Prime cost and conversion cost definitions, explanations, formula, differences, examples

Therefore, the conversion cost per unit for the month was $6.80 per unit (calculated as $136,000 of total conversion costs divided by the 20,000 units produced). Prime costs are all of the costs that are directly attributed to the production of each product. Prime costs are direct costs, meaning they include the costs of direct materials and direct labor involved in manufacturing an item. During April, Company A has a total cost of $50,000 in direct labor and related expenses, as well as $86,000 in factory overhead costs.

Direct labor includes only wages paid to workers who directly contribute to the formation, assembly, or creation of the product. Direct labor would not include, for example, salaries for factory managers or fees paid to engineers or designers. These employees are involved in the creation of the product concept and the day-to-day operation of the business rather than the hands-on assembly of items for sale. However, commissions paid to salespeople who act as intermediaries between the manufacturer and the consumer are included in the prime cost equation.

Prime costs vs. conversion costs: What’s the difference?

Conversion costs are your expenses that turn raw materials into finished goods. It’s the sum of the labour (which falls into both categories, prime and conversion) and the overhead costs that go into making your products. Your labour costs are the compensation you pay the employees who make your products. Overhead costs are your expenses that don’t directly relate to any single product. Utilities or rent are overhead expenses, because they’re necessary to make your products but don’t actually contribute to the final product.

• The conversion costs can also be used as a measure of the efficiency of the production process.
• Revenues are sale proceeds obtained from the sale of the aforementioned goods or services known as the products of those businesses.
• Prime costs include the expenditure incurred on direct materials in addition to direct labor.
• The furniture maker charges $50/hour for labor, and this project takes three hours to complete.

Direct materials are the raw materials used to produce the product, while direct labor is the cost of the workers who are directly involved in the production process. In other words, prime costs are the costs of the inputs that are required to create a finished product. Prime costs and conversion costs are relied upon heavily in the manufacturing sector as a metric to determine efficiency in the production of a specific product. Prime costs are defined as the expenditures directly related to creating finished products, while conversion costs are the expenses incurred when turning raw materials into a product.

Evaluating Operations

Direct materials are one of the main components of prime costs and include raw materials and supplies that are consumed directly during the production of goods. Prime costs include the expenditure incurred on direct materials in addition to direct labor. Assume that direct materials cost $700, direct labor is $500, and factory overhead is $300 for cabinets that have been manufactured. Direct materials is the basic physical ingredient, matter or substance which the company processes to make a salable product. Plastic, rubber, steel, iron, timber and many agricultural outputs like sugarcane, sugar beets, jute and cotton etc. are examples of direct materials that are processed to produce salable finished products.

• Therefore, the conversion cost per unit for the month was $6.80 per unit (calculated as $136,000 of total conversion costs divided by the 20,000 units produced).
• During the month of April, Company A has a total cost of $50,000 in direct labor and related expenses, as well as $86,000 in factory overhead costs.
• Manufacturers can lower their prime costs to either increase profit or undercut the competition.
• It’s challenging to allocate overhead accurately, so it can potentially cloud your understanding of a product’s profitability.

Examples of direct labor workers include welders, machine operators, assemblers and painters etc. As you can see, the direct labor costs are considered to be both a prime cost and a conversion cost. Manufacturing overhead houses indirect costs, meaning they aren’t easily traceable to a final product. Businesses allocate overhead costs among their products based on the amount of indirect resources used to manufacture them. Factory rent, advertising, and supervisors’ wages are some of the most common overhead costs. Prime costs and conversion costs have direct labor cost as an overlapping item.

How to Calculate Prime Costs

Both prime costs and conversion costs are sub-categorizations of product or manufacturing costs. These cost concepts are primarily found in manufacturing entities as other entities such as trading entities and service entities do not deploy direct materials and labor to produce finished goods. To calculate the total cost of production, both prime costs and conversion costs must be added together. This total cost figure can then be used to determine the selling price of the product or service, as well as to analyze the profitability of different products or services. Businesses calculate prime costs when analyzing manufacturing expenses, efficiency, and profitability.

Any materials or labor whose direct association in the production process cannot be established must be excluded from the prime costs. For example, factory overhead and administrative costs are not part of prime costs. The manufacturing sector relies on prime costs and conversion costs to measure the efficiency in the production of a product. Manufacturing overheads under conversion costs are portions attributable to the unit production process. Examples include electricity, insurance, machine repair and maintenance, depreciation, and taxes. The conversion costs can also be used as a measure of the efficiency of the production process.

What Is Prime Cost? Definition, Formula, Calculation, and Purpose

Typically, it is equal to the sum of entity’s total direct labor cost and total manufacturing overhead cost. Prime costs ignore manufacturing cash payments or disbursements journal overhead, while conversion costs leave out direct materials. Businesses use both cost formulas to assess profitability and labor efficiency.

Direct labor comprises costs like salaries, staff insurance, and pension. To produce these bicycles, a frame is purchased https://online-accounting.net/ from a supplier costing $10. These are the materials that go directly into the production of the bicycle.

Examples of Prime Costs

As they are directly traceable, the quantum of direct materials utilized for each product manufactured can be fairly easily determined. For example, raw materials and packing materials such as leather, soles, packing boxes for a shoe manufacturer and wood for a furniture maker etc. Prime costs and conversion costs include some of the same factors of production expenses, but each provides a different perspective of production efficiency. Consider the example of a professional furniture maker who is hired to construct a coffee table for a customer. The prime costs for creating the table include both the cost of the furniture maker’s labor and the raw materials required to construct the table, including the lumber, hardware, and paint. Prime costs and conversion costs include some of the same factors of production expenses, but each provides a different perspective when it comes to production efficiency.

A company likely incurs several other expenses that would not be included in the calculation of the prime cost, such as manager salaries or expenses for additional supplies needed to keep the factory running. These other expenses are considered manufacturing overhead expenses and are included in the calculation of the conversion cost. The conversion cost takes labor and overhead expenses into account, but not the cost of materials. The calculation for prime costs includes the amount spent on both direct materials and direct labor.

Classifying Costs

The management of the business regularly check the prime costs related to production to ensure that the production process is efficient. These costs are checked against certain standards set at the start of the year. Tools such as variance analysis are used to see if any favorable or adverse variances exist against the set standards.