Product and period costs are two categories of expenses incurred by companies from the point of production to selling merchandise. When differentiating between product cost vs period cost, you may wonder what the difference is. This article will explain the difference and other essential facts every business owner should know about these two categories of costs.
What Are Product Costs?
Product costs are directly involved in the production and manufacture of your company’s products. A manufacturing company’s product costs include raw materials and direct labor costs. A retailer’s product costs consist of expenses incurred in purchasing and delivering their products to their market.
Product costs are considered inventoriable costs. This is because most businesses treat them as inventory costs as they reflect the price of manufacturing or acquiring a company’s products. Below are the four types of product costs:
1. Direct Labor Costs
Direct labor costs are payments, benefits, and wages paid directly to employees and workers involved in the production process. Such workers include line workers like welders and assembly line employees.
2. Direct Raw Material payments
This is the cost you incur when purchasing the raw materials needed to create your product. For example, if you are manufacturing tables, your raw materials will be wood. The cost of securing the wood is considered a direct raw material cost.
3. Direct Supplier Costs
After purchasing your raw materials, you will also require other products such as nails, glue, and wood varnish. These are necessary items for assembling the tables. Thus, they are known as direct supplies, and the cost of purchasing them is included in the product cost.
4. Factory Overhead
Factory overhead is the cost of renting and sustaining your production facility. Most company’s production or manufacturing facilities are often placed in a different location from the establishments’ headquarters.
Factory overhead costs include administrative fees, rent, security costs, mortgage payments, and other utility bills such as electricity, water, and gas. If your company’s administrative headquarter and manufacturing facility are located in the same building, you should include the manufacturing facility’s overhead expenses in the production cost.
What Are Period Costs?
Period costs are the expenses incurred by a company that cannot be directly linked to production processes. These types of costs have no direct relation to inventory production. They are categorized into two classes; selling costs and administrative costs.
Examples of company period costs include:
- Office expenses such as cleaning, rent, and office supplies
- Insurance expenses
- Non-productive employees’ salaries
- Utility expenses like electricity and gas
- Professional consultant fees such as attorney retainers and accountancy expenses
- All expenses associated with selling your products
All period costs are incurred whether production is stopped, running at average speed, or doubled. Most of them are recurring fixed costs. However, in some cases, they are considered semi-variable costs.
Semi-variable costs may include monthly utility bills that are not directly related to the manufacture of your products.
Product vs Period Costs: The Difference
Product costs are related to the manufacture and production of your merchandise. On the other hand, period costs are overhead and indirect costs associated with running your business.
If you stopped manufacturing your products for a few months, you would not incur any production costs. However, you must pay rent, taxes, and insurance fees which are examples of period costs.
Below are other differences between product vs. period costs:
- Period costs are recorded on income statements, while production costs are recorded on a balance sheet
- Product costs include raw materials labor, factory overhead, and supplies, while period costs include sales, distribution, and administrative costs.
- Period costs are related to indirect and overhead expenses, while production costs are related to the production volumes and labor hours
- Product costs are variable and depend on the level of stock manufacture, while period costs are fixed and semi-permanent
By differentiating between the two costs, you can easily pinpoint any potential problems in the production process. Such issues may include inefficient labor, outdated methods, and inferior machinery. You can also identify issues in the administrative area, such as overspending and increased overhead costs.
How to Lower Product Costs
An operating business is considered an economic activity; thus, it runs on the maximization of revenue. There are two main ways to increase your company’s profit. The first one is increasing the price of your products and the second is reducing production costs.
Most businesses prefer reducing production costs to maximize their profits. Increasing your product prices can be pretty risky as it could lead to reduced sales. Below are effective ways of reducing product costs:
1. Start Tracking Your Numbers
Before implementing any processes to reduce your product costs, ensure you start by tracking your numbers. Ensure you start by monitoring the following expenses:
- Overtime expenses
- Cost of sold goods
- Carrying costs of your inventory
- Labor efficiency
- Actual used capacity
- Production capacity
- Direct labor costs
- Manufacturing overheads
You can use accounting and shipping management software to track your inventory. Systems such as Upstart Works shipping management software will offer your company end-to-end freight management solutions.
You can also record your numbers in an excel sheet. The main point is recording your numbers. Even simple number tracking can help you diagnose what is wrong with your production process.
2. Reduce Material costs
A large percentage of your total production costs goes to raw material expenses. Ensure you reduce your raw material costs effectively without affecting end-product quality. You can do this by negotiating for better prices and signing a long-term contract with your supplier.
You can also try outsourcing from cheaper B2B wholesalers and restructure the product. Check whether you can supplement certain raw materials with more affordable alternatives.
3. Reduce Inventory Carrying Costs
Your inventory carrying cost is your company’s expenses to store and take care of products before selling them. You can reduce the carrying costs by doing the following:
- Rent a cheaper, smaller warehouse
- Use ABC system to manage and prioritize stock
- Use Just-in-time method of distribution
- Sublet any additional space in your warehouse
The main idea is to reduce the inventory carrying costs without affecting the production schedule and sales. Using the above tips can help you reduce your inventory costs to an optimum level.
Product Cost vs Period Cost: Now You Know the Difference
Most business leaders don’t know the difference between product cost vs period cost. These two cost categories are expenses incurred when managing and running a business. These costs are incurred from manufacturing to selling your company’s products.
For more business tips, check out other articles on our site.