Why is it Wise to Separate Product Costs from Period Costs
Perhaps the wise question here is, what the heck are product costs and what are period costs? Well… this article is not intended to be like a text book, so let’s cover product and period costs very briefly. A product cost is all the material, overhead, and labor that is put into a company’s product or service. For the sake of this article, we are going to consider product inventory or a service rendered as a product. Product costs typically include direct materials, Direct Labor, and Overhead which includes indirect labor and indirect materials. Period costs are the selling, general, and administrative costs, sometimes seen as SG&A. Alright… onto the juicy stuff!
Let’s Get to the Point
So now to answer the question, why is it wise to separate product costs from period costs? For those who are just starting a business, he or she may not have the slightest idea what this article is even talking about. For those who are an experienced business person, he or she already knows the answer to the question from trial and error or because he or she is educated in the subject.
Let’s answer the question with a scenario for those who are just starting a business, or those who can better their accounting and managerial practices. Imagine having this totally amazing new product that is “off the hook, in your face, bad @#s,” and it is bound to make millions of dollars the first year it’s available. If managers don’t track the costs of producing this product, how would they ever figure out ways to reduce costs when the company needs cash to expand and accommodate new expenses, more expenses, more costs, and just all around more of everything? If those costs are never reduced to allow for future costs, imagine what an investing bank will think when looking at high costs on a balance sheet and income statement. Imagine trying to figure out if different variations of a product are profitable if all the costs are jumbled together with all types of expenses and costs.
The point is that separating product costs from period costs allows for better managerial decisions for both future routine operations and future non-routine operations.
Separating Costs and Small Business
Too many small businesses jumble all their costs and expenses, which by the way a cost is not the same as an expense, and make decision making very difficult for future business operations. Even if the business isn’t out to take over the world by striving to be the next Wal-Mart or the next Google, accounting for product costs separately from period costs is essential for good managerial decisions.
Some might believe that a business needs a fancy ERP system from Oracle with a price tag in the millions. Those who are familiar with YouTube know how easy it is to discover the potential of Microsoft Excel. MS Excel is more than enough to separate product costs and period costs for any small business. It wouldn’t work on a large scale due to several factors like security, but it is an incredible tool for accounting and recording essential managerial information necessary for decisions. YouTube has more videos than anyone is willing to watch on how to format an MS Excel spreadsheet as a general ledger, subsidiary ledger, product costs table, period costs table, and even inventory management or fleet management.
Cost Management and Service Companies
Service companies, companies that provide a service, can greatly benefit from cost management, also known as cost accounting or managerial accounting. In recent years, companies of all types are realizing that cost management is beneficial to all types of businesses, not just manufacturing. It can even be applied to a small business like a sole proprietorship or a one man/ woman company. It is an excellent way to distinguish between expenses and costs. In this article, it was mentioned that expenses are not the same as costs. An expense is out going money or value that is no longer going to be beneficial in future decision making or no longer adds value to the company once it is expensed. A cost is out going money that adds value and affects future decision making. Actually, a cost decision isn’t always dealing with outbound money. It can deal with opportunity cost, which may or may not have a cash value at the moment. Service companies can greatly benefit by looking into opportunity costs associated with services, branches, equipment, or more efficient procedures.
So after reading this article there is no excuse for not separating product costs from period costs. Ok… but seriously, all that boring stuff in cost management text books is actually good juicy stuff. Is it easy? To put it bluntly… HELL NO!!! Cost management is no easy concept to understand, but once understood, one will see how people already use several cost management principles in everyday life. If your business is struggling with managing costs, take a cost management course. Several text books on cost management are available on Amazon.com for just a few dollars. It’s not a bad idea to get somewhat familiar with cost accounting.
Wishing you much success,
Sergio with the iBrand Your Business Team