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 include some of the same factors of production expenses, but each provides a different perspective into production efficiency.
The calculation for prime costs includes the total amount spent on direct materials in addition to direct labor. Tangible components, such as raw materials, necessary to create a finished product are included in direct materials. For instance, the engine of a car or the spokes of a bicycle are included in direct material costs because they are each necessary to complete production of that specific item. Direct labor costs include the salary, wages or benefits paid to an employee who works on the completion of 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 produce an acceptable amount of profit.
Example of How Prime Costs Work
Consider a professional furniture maker who is hired to construct a coffee table for a customer. The prime costs for creating the table include direct labor and raw materials, such as lumber, hardware, and paint. The materials directly contributing to the table's production cost $200. The furniture maker charges $50/hour for labor, and this project takes three hours to complete. The prime cost to produce the table is $350 ($200 for the raw materials + $150 in direct labor). To generate a profit, the table's price should be set above its prime cost.
Conversion costs include direct labor and overhead expenses incurred due to 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
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. Company A produced 20,000 units during April. 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).