Are Sales Commissions Period Costs or Product Costs?

Understanding how costs are categorized is fundamental for accurate financial reporting and informed decision-making. Businesses constantly incur various expenditures, and their classification directly impacts financial statements and profitability. Properly distinguishing between different cost types is a basic accounting principle that ensures financial transparency.

Understanding Period Costs

Period costs are expenses recognized in the accounting period in which they occur. These costs are not directly tied to the production process of goods or services but are associated with overall operational activities. Common examples include administrative salaries, office rent, non-production utility expenses, and general marketing and advertising expenditures. These expenses are typically classified as selling, general, and administrative (SG&A) expenses on the income statement. They are deducted from revenues in the period they are incurred, directly influencing the net income for that specific period.

Sales commissions are explicitly classified as period costs. This is because sales commissions are incurred to generate sales, not to produce the product itself. Therefore, sales commissions are expensed in the period the sale takes place and the commission is earned, aligning with the revenue recognition principle. They do not become part of the inventory cost or inflate the value of products on the balance sheet.

Understanding Product Costs

Product costs are expenses directly linked to the creation or acquisition of goods for sale. These costs “attach” to the product and are initially treated as inventory on the balance sheet. They remain on the balance sheet until the associated product is sold.

The three main components of product costs for a manufacturing business are direct materials, direct labor, and manufacturing overhead. Direct materials are raw goods that become part of the finished product, such as wood for furniture. Direct labor includes wages and benefits paid to employees directly involved in manufacturing, like assembly line workers.

Manufacturing overhead encompasses all other indirect costs associated with the production facility. This can include indirect materials (like glues or screws), indirect labor (such as a factory supervisor’s salary), depreciation on factory equipment, and factory utilities or rent. Once the product is sold, these accumulated product costs are then transferred from inventory to the income statement as Cost of Goods Sold (COGS).

Distinguishing Between Period and Product Costs

The difference between period and product costs lies in their relationship to the production process and accounting treatment. Product costs are tied to manufacturing and capitalized as inventory until sold, becoming an expense as Cost of Goods Sold. This means product costs impact the balance sheet as an asset before affecting the income statement.

In contrast, period costs are not tied to manufacturing and are expensed immediately in the period they are incurred. They directly impact the income statement as operating expenses, such as selling, general, and administrative expenses, in the period they arise. This immediate expensing reflects their benefit is consumed within that period.

Misclassifying a cost can lead to inaccurate financial statements, distorting a company’s reported profit and the value of its inventory. For instance, if a period cost were incorrectly capitalized as a product cost, it would overstate inventory on the balance sheet and understate expenses on the income statement until the related product is sold.

Sales commissions are incurred to facilitate sales, not creation. They align with period costs because they are expensed when the sale occurs and the commission is earned. This classification ensures revenue generation costs are matched with revenue in the correct period, providing a clearer picture of selling efficiency and financial performance.