What types of costs are incurred in making and selling products and services, and how are these costs treated for financial accounting purposes? Let's start with an organization that provides services, say, a consulting firm. It will incur costs for wages for office personnel, maybe rent for the office, equipment like copy machines and computers it uses in the office, sales effort, administrative items, and salaries for consultants, managers and partners, and probably many more things. What about a merchandising company, say, a retail store that buys inventory to resell to customers? It will incur costs of the inventory it purchases for resale, but also costs for wages for store employees, rent for the store, equipment, like cash registers and computers that it uses in the store, administrative items, salaries for store managers, and so on. What about a manufacturing company, say, a t-shirt maker? It will incur costs for material to make the t-shirts and costs for wages for workers making the t-shirts, rent for the workspace, equipment it uses in making the shirts, sales efforts, administrative items, salaries for managers and others, and perhaps many more things. How are all these costs treated for financial accounting purposes? In other words, how do these costs flow through the company's financial statements that are prepared according to the appropriate accounting standards? Here, a distinction between product and period costs is important. Product costs are the costs associated with making a product, and are also called manufacturing costs. Period costs are the costs not associated with making the product, and they're called non-manufacturing costs. Recall how these flow through the financial statements for a service organization, like the consulting firm. Since the service organization is not making a product, it has no product cost and thus, essentially, no inventory. All of its costs are period costs, and they're recorded as expenses on the income statement, As they are incurred. Also recall how costs flow through the financial statements for a merchandising organization, like the retail store. The merchandising company is not making a product, but the cost of the product that it purchases to resell is included in inventory on the balance sheet when it's purchased. And it stays there until it's sold to a customer, and at that time those costs move to the income statement as cost of goods sold. Remember, though, that the merchandising organization also has other costs it incurs, like the rent on the store, the administrative costs, and so on. And those costs are period costs and recorded on the income statement as they are incurred. Now let's move to the manufacturing organization, like our t-shirt maker. The manufacturing company incurs the cost of material, labor, and other costs to make the product. Those costs are product or manufacturing costs, and they're included on the balance sheet in inventory as the product is being made. Once the product is sold to the customer, those costs move to the income statement, As cost of goods sold expense. Like servicing and merchandising companies, the manufacturing company has other costs that it incurs, but these are costs not incurred to make the product. They include things like selling and administration, and they're treated as period costs. And recorded on the income statement as expenses as they are incurred. They're not included in inventory. So in summary, service, merchandising, and manufacturing companies incur a variety of costs. Which for financial statement purposes can be thought of as product or period costs. Product costs are accumulated in inventory on the balance sheet and expensed on the income statement when the product is sold. And period costs are expensed on the income statement as incurred.
