Prime Costs vs. Conversion Costs: An Overview
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.
- 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.
- Prime costs include direct material and direct labor costs.
- Conversion costs include direct labor and overhead expenses.
- Both are a metric used to determine the efficiency of production.
The calculation for prime costs includes the amount spent on both direct materials and direct labor. Tangible components—such as raw materials—necessary to create a finished product are included as a part of direct materials. For instance, the engine of a car and the spokes of a bicycle are included in direct material costs because they are each necessary to complete the production of that specific item.
Direct labor costs include the salary, wages, or benefits paid to an employee who works on the completion of all finished products. Compensation paid to machinists, painters, or welders is common in calculating prime costs. Unlike conversion costs, prime costs do not include any indirect costs.
Prime costs are reviewed by operations managers to ensure the company has an efficient production process. The calculation of prime costs also helps organizations set prices at a level that produces an acceptable amount of profit.
Example of How Prime Costs Work
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.
Suppose that the cost of the raw materials—lumber, hardware, and paint—cost $200. The furniture maker charges $50/hour for labor, and this project takes them three hours to complete. The prime cost to produce the table is $350 ($200 for the raw materials + (50 x 3 hours of labor = $150 in direct labor). To generate a profit, the table's price should be set above its prime cost. In order for the furniture maker to be profitable, they must charge at least $151.
The manufacturing sector relies on prime costs and conversion costs to measure the efficiency in the production of a product.
Conversion costs include direct labor and overhead expenses incurred as a result of the transformation of raw materials into finished products. Overhead costs are defined as the expenses that cannot be directly attributed to the production process but are necessary for operations, such as electricity or other utilities required to keep a manufacturing plant functioning throughout the day. Direct labor costs are the same as those used in prime cost calculations.
Conversion costs are also used as a measure to gauge the efficiencies in production processes but take into account the overhead expenses left out of prime cost calculations. Operations managers also use conversion costs to determine where there may be waste within the manufacturing process.
Example of How Conversion Costs Work
Consider the example of Company A: The company has a total cost of $50,000 in direct labor and related expenses, in addition to $86,000 in factory overhead costs, during the month of April. Suppose that Company A produces 20,000 units during the month of April. Thus, the company's conversion costs per unit for the month of April are $6.80 per unit ($136,000 of total conversion costs / by 20,000 units produced = $6.80).
Prime Costs vs. Conversion Costs FAQs
Which Costs Are Part of Both Prime and Conversion Costs?
The cost of direct labor is included in both prime and conversion costs. The calculation for prime costs includes direct labor, plus the amount spent on direct materials. The calculation for conversion costs also includes direct labor (in addition to overhead expenses incurred as a result of the transformation of raw materials into finished products).
How Do You Calculate Overhead Cost Using Prime Costs, Conversion Costs, and Direct Materials?
Overhead costs are what it costs for a business to simply stay running—in other words, overhead costs refer to the costs of day-to-day business operations. Overhead costs include:
- Rent and utilities
- Repairs and maintenance
- Office space and office equipment
- Certain taxes
- Management salaries
Overhead costs are business costs that are relatively fixed. For this reason, they are sometimes referred to as fixed costs. Overheads costs are included in the calculation of a business's conversion costs, specifically as those overhead costs are necessary to the transformation of raw materials into finished products.
How Do You Calculate Conversion Cost?
This is the formula for conversion costs:
Conversion costs = direct labor + manufacturing overhead costs.
How Do You Calculate Prime Cost?
This is the formula for prime costs:
Prime costs = raw materials + direct labor.
Is Direct Labor Considered Both a Prime and a Conversion Cost?
Direct labor is considered part of both prime costs and conversion costs. Prime costs are the combination of the two direct product costs: direct materials costs and direct labor costs. Conversion costs include the manufacturing costs that are needed to convert direct materials into final products: direct labor costs and manufacturing overhead costs.