A distinction is often made between product costs and period costs. Product costs are those costs incurred as result of actually producing an item, and include both direct and indirect production costs. Period costs are all other costs not included in product costs.
The distinction is important due to the different accounting treatment of each group of costs. Until an item of finished goods is sold, product costs appear as part of a company’s stock value i.e. they are a balance sheet item. In contrast, period costs are expensed in full to the profit and loss account in the period that they occur and never appear on the balance sheet.
By breaking down costs in this way, it becomes possible to identify the cause of costs within an organisation. From this it becomes possible to develop cost control and cost reduction strategies.
Marginal Costing V. Total Absorption Costing
The essential differences between Marginal Costing (MC) and Total Absorption Costing (TAC) are seen more clearly and are more relevant in a manufacturing environment, where there are differences in the accounting and management treatment of fixed costs. Under marginal costing fixed are seen and treated as period costs, whereas under TAC these are seen as treated as product costs.
Period costs are those that are ‘expensed’ (charged) to the income statement in the period in which they are incurred; product costs are those that are included in the valuation of inventories, both of these costs will affect reported profit in a period in different ways.
Reported profit will be different under both systems where there is a change in the level of inventories between the start of a reporting period and the end of that reporting period. A change in the level of inventories will occur where inventory levels are higher or lower as compared to the inventory level at the beginning of a reporting period.