Understanding Business Accounting For Dummies, 2nd Edition (91 page)

Product versus period costs

Product costs:
Costs attached to particular products. The cost is recorded in the stock asset account until the product is sold, at which time the cost goes into the cost of goods sold expense account. (See Chapters 5 and 6 for more about these accounts; also, see Chapter 13 for alternative methods for selecting which product costs are first charged to the cost of goods sold expense.) One key point to keep in mind is that product cost is deferred and not recorded to expense until the product is sold.

For example, the cost of a new Ford Mondeo sitting on a car dealer's showroom floor is a product cost. The dealer keeps the cost in the stock asset account until you buy the car, at which point the dealer charges the cost to the cost of goods sold expense.

Period costs:
Costs that are
not
attached to particular products. These costs do not spend time in the ‘waiting room' of stock. Period costs are recorded as expenses immediately; unlike product costs, period costs don't pass through the stock account first. Advertising costs, for example, are accounted for as period costs and recorded immediately in an expense account. Also, research and development costs are treated as a period cost.

Separating between product costs and period costs is particularly important for manufacturing businesses, as you find out in the following section.

Putting Together the Pieces of Product Cost for Manufacturers

Businesses that manufacture products have several additional cost problems to deal with. We use the term
manufacture
in the broadest sense: Car makers assemble cars, beer companies brew beer, oil companies refine oil, ICI makes products through chemical synthesis, and so on.
Retailers
, on the other hand, buy products in a condition ready for resale to the end consumer. For example, Levi Strauss manufactures clothing, and Selfridges is a retailer that buys from Levi Strauss and sells the clothes to the public.

The following sections describe costs that are unique to manufacturers and address the issue of determining the cost of products that are manufactured.

Minding manufacturing costs

Manufacturing costs consist of four basic types:

Raw materials:
What a manufacturer buys from other companies to use in the production of its own products. For example, The Ford Motor Company buys tyres from Goodyear (and other tyre manufacturers) that then become part of Ford's cars.

Direct labour:
The employees who work on the production line.

Variable overhead:
Indirect production costs that increase or decrease as the quantity produced increases or decreases. An example is the cost of electricity that runs the production equipment: You pay for the electricity for the whole plant, not machine by machine, so you can't attach this cost to one particular part of the process. But if you increase or decrease the use of those machines, the electricity cost increases or decreases accordingly.

Fixed overhead:
Indirect production costs that do
not
increase or decrease as the quantity produced increases or decreases. These fixed costs remain the same over a fairly broad range of production output levels (see ‘Fixed versus variable costs' earlier in this chapter). Three significant fixed manufacturing costs are:

• Salaries for certain production employees who don't work directly on the production line, such as department managers, safety inspectors, security guards, accountants, and shipping and receiving workers.

• Depreciation of production buildings, equipment, and other manufacturing fixed assets.

• Occupancy costs, such as building insurance, property rental, and heating and lighting charges.

Figure 12-2 shows a sample management profit and loss account for a manufacturer, including supplementary information about its manufacturing costs. Notice that the cost of goods sold expense depends directly on the product cost from the manufacturing cost summary that appears below the management profit and loss account. A business may manufacture 100 or 1,000 different products, or even more. To keep the example easy to follow, Figure 12-2 presents a scenario for a one-product manufacturer. The example is realistic yet avoids the clutter of too much detail. The multi-product manufacturer has some additional accounting problems, but these are too technical for a book like this. The fundamental accounting problems and methods of all manufacturers are illustrated in the example.