Most companies use products as the main basis for their cost objects.

Looking at the cost of products is

extremely important to pricing of those products. As we classify costs, one of the most useful
classifications is product and period costs. All costs can be classified as product or period costs. These
costs can also be broken down further. Let’s look at which costs are considered product costs and which
are period costs and what defines each of these costs.

Product Costs

Product costs include all the direct and indirect costs of producing a product. Let’s look at a travel coffee
mug (this is actually my travel mug which I bring to work each morning).

What do we need to make a travel mug? Well this one is plastic so we would need plastic.

We would also need people to operate the machines that mold the plastic. What other people would we
need?

 Supervisors
 Janitors
 Mechanics to keep the machinery working
 Plant managers to plan and make decisions
 Receptionists to answer the phones
 People to order materials

It takes a lot of people to run a plant. This is by no means a comprehensive list.

What else do we need?

Well we need the machinery to mold the plastic, a building to house the machinery, utilities to make the
machinery work, computers for the supervisors, managers, receptionists, purchasers and others within
the organization. We might have uniforms and protective gear for the employees. We must pay
property taxes on the building and equipment. There are a lot of costs that go into making a product.

Now that we have all of these product costs, we need to classify them further. Product, or
manufacturing costs, can be classified into direct materials (DM), direct labor (DL), and manufacturing
overhead (MOH).

Direct materials

We said in the previous post that direct costs are those that are easy to trace to a cost object. In this
case, our cost object is the product. Therefore, direct materials are the materials that are easy to trace
to the product. In the case of our travel mug, the direct material would be plastic. It is easy for the
company to measure how much plastic goes into the production of each travel mug and therefore we
can easily calculate the cost of plastic in this mug.

Direct labor

Direct labor is also called “touch labor”. This is the cost of the people who make your product. In the
case of the travel mugs, these are the people who run the machines that mold the plastic. These are also
the people who put the various pieces together by hand. Most people think of direct labor as assembly
line workers.

This is a direct cost because it is easy to measure how many travel mugs a worker can make in an hour
and therefore determine the direct labor cost per mug. If a worker can make 40 mugs per hour and the
worker makes $20 per hour in wages and benefits we can divide the cost per hour by the number of
mugs to get the cost per mug.

DL cost per mug = $20 per hour / 40 mugs per hour

DL cost per mug = $ 0.50 per mug

The cost of direct labor is $ 0.50 per mug. Remember that a direct cost must be easy to trace.

What about the rest of the workers that were mentioned in our list above? Are they considered direct
labor also? To answer that question, you must consider if the cost of their labor is easy to trace to the
product. If a janitor is working to clean up a plant that makes four different products, how can we trace
his hourly wage back to each of the products? We can’t. Just like the other employees in the list above, a
janitor’s wages are hard to trace to the product and therefore, are not considered part of direct labor.

Manufacturing overhead – The best way to describe manufacturing overhead is to say that it is all the
other indirect product costs need to make the product. Manufacturing overhead is all the other stuff
that does not fit into the direct materials classification or the direct labor classification but is still a
product cost. That includes indirect materials and indirect labor.

Indirect materials are the materials that are too hard to trace to the product to be direct materials. This
includes things like glue, solder (a low-melting alloy used to join metals together), and nails.
Indirect labor includes all the other wages and salaries paid to people who work in the production of the
product but who are not touch or direct labor. This is where the cost of supervisors, janitors, plant
managers, machine repair technicians, materials ordering personnel, and receptionists for the plant
would be placed. They contribute to the production process but are not actually making the product.

Costs associated with running the plant are also considered manufacturing overhead costs. These costs
include depreciation on machinery and the building, utilities, property taxes, insurance on the building,
and repairs and maintenance on the building and machinery.

When classifying costs as product costs, ask yourself if this cost is need to make the product. If it is, then
it is a product cost. Next as yourself if the cost is a direct material or direct labor cost. If the answer is
no, then the cost is part of manufacturing overhead.

Product costs are also called inventoriable costs because these are the only costs that can be included in
inventory on the balance sheet. When the products are sold, these costs are expensed as cost of goods
sold.

Period Costs

Period costs are all the costs that a company incurs that are not period costs. These costs are called
period costs because they are expensed in the period in which they are incurred. Period costs are
sometimes called operating expenses. Periods costs are divided into two categories: selling costs and
administrative costs.

Selling costs

Selling costs are all of the costs associated with selling your products. This includes the cost of sales
people, sales commissions, marketing, advertising, and distribution of your product. If you have retail
locations, the costs of those locations are selling costs. If you have a website that you use to sell your
product, that is a selling cost. The cost of the people who run your social media accounts is a selling cost.

You might be wondering why distribution is a selling cost. Many students believe that the cost to ship
the product to the end user should be a product cost. However, think back to our discussion of finished
goods inventory. We stated that once a product has gone through the production process and is
considered finished, no more product related costs can be added. We now know that those product
costs are direct materials, direct labor and overhead. Therefore, once a product has been produced, we
cannot add more cost. Distribution happens after the product is manufactured, so it cannot be a product
cost. It is considered a selling cost because I cannot complete the sale of the product if I cannot get it to
the customer. No distribution equals no sale. That’s why it is considered a selling cost.

Administrative costs

Administrative costs are all the costs associated with the general operations of the company. This would
include the costs of executive salaries and offices, the human resource department, research and
development of new products, and costs related to maintaining a company headquarters.
Why is research and development an administrative cost? Product costs relate the costs associated with
making our current products. Research and development deals with creating new products or improving
products, not with the production of current products. Therefore, R & D is not a product cost. What
about a selling cost? Well, does R & D help us sell our existing products? It could actually be argued that
if R & D information was leaked, it might actually hurt the sales of our existing products because
customers might wait to get the new model. The only category that is left is administrative costs. That is
why R & D is considered an administrative cost.

Classifying costs

When attempting to classify costs, first ask yourself if the cost is part of the manufacturing process. Look
for key terms like “plant” or “factory”. These will help to indicate that the cost is associated with making
the product. If it is, then the cost is a product cost. If it is not, then it is a period cost.

If it is a product cost, determine if the cost is a direct material or direct (touch) labor. If it is neither of
these, it should be classified as manufacturing overhead.

If it is a period cost, determine if the cost is related to selling the product or the general administration
of the company. Look for terms like marketing or selling. These terms indicate selling costs. Terms like
administrative indicate that the cost is an administrative cost.

Knowing the terminology and reading carefully will make it much easier to classify costs.