When preparing financial statements, companies need to classify costs as either product costs or period costs.  We need to first revisit the concept of the matching principle from financial accounting.

As a general rule, costs are recognized as expenses on the income statement in the period that the benefit was derived from the cost.  So if you pay for two years of liability insurance, it wouldn’t be good to claim all of that expense in the period the bill was paid. Since the expense covers a two year period, it should be recognized over both years. This is an example of the accrual basis of recording costs.

The matching principle operates on the accrual basis of accounting and states: Costs incurred to generate a particular revenue, should be recognized as expense in the same period that the revenue is recognized. If a cost is incurred to acquire or produce a product that will ultimately be sold, then the cost should be recorded as an expense when the sale takes place because that is when the benefit occurs. These costs are called product costs.

Product Costs

Product Costs include any cost of acquiring or producing a product. If you manufacture a product, these costs would include direct materials and labor along with manufacturing overhead. Most of the components of a manufactured item will be raw materials that, when received, are recorded as inventory on the balance sheet. Only when they are used to produce and sell goods are they moved to cost of goods sold, which is located on the income statement. When the raw materials are brought in they will sit on the balance sheet. When the product is manufactured and then sold a corresponding amount from the inventory account will be moved to the income statement. So if you sell a widget for $20 that had $10 worth of raw materials, you would record the sale as a credit (increasing) to sales and a debit (increasing) either cash or accounts receivable. The  $10 direct materials would be a debit to cost of goods sold (increasing) and a credit to inventory (decreasing).

Period Costs

Period costs include any costs not related to the manufacture or acquisition of your product. Sales commissions, administrative costs, advertising and rent of office space are all period costs. These costs are not included as part of the cost of either purchased or manufactured goods, but are recorded as expenses on the income statement in the period they are incurred. Remember, when expenses incurred may not be when cash changes hands. If advertising happens in June, you will receive an invoice, and record the expense in June, even if you have terms that allow you to actually pay the expense in July. Remember back to our insurance situation in the first paragraph. The cash may actually be spent on an item that will be incurred later, like insurance. It is important to understand through the accrual method of accounting, that expenses and income should be recognized when incurred, not necessarily when they are paid or cash received.