direct material DM direct labor DL and manufacturing overhea

direct material (DM), direct labor (DL) and manufacturing overhead (MOH) are considered components of product cost that eventually become part of inventory cost. Selling and administrative expenses are typically considered period costs that should be charged to expenses in the period in which those are incurred.

Now, what happens if a period cost is incorrectly classified as a product cost, and vice versa? What is affected, and how does that matter? [think about where these costs eventually end up and you will know the answer.]

Solution

If Period Costs are incorrectly classified as product cost:

Let us assume :

Direct material cost per unit=$5

Direct labor cost per unit=$5

Manufacturing overhead per unit =$10

Total Product cost per unit=(5+5+10)=$20

Units produced=100

Total manufacturing expenses=20*100=$2000

Units sold=50

Selling & administrative expenses=$800

Unit Price=$40

Sales=$2000(50*40)

Cost of goods sold=$1000(20*50)

Period cost=$800

Profit=$200(2000-1000-800)

Per unit profit=(200/50)=$4

Finished goods=2000-1000=$1000

If the period cost is classified as product cost,

Unit product cost will increase by (800/100)=$8

Total product cost=$2000+$800=$2800

Unit product cost=20+8=$28

Cost of goods sold=50*28=$1400

Period cost=Nil

Sales=$2000

Profit=(2000-1400)=$600

Per unit profit=600/50=$12

Finished goods=50*28=$1400

Period cost is absorbed in the product cost. Profit and ending finished goods inventory increases.

If Product Costs are incorrectly classified as period cost:

Assume , in the above example Manufacturing overhead of $1000(100*10) is classified as period cost.

Product cost per unit=(20-10)=$10

Total product cost=100*10=$1000

Total period cost=1000+800=$1800

Finished goods inventory=50*10=$500

Sales=50*40=$2000

Product cost=(50*10)=$500

Profit=(2000-500-1800)=(-)300

Finished goods inventory decreases and profit decreases

Conclusion:

.A. If Period Costs are incorrectly classified as product cost, Profit and ending finished goods inventory increases.

.B. If Product Costs are incorrectly classified as period cost, Finished goods inventory decreases and profit decreases