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Period Costs in Accounting: Definition & Examples

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  • 0:03 Accounting Periods Matter
  • 1:27 What's the Problem?
  • 2:52 Examples
  • 4:07 Period Costs vs. Product Costs
  • 5:42 Lesson Summary
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Lesson Transcript
Instructor: Tiffany Crosby
In this lesson, we'll discuss the importance of accurately determining period costs. We'll also review accounting principles associated with classifying costs and examine types of period costs.

Accounting Periods Matter

Business leaders, investors, and many others examine the financial statements of businesses in order to make decisions. They determine whether to make more or less of a product, hire or layoff staff, raise or lower prices, and they use financial statements to determine if they should invest in a company. For this reason, it's very important that financial statements provide an accurate representation of the assets, liabilities, income, and expenses of a business.

Before financial statements can be prepared, an accountant has to determine the period of time covered by the financial statements. Financial statements may only provide a snapshot of the assets and liabilities as of a particular date, for example, Dec. 31. Financial statements may provide a view of the activity over a month, a quarter, or a year. Whenever a period of time is presented, there has to be a start date and an end date. This means that accountants now have to make sure that expenses are recorded in the right time period.

Take rent payments as an example.Your monthly rent is $1,300, and you're preparing an income and expense statement for the period of Jan. 1 to March 31. You would expect to have three months of expenses included. Therefore, your rent expense should be $3,900 for the quarterly statement. That seems pretty easy, and for some expenses, it is just that easy. However, for other expenses it's more complicated.

What's the Problem?

In accounting, there's the matching principle, which states that any expenses you incurred to generate income should be reported in the same period as the income. On the surface, this sounds pretty straightforward. If you spend money to buy inventory, that's an expense. When you sell that inventory, that's income. The difference between what you spent to buy the inventory and what you sold it for is the profit.

Income - Expenses = Profit

But then, there's this little wrinkle about timing. You may buy the inventory in one period (say January) and sell it in another (say June). So the expenses were incurred in the first quarter, but the sale occurred in the second quarter. If you're doing quarterly statements, how do you match the income with the expense? This is where the concept of separating costs into period costs and product costs originated.

Period costs are those costs that are not a necessary part of the process of producing a product or service to be sold. As the name implies, period costs are recorded as an expense in the income statement in the period that the cost is incurred. So, if you pay rent in June, it's recorded in the period in which June falls.

The same is not true for product costs. Recognition of product costs in the income statement is delayed until the product is actually sold.

  • Period cost = an expense now
  • Product cost = an asset now, an expense later

Examples

Look at a couple of examples of period costs in different settings:

Period costs in manufacturing would include expenses related to the sales and marketing functions (like advertising expenses and sales promotions) and corporate office expenses (like finance, accounting, human resources, and executive salaries as well as corporate office rent and utilities). Period costs would not include the cost of labor or the cost of material related to products. It also would not include any overhead expenses necessary to be able to run the factory, such as factory rent and utilities or factory administrative salaries. Instead, these production-related costs would become part of the inventory costs.

Period costs in service industries are quite different than the manufacturing industry; you're not selling a product, you're selling knowledge or an experience. The concept of period costs and product costs changes slightly. The salaries of professionals, such as business consultants, who deliver services would be a product cost instead of a period cost because they are 'producing' the service that you sell. Likewise, the cost of supplies that these professionals use as they render service may also be considered product costs instead of period costs. However, general office costs and general business costs such as rent and insurance would still be considered period costs.

Period Costs vs. Product Costs

So, given the definitions of period and product costs, how do you determine whether an expense is a period cost or a product cost?

Approach #1: Rule out Product Cost Treatment

Determine that the cost doesn't fit the criteria for product costs. In this way, you rule out product cost treatment, which leaves you with period cost treatment. In this approach, you'd work your way through a few questions:

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