Period costs do not affect inventory value.
• Income Statement: Period costs are expensed in the period incurred, impacting Net Profit.

Immateriality

Period costing may be used if the product cost concerned can be allocated but is too small to affect decision-making; that is, it is immaterial.

EXAM TIP: Be able to identify and classify costs as either product or period costs based on the scenario provided. Justify your answer.

Product Cost vs. Period Cost: A Comparison

Impact of Incorrect Classification

Relevance

It is important to correctly classify costs as product or period costs. Except where the cost is insignificant, treating a product cost as a period cost leads to the omission of information that would be useful for decision-making, and thus breaches Relevance.

Overstatement/Understatement

• Product Cost treated as Period Cost:
  • Cost of Goods Sold is overstated in the period of purchase.
  • Inventory (and thus assets) on the Balance Sheet is understated.
  • Profit is understated in the period of purchase.
• Period Cost treated as Product Cost:
  • Cost of Goods Sold is understated in the period of sale.
  • Inventory (and thus assets) on the Balance Sheet is overstated.
  • Profit is overstated in the period of sale.

Example:

A business incorrectly treats cartage inwards (a product cost) as a period cost. This results in:

• Higher expenses (due to immediate expensing of cartage).
• Lower net profit in the current period.
• Lower inventory value on the balance sheet.

COMMON MISTAKE: Students often confuse cartage inwards as always being a product cost. It is only a product cost if it can be logically allocated to individual units of inventory.

Circumstances for Using Period Costing

1. No logical basis for allocation: When a cost is incurred to get inventory ready for sale, but there is no logical way to allocate it to individual units.
2. Immateriality: When the cost is insignificant and would not affect decision-making.

Example:

Consider a business that purchases 100 units of inventory for \$10 each. They also incur \$50 in rent for the warehouse where the inventory is stored.

• Supplier’s Price: \$10 per unit (Product Cost)
• Rent: \$50 total (Period Cost) - cannot be logically allocated to each unit.

STUDY HINT: Create flashcards with different types of costs and practice classifying them as either product or period costs.

Effect on Profit and Balance Sheet

Period Costing vs. Product Costing

Period costing recognises the entire cost as an expense in the Period when the inventory is purchased, whereas product costing includes the cost as an expense only in the Period in which the inventory is sold.

• Income Statement (COGS):
  • Period costing leads to a higher Cost of Goods Sold in the period of purchase.
  • Product costing leads to a higher Cost of Goods Sold in the period of sale.
• Balance Sheet (Inventory):
  • Period costing leads to a lower Inventory value (and thus lower assets).
  • Product costing leads to a higher Inventory value (and thus higher assets).
• Profit:
  • Period costing leads to a lower profit in the period of purchase.
  • Product costing leads to a higher profit in the period of purchase, and a lower profit in the period of sale (assuming the inventory is sold in a later period).

Important Caveat: If all inventory is sold in the same accounting period, both methods will ultimately produce the same figures for profit and owner’s equity.

REMEMBER: “P-P-P” - Period Costing in Period of Purchase leads to lower Profit.

Qualitative Characteristics

Applying the correct inventory valuation method (product vs. period costing) is crucial for maintaining the qualitative characteristics of accounting information, particularly:

• Relevance: Providing information that is capable of influencing decisions.
• Faithful Representation: Providing information that is complete, neutral, and free from error.

Incorrectly classifying costs can lead to misleading financial statements, which can negatively impact decision-making.

APPLICATION: Businesses use product and period costing to accurately determine the profitability of their products and make informed pricing and production decisions.

Example:

A business purchases 100 units for \$10 each and incurs \$200 of cartage.

• Product Costing: Cartage allocated ($200/100 = \$2 per unit). Total cost per unit = \$12.
• Period Costing: Cartage expensed immediately. Cost per unit remains \$10 for inventory valuation.

If only 50 units are sold:

• Product Costing: COGS = 50 * \$12 = \$600
• Period Costing: COGS = 50 * \$10 = \$500

VCAA FOCUS: VCAA exams often include scenarios where you must determine the correct classification of costs and analyze the impact on financial statements.