Question

Do you think it makes sense to separate product costs from period costs for management purposes? What about for external reporting purposes? Why or why not? Should the costs be treated differently for management and external reporting purposes?

Answer 1

Do you think it makes sense to separate product costs from period costs for management purposes?

The distinction between product costs and period costs is important becuase of the following reasons.

• Properly measuring net income during a period of time .
• Reporting the proper cost of inventory on the balance sheet.

Product costs cling to the units of products purchased or manufactured. If a unit is unsold, the product costs will be reported as inventory, a current asset on the balance sheet. The product costs for a retailer will be the amount paid to the supplier plus any freight-in. Product costs for a manufacturer will be the direct materials, direct labor, and manufacturing overhead. Product costs will be reported on the income statement as the cost of goods sold expense in the period that the units of product are sold.

Period costs do not cling or attach to the units of product and will not be included in the cost of inventory. For example, the interest incurred by a retailer to finance its operations will be expensed in the period in which the interest occurs. Interest is not deferred by adding it to the cost of the units in inventory. Similarly, selling expenses and general administrative salaries are expensed in the period that the employees earn those salaries, the same period in which the company incurs the salaries expense. The insurance premiums that a company pays for nonmanufacturing protection will be expensed in the period in which the insurance premiums expire.

Determination of variable cost is the part of cost and management accounting which is meant for the internal purpose of the business enterprise. Financial reporting practices are mandatory under the law because of different stakeholders, particularly the investors and lenders have to take a decision on the basis of the financial position of the business as well as their financial interest in the company.

What about for external reporting purposes? Why or why not?

Reason 1; Computing variable cost under cost sheet is the part of cost accounting which is used by the management for internal decision making.

Reason 2: Variable cost is computed under cost sheets, budgeting and under various costing methods. Costing methods are never shown publically because it is not mandatory under Law.

Reason 3: Showing information about variable cost must be kept confidential because every company has their own way of dealing with cost as well as their own cost-cutting strategies which may provide them a competitive advantage in the market. Leaking such information is detrimental for the company from a competitiveness perspective.

Should the costs be treated differently for management and external reporting purposes?

Different Costing Approaches for external and mangement or internal reporting

External reporting: Absorption costing is used in preparing financial statements for external reporting purposes. US GAAP states that all product costs should be expensed as cost of goods sold and thus should be matched against revenues when products are sold. That is, product costs can be incurred in one when goods are manufactured and recognized in another period when goods are sold. On other hand, period costs such as administrative and selling SG&A expenses are recognized when incurred because these costs have no future benefits.

Internal reporting: For internal reporting purposes, however, absorption, variable, or throughput costing approaches can be used. Absorption costing can be used to save additional costs of preparing reports since absorption costing must be used for external reporting purposes in any case. For short-term planning, however, it is more appropriate to use either variable or throughput costing approach because fixed costs do not change within a relevant range as a result of short-term decisions. In addition, throughput costing reduces the incentives for management to build up inventory to inappropriate levels because this method includes only direct materials cost into the inventory cost. As direct labor and factory overhead costs are treated as period costs under the throughput costing approach, managers tend to control these costs more carefully