Nonmanufacturing overhead costs are the business expenses that are outside of a company's manufacturing operations. These are often referred to as the selling, general and administrative (SG&A) expenses plus the company's interest expense. Examples of the nonmanufacturing overhead costs include the salaries and other expenses for the following business activities: selling, distribution, marketing, finance, IT, human resources, legal, and so on. (We have additional examples within our AccountingCoach.com topic Nonmanufacturing Overhead.)
Since these costs are outside of the manufacturing function, they are not considered to be costs of the products. As a result, the nonmanufacturing costs are not allocated to the products for determining the costs for inventory or for the cost of goods sold. Instead, the nonmanufacturing costs are immediately expensed in the accounting period in which they are incurred. That is why accountants say that the nonmanufacturing costs are period costs or period expenses. (Only the manufacturing costs of direct materials, direct labor and manufacturing overhead are product costs.)
While the nonmanufacturing overhead costs are not allocated to the products, the company must have its selling prices and sales revenues sufficient to cover both the product costs and the period expenses in order to avoid a negative net income.
A manufacturer's selling prices should not be based on costs alone. One reason is that the actual cost of each product is not known with precision. At best, each product's cost is an average that resulted from allocations of the indirect manufacturing costs. In addition, there are selling, general and administrative expenses that are even more difficult to associate with individual products.
A more compelling reason that selling prices should not be based solely on costs is the market for a product. If a product is unique, protected by a patent and trademark, and the demand for the product is high, customers may accept a selling price that is unusually high. In other words, the value of the product is much greater than the costs identified with the product plus a normal profit or markup.
At other times the market will include competitors offering a similar product at lower selling prices because of efficiencies, lower costs, or inaccurate cost calculations. Perhaps another competitor will sell a similar product at a lower selling price in hopes of attracting customers who will buy additional, more profitable products. These situations will likely prevent the manufacturer from achieving significant sales at selling prices that are based on costs plus a desired profit.
Given the complexity of a manufacturer's operations and the competition in the market place, it is rare for a manufacturer to have selling prices based on its true costs plus a uniform rate of profit.
The distinction between product costs and period costs is important for 1) properly measuring net income during a period of time and 2) 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. (Insurance premiums for the factory building will be included in the manufacturing overhead which will be part of the products' cost.)