Cost accounting addresses how we account for costs and when and where we report them (on the balance sheet or the income statement). After understanding cost accounting, we need to answer why it matters.

It’s vital to accurately track a company’s costs because it’s not just about how much revenue a company generates throughout the year, it’s about how much income is kept (i.e., net income). Cost accounting helps us determine our costs, which then helps us figure out our net income.

Product Costs – Cost Accounting

To delve into the specifics of the types of product costs, let’s consider an example of a laptop manufacturer, Platinum Tech.

Within cost accounting, we have product costs, which are divided into three categories. First, there are direct materials. For instance, when manufacturing laptops, these would be components like glass and aluminum. Then we have direct labor, which would be the actual cost of the labor involved in building those laptops. These first items, direct labor, and direct materials, can be directly traced to the product.

The third product cost, known as manufacturing overhead, is indirectly traced to the product. Manufacturing overhead includes all other costs associated with creating the product that cannot be directly traced to it. For example, rent expenses for the manufacturing facility, utilities expenses for lighting, and the salary of the floor manager. These are costs that are hard to directly trace to the individual product. In summary, these three costs, direct materials, direct labor, and manufacturing overhead, are known as product costs. Product costs are the costs associated with creating a product.

Study Tip 😀

Product costs include direct materials, direct labor, and manufacturing overhead.

Product Costs Example – Platinum Tech

Let’s suppose that it’s Platinum Tech’s first year in business. The company spends $1 million building 1,000 laptops, which amounts to $1,000 per laptop. This expenditure includes direct labor, direct materials, and manufacturing overhead. Since it is the first year of business, sales were relatively low. Instead of selling a large number of laptops, the company only sold 200 laptops at $2,000 each, resulting in a revenue of $400,000. The company spent $1 million, but its revenue was only $400,000.

Does the fact that it spent $1 million imply that it has $1 million in expenses? No, it does not. You only record the expenses of the laptops that you have sold.

Study Tip 😀

We expense product costs when we sell the products, not when we manufacture them.

Since the company sold 200 laptops, it will only record the expenses associated with those 200 laptops. Given that each laptop costs $1,000 and 200 were sold, the expenses total to $200,000. The revenue of $400,000 and expenses of $200,000 result in a net income of $200,000.

If we expensed $200,000 but spent $1,000,000 what happens to the remaining $800,000? Let’s look at the journal entry for the year:

	Debit	Credit
Cost of Goods Sold	$200,000
Inventory	$800,000
Cash		$1,000,000

Period Costs – Cost Accounting

We’ve addressed the first kind of costs, which are product costs. Now let’s explore the second type, period costs.

Period costs are not associated with making a product. For instance, consider the salary of a marketing manager. The market manager aids the company in selling more products, but they are not involved in product creation, making their salary a period cost. Similarly, an accountant’s salary would be a period cost because they’re not assisting in manufacturing the product.

It’s crucial to note that period costs are expensed as incurred. Unlike product costs, you don’t have to wait until you sell items to expense period costs.

Study Tip 😀

We expense period costs right away.

Period Costs Example – Platinum Tech

Using the Platinum Tech example, if the company hired a marketing manager for $50,000 since this is a period cost, it would be expensed for the year in its entirety.

Thus, you would have revenue of $400,000, a period cost of $50,000, and product costs of $200,000. As a result, the net income would be $150,000.

Differentiating between product and period costs is important not only when we expense them but also for where we display them on the income statement.

A typical income statement appears as follows:

Revenue -COGS = Gross Profit -General and Administrative Expenses = Net Income

Product costs are recorded as COGS and influence gross profit, while period costs are recorded under general and administrative expenses and affect net income.

Study Tip 😀

Product costs are recorded as COGS, while period costs are recorded under general and administrative expenses.

From our example, the income statement would appear as follows:

Revenue $400,000

-COGS ($200,000)

= Gross Profit $200,000

-General and Administrative Expenses ($50,000)

= Net Income $150,000

Prime Costs and Conversion Costs

In cost accounting, it’s also crucial to understand two other terms: prime costs and conversion costs. Prime costs are the sum of direct materials and direct labor. Conversion costs consist of direct labor and manufacturing overhead. Although both involve labor, these two terms offer distinct ways of measuring the costs going into a product.

Study Tip 😀

Prime Costs = Direct Materials + Direct Labor

Conversion Costs = Direct Labor + Manufacturing Overhead

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