The difference between prime costs and conversion costs

These costs are useful for determining the contribution margin of a product or service, as well as for calculating the absolute minimum price at in between stimulus payments retail sales decline which a product should be sold. Samsung has a cell phone production unit with a production capacity of 10,000 daily it incurs day-to-day expenses to keep its business running. The company wants to know its conversion cost from the following mentioned information.

1. Conversion costs is a term used in cost accounting that represents the combination of direct labor costs and manufacturing overhead costs.
2. Thus, each cost concept provides a somewhat different view of the costs incurred to create products.
3. It is rudimentary to gauge the value of closing inventory since it is a line item reported on both the income statement and the company’s balance sheet.
4. Consider a professional furniture maker who is hired to make a coffee table for a customer.
5. Prime costs are reviewed by operations managers to ensure that the company is maintaining an efficient production process.

Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018. Thomas’ experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning. It is rudimentary to gauge the value of closing inventory since it is a line item reported on both the income statement and the company’s balance sheet.

Managerial accountants and production managers measure these conversion costs to estimate production expenses, develop product-pricing models, and estimate the value of finished inventory. Managers also use these costs to evaluate the efficiency of the production process and identify waste. Direct labor, as mentioned above, refers to the salaries of production workers. Factory overhead refers to costs incurred in production other than direct materials and direct labor.

Managers can view this information on the importance of identifying prime and conversion costs from Investopedia, a resource for managers. Conversion cost is the cost incurred by any manufacturing entity in converting its raw material into finished goods capable of being sold in the market. It usually includes the total value of labor cost and other applied overheads like factory overheads, administrative overheads, etc. Conversion costs are also used as a way to measure the efficiencies in the production processes but they also take into account the overheads in the production process, which are not calculated in prime costs. Examples of manufacturing overhead include the utilities, indirect labor, repairs and maintenance, depreciation, etc. that is occurring within a company’s manufacturing facilities. Direct materials are added at the beginning of shaping and packaging departments, so the work in process inventory for those departments is 100% complete with regard to materials, but it is not complete with regard to conversion costs.

Conversion costs include indirect materials, indirect labor, and other overhead costs. During the month of December, MGM Company used materials costing $360,000. Direct labor cost amounted to $200,000 and factory overhead is estimated at $250,000 based on direct labor hours.

Thus, each cost concept provides a somewhat different view of the costs incurred to create products. The difference between the two cost classifications is that prime costs only relate to direct material and direct labor costs, while conversion costs only include direct labor costs and factory overhead costs. Thus, the essential difference is that prime costs do not include the factory overhead costs that are included in conversion costs, while conversion costs do not include the direct material costs that are included in prime costs. Conversion costs can be considered to layer on top of prime costs, where they are needed to convert raw materials into finished goods. In a processing environment, there are two concepts important to determining the cost of products produced. As you have learned, equivalent units are the number of units that would have been produced if one unit was completed before starting a second unit.

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The calculation for prime costs includes the amounts spent on direct materials and direct labor. Tangible components—such as raw materials—that are needed to create a finished product are included in direct materials. Conversion costs include the direct labor and overhead expenses incurred as raw materials are transformed into finished products. Prime costs and conversion costs are relied upon heavily in the manufacturing sector to measure efficiency in the production of a product. Prime costs are expenditures directly related to creating finished products, while conversion costs are expenses incurred when turning raw materials into a product.

Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License . The OpenStax name, OpenStax logo, OpenStax book covers, OpenStax CNX name, and OpenStax CNX logo are not subject to the Creative Commons license and may not be reproduced without the prior and express written consent of Rice University.

What are conversion costs?

Prime costs and conversion costs are two methods that businesses use to measure the efficiency of their production operations. Pls noted that depreciation expenses, insurance expenses, maintnain expenses and electricity expenses are considered as manufactoruing overhead and we have to include all of these cost for our calculation with direct labor cots. TThese direct labor costs are the same ones used in calculating the prime cost in manufacturing. It is easier to track the materials and conversion costs for one batch and have those costs follow the batch to the next process. Bruce’s Bike Company is a bicycle manufacturer that specializes in high-end 10-speed bikes. Bruce is trying to figure out what his conversion costs are for the quarter in order to estimate his finished inventory for the interim financial statements.

For example, four units that are one-fourth finished would equal one equivalent unit. Conversion costs are the labor and overhead expenses that “convert” raw materials into a completed unit. Conversion costs are those production costs required to convert raw materials into completed products. These costs include direct labor and factory overhead, but not raw materials.

Conversion Cost vs Prime Cost

These costs can’t be traced back to a single unit in the production process. Some other examples of manufacturing overheads are insurance, building maintenance, machine maintenance, taxes, equipment depreciation, machining, and inspection. Therefore, once the batch of sticks gets to the second process—the packaging department—it already has costs attached to it. In other words, the packaging department receives both the drumsticks and their related costs from the shaping department. For the basic size 5A stick, the packaging department adds material at the beginning of the process. The 5A uses only packaging sleeves as its direct material, while other types may also include nylon, felt, and/or the ingredients for the proprietary handgrip.

Examples of conversion costs are production line labor, equipment maintenance, factory rent, inspection costs, and small tools charged to expense. Conversion costs is a term used in cost accounting that represents the combination of direct labor costs and manufacturing overhead costs. In other words, conversion costs are a manufacturer’s product or production costs other than the cost of a product’s direct materials. The raw materials are considered direct material costs and are not included in conversion costs. Instead, these expenses are included in another category of production costs called prime costs. The true cost a company uses in the process of turning raw materials into finished goodsincludes both overhead and direct labor.

Conversion costs are restricted to direct labor and manufacturing overhead, which are needed to convert raw materials into completed products. Prime costs are the direct labor and direct materials costs incurred to build a product. Therefore, one difference between the two concepts is that manufacturing overhead is only included in conversion costs. The other difference is that the cost of direct materials is only included in prime costs.

Operations managers use conversion costs to help identify waste within the manufacturing process. Suppose that the cost of the raw materials—lumber, hardware, and paint—totals $200. The furniture maker charges $50 per hour for labor, and the project takes three hours to complete. Conversion costs are calculated in order to know the cost per unit, which assists the company in deciding a price for the product.

Direct labor refers to the salaries and wages of workers who functional expense allocation transform the materials into finished goods. As can be seen from the list, the bulk of all conversion costs are likely to be in the manufacturing overhead classification. Some costs, notably labor, are included in each, so adding them together would overstate manufacturing cost. Prime costs are the costs directly incurred to create a product or service.