Product costs

Merchandising companies sell products but do not make them. Therefore, these companies will have cost of goods sold but the calculation is much easier than for a manufacturing company. Expenses for a merchandising company must be broken down into product costs (cost of goods sold) and period costs (selling and administrative).

Just like all income statements, the first line is revenue. In the case of a business that sells a product, we refer to revenue as Sales or Sales Revenue. This lets the reader know that the company generates its revenue from the sale of products rather than the delivery of services.

Cost of Goods Sold

Next, we subtract cost of goods sold. Cost of goods sold is the cost of all the products (goods) that were sold during the period. If the company uses a perpetual inventory system, cost of goods sold is being calculated every time a sale takes place.  In this case, no calculation is needed. We can simply take the amount from the cost of goods sold account on the trial balance. And you thought you could forget everything from financial accounting!

If the company uses a periodic inventory system, we must do some calculations to figure out cost o f goods sold. Under a periodic inventory system, all goods purchased as placed in the Purchases account, not the inventory account. When sales are recorded, there is no adjustment to inventory and cost of goods sold like there is in a perpetual system. Therefore, at the end of the year, we must look at how much was purchased and physically count how much inventory is left in order to manually calculate cost of goods sold.


Under a periodic system, we add beginning inventory to the cost of purchases. This gives us goods available for sale. Goods available for sale is the maximum value of goods that could be sold. If we sold every unit we had on hand and had no inventory left at the end of the year, goods available for sale would equal cost of goods sold. If there is inventory remaining, we must subtract the ending inventory from goods available for sale to calculate cost of goods sold.

To calculate cost of goods sold under a period inventory system:

Beginning Inventory
Plus: Purchases
= Goods Available for Sale
Less: Ending Inventory
= Cost of Goods Sold

Let’s look at an example to help illustrate the point.

Example #1

Kingram Pencil Pushers sells pencils to office supply stores and other retailers around the world. On January 1, the company’s inventory was $41,000. During the year, the company purchased $895,000 worth of pencils. A physical count of the inventory on December 31 revealed that there were $23,000 worth of pencils remaining. Calculate cost of goods sold for the year.

Whenever you are working on a word problem, the first thing you want to do is remove the numbers from the problem and label them. We are told that January 1 inventory is $41,000. How would you label this number? If you said beginning inventory you are correct. January 1 is the beginning of the year, hence our beginning inventory.

$41,000 beginning inventory

How would you label $895,000? Well we are told this is what the company purchased, therefore this is the amount of our purchases.

$41,000 beginning inventory
$895,000 purchases

Can you guess what the last number is? Ending inventory! If January 1 is the beginning of the year then December 31 is the end of the year.

$41,000 beginning inventory
$895,000 purchases
$23,000 ending inventory

What is the problem asking us to do with these numbers? Calculate cost of goods sold.

$41,000 beginning inventory
$895,000 purchases
$23,000 ending inventory
?????? cost of goods sold

Okay, let’s think about this logically. We need to figure out what we sold. Now we can jump to the formula or we can try to think this through without the formula. What is cost of goods sold? It’s the stuff we sold, therefore it is no longer in the building. So if we take the stuff we could have sold (goods available for sale) and subtract the stuff we have left, we can figure out what was sold.

What is the maximum amount of goods that were available for sale? Well we had some pencils, $41,000 worth of pencils actually. Then we purchased more pencils, $895,000 worth. So if we add the pencils we had, plus the pencils we bought, that tells us how many pencils we had available that could have been sold.

Goods available for sale

So we could have sold $936,000 worth of pencils but we know we had some pencils left so our cost of goods sold must be less than $936,000. Cost of goods sold CANNOT be more than goods available for sale. I can’t stress this point enough because this is where a lot of people mess up this calculation. If you keep in mind that cost of goods sold cannot be more than goods available for sale, it might save you points on your next exam.

I have $23,000 worth of pencils leftover. These pencils were not sold. So if I take the number of pencils I could have sold and subtract what I did not sell, that will tell me what I did sell.

Cost of Goods Sold

Of the $936,000 in pencils we could have sold, $913,000 were sold. That is the answer to the problem.

Putting together the income statement

It’s been a long, strange journey to get here but we are finally ready to do our income statement. Once you have cost of goods sold, the rest of the statement is fairly easy. Here is the format:

Less: Cost of Goods Sold
=Gross Profit
Less: Selling and Administrative Expenses
=Operating Income

This is called the traditional format income statement. Later on in the course, we will discuss another format for the income statement called the contribution margin income statement. This statement breaks out costs into product and period costs. Gross profit is the amount from sales that is left over after your product is paid for. This is an important figure for many companies because it lets the company know the average percentage of each sale left over to cover operating expenses and generate profit.

Let’s look at an example of a traditional format income statement for a manufacturing company:

Merch income statement

You will notice that there is less detail in this statement than there was in the service company income statement. You can add all the detail if you wish but many times that causes the statement to become a bit cluttered, especially if you are putting in a subtotal for selling expenses and another for administrative expenses. Many times selling and administrative expenses are called operating expenses. These terms are used interchangeably. Sometimes, you will just see operating expenses or selling and administrative expenses and the total without the breakdown shown above. This format is also perfectly acceptable.

Merch IS less detail

Final thoughts

When creating the income statement for a merchandising company, it is important to break costs out into product costs and period costs. If you are working with a company that uses a perpetual inventory system, cost of goods sold will already be computed for you. In a period system, you will have to do some calculations to compute cost of goods sold. Focus on what is actually happening, the business process, and the calculations are much easier. Don’t forget to calculate gross profit (sales – cost of goods sold). Operating expenses and selling and administrative expenses can be used interchangeably to refer to period costs.

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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).2014-10-30 06.41.51

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.

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Types of Businesses, Product Costs and Period Costs

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