Once the costs incurred during the period have been identified and accumulated, the next step of the costing process for asset valuation consists in separating costs following products in the inventory (product costs, or more precisely manufacturing costs which are “inventoriable”) and costs expended right away in the income statement (period costs which are not “inventoriable”).
Manufacturing costs are costs incurred to physically make products and which are therefore assigned to these products and follow them first in the inventory and then, when the products are sold, in the cost of goods sold.
Period costs are costs incurred for purposes other than physically making products and which therefore cannot follow them in the inventory. They are therefore expended during the accounting period.
Note that in these definitions, the phrase “physically make products” has a very restrictive meaning: it refers to manufacturing or production. All costs deemed necessary to ensure ongoing production (materials, productive labor or manufacturing overhead like maintenance of the productive equipment) are manufacturing costs. However, all costs incurred to design products or production processes (process design and re-engineering, equipment installation) are period costs, and more specifically upstream period costs. They are qualified as “upstream” because they are incurred before any production can even start.
Upstream period costs are period costs incurred to design products and production processes as well as costs of installing production equipment before production can start.
All costs incurred to advertise, sell or deliver products to the customers as well as costs incurred to administer the company are also period costs, and more specifically downstream period costs because they are incurred either after production or are independent from production.
Selling costs include all costs that are incurred to secure customer orders and get the finished product to the customer.
Administrative costs include all costs associated with the general management of an organization rather than with manufacturing or selling.
Downstream period costs or Selling, General and Administrative (SG&A) expenses are period costs incurred after or next to the production process to advertise, sell and deliver products, as well as general costs incurred to manage the company.
Note that the nature of the cost (external services, consumption of materials, wages, rent or depreciation) does not matter. Only the purpose of the cost matters in management accounting.
Moreover, only manufacturing costs are inventoriable.
Manufacturing costs follow the products for which they were incurred in the inventory, and they stay in the inventory until the product is sold or scrapped. On the contrary, period costs are expended in the period in which they are incurred, i.e. in which the resource is consumed, not bought!). This is an important distinction, because putting costs in the inventory delays their impact on operating income. In other words, when inventory increases, mis-classifying period costs as manufacturing costs temporarily improves operating income. This is one approach to earnings management, a topic we will see this in greater detail in section 242.
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