A note on manufactory rental expense: product cost or period cost?

A note on manufactory rental expense: product cost or period cost?

 

Rental expense paid to rent a factory is a manufacturing overhead cost; it is included in the product cost under absorption costing; is my understanding correct? This means that, in this case, a period cost is treated as a product cost; but factory rental expense is a period cost; thus it is not a product cost, under variable costing. Is it the case?

Yes—your understanding is correct, with one important qualification: whether factory rent is a product cost or a period cost depends on the costing method being used.

If the factory is used in production and the rent is fixed regardless of output, it is fixed manufacturing overhead (FMOH). Absorption costing treats it as a product cost, while variable costing treats it as a period cost.

Classification of factory rent

Factory rent is normally an indirect manufacturing cost because it supports the factory as a whole rather than being traceable economically to one particular unit of product.

It is normally also fixed manufacturing overhead, assuming total rent does not change with the level of production within the relevant range. Other typical examples are factory-building insurance, depreciation of production equipment, and production supervisor salaries.

This differs from:

• Rent for the head office: administrative period cost
• Rent for a retail shop: selling/distribution period cost
• Rent for a warehouse holding finished goods: usually a distribution or storage period cost, unless the storage is necessary during production
• Factory rent: manufacturing overhead

Treatment under each method

Costing method	Treatment of factory rent	Included in inventory?	When expensed?
Absorption costing	Fixed manufacturing overhead; product cost	Yes	When the related goods are sold, through cost of goods sold
Variable costing	Fixed manufacturing overhead; period cost	No	In full in the period incurred

Under absorption costing, all manufacturing costs—direct materials, direct labour, variable manufacturing overhead, and fixed manufacturing overhead—are assigned to units produced. Thus, a share of factory rent becomes part of the inventory cost.

Under variable costing, only variable manufacturing costs are assigned to products. Fixed manufacturing overhead, including factory rent, is charged immediately as a period expense; it never becomes part of inventory.

The conceptual refinement

Your statement that “a period cost is treated as a product cost under absorption costing” is understandable, but technically it is better phrased this way:

Factory rent is fixed manufacturing overhead. It is a product cost under absorption costing but a period cost under variable costing.

In other words, “product cost” versus “period cost” is not an inherent, permanent label for fixed factory rent in managerial accounting. Its classification changes according to the cost-accounting approach.

However, the underlying nature of the cost remains the same: it is a fixed, indirect manufacturing cost.

Short example

Assume:

• Monthly factory rent = $100,000
• Units produced in the month = 10,000 units
• Units sold in the month = 8,000 units

Under absorption costing:

Factory rent per unit=$100,00010,000=$10

$80,000, relating to the 8,000 units sold, is included in cost of goods sold.

• $20,000, relating to 2,000 unsold units, remains in closing inventory.

Under variable costing:

• The full $100,000 is expensed in the current month as fixed manufacturing overhead.
• No part of the factory rent is carried in inventory.

This is why, if production exceeds sales and inventory rises, reported profit is usually higher under absorption costing: some fixed factory overhead is deferred in unsold inventory rather than being expensed immediately. If inventory falls, the reverse effect occurs.

Bottom line

Your conclusion is right:

• Absorption costing: factory rental expense is manufacturing overhead and is included in product cost.
• Variable costing: the same fixed factory rental expense is treated as a period cost, not included in product cost.
• Non-manufacturing rent—such as office or shop rent—is a period cost under both methods because it is not incurred to manufacture the product.

** reference:  a collection of management accounting notes