Question

Should we evaluate a production manager’s performance on the basis of operating expenses? Why?

Explain why product costs are capitalized but period costs are expenses in the accounting period. You may want to define capitalizing costs versus period costs before addressing the question.

Answer 1

Although it is a rampant practice in many organizations to evaluate a production manager's performance based on the cost budget and whether the operating expenses are in line with the budget, it is not entirely correct to do so. Operating expenses include cost of raw materials and labour. If the price of raw materials rises in the market, the operating expenses shall increase , but the manager is not at fault in such a scenario. Similarly, if the labour strikes for a higher pay, the higher rates might have to be paid out to continue production and the operating expenses shall rise.

Product costs are costs related to direct manufacturing of the product and capitalized as inventory on the face of the balance sheet. Period costs benefit only a certain period and are expenses out in the period in which they are incurred.

Product costs are capitalized as inventory as the cost of goods sold is recognized in the income statement only when the goods are sold. The cost flows from inventory to cost of goods sold when a sale is made. However, in case of a period cost, they only benefit a particular accounting period and are not associated with direct manufacture of the product. Example, rent paid for a factory for 12 months. Thus, the appropriate accounting treatment is to expense this cost out.