Product costs are the manufacturing costs that are considered to be a cost of a product. For manufacturing firms, product costs are only costs that are necessary to produce a finished product. As discussed earlier in the lecture, product costs (i.e. manufacturing costs) consist of direct materials, direct labor, and factory overhead.

Product costs are assigned to an inventory account on the balance sheet, initially. When finished goods are sold, the cost of goods sold is transferred to the balance sheet (expensed) and matched with sales revenue.  As product costs are assigned to inventory accounts, sometimes they are called inventoriable costs. 

Important to note, that product costs are not always expensed in the period they are incurred. They are rather expensed in the period when finished goods are sold: that is the cost of goods sold expense  is matched with the sales revenue. For instance, if in a company produced 50,000 units costing $10,000 in May 20X9, and in June 20X9 the company sold the aforementioned 50,000 units, the company would record the expense (i.e. cost of goods sold) of $10,000 in June 20X9, not in May 20X9.

Period costs (also called, nonmanufacturing costs) are costs necessary to maintain business operations but are not a necessary or integral part of the manufacturing process.  They are matched with the revenues of a specific time period (usually monthly) rather than included in the cost of the goods sold.

The most common example of period costs is selling and administrative expenses (S&A). S&A expenses are deducted from revenues in the period in which they are incurred. See Illustration below for examples of period costs.

Illustration 6: Examples of period costs (selling and administrative expenses)

We will review accounting for manufacturing costs later in greater detail. Accounting for nonmanufacturing costs is described here. Let’s assume that in March 20X9 Friends Corporation incurred on account $500 of marketing expense, $1,200 of sales salaries, $1,800 of office salaries, and $1,400 of office building depreciation expenses. After adding up these costs the total period cost is $ 4,900. Friends Corporation records the following journal entries for these costs:

Overall, so far we have covered different types of product (manufacturing) and period (nonmanufacturing) costs. Now, we will look in more detail how product costs are recorded by a company and flow from the beginning to the end of the manufacturing process.

Let us begin by remembering the definition of inventory for manufacturing companies:

Inventory in a manufacturing company is items purchased (or created) by a company for (a) production of other parts (raw materials or work-in-process) or (b) selling to customers (finished goods).

In our example of Friends Corporation what will be inventory? Items such as plastic parts, metal parts and paint can be examples of manufacturing inventory.

(For people with technical background, we guessed what parts go into production of a valve.  The guess may not be 100% correct; however, for the purpose of our lecture it should be fine.)

When a company manufactures a product, inventories go through the manufacturing process. The manufacturing process has different stages.  Depending on where inventory is (at what manufacturing stage) at a point in time, it can be classified as raw materials, work-in-process, or finished goods.  The below illustration shows the sequence of inventory classification at different manufacturing stages.

Illustration 7: Inventory at different manufacturing stages