To generate a profit, the table’s price should be set above its prime cost. 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. Manufacturing overheads include all product costs other than direct materials and direct labor. These are the expenses that must be incurred to keep manufacturing operations afloat but cannot be directly traced to a specific product or process. For example, these can include factory rent, plant insurance, indirect manufacturing materials, indirect labor involved in manufacturing process and annual depreciation charge for plant and machinery etc.

• Consider the same woodworker who constructed and sold a new hand-crafted table for $250.
• Prime costs are all of the costs that are directly attributed to the production of each product.
• Raw materials are the physical components that are converted into finished goods.
• Direct labor costs include the salaries, wages, and benefits paid to employees who work on the finished products.
• Businesses use both cost formulas to assess profitability and labor efficiency.

This article looks at meaning of and differences between two categorizations of product cots – prime cost and conversion cost. When costs are classified by element, they are classified by whether these costs are related to material, labor or other expenses. This can be an effective classification to determine the proportion of each element in the production of a product.

Manufacturing overheads:

For example, employee expenses made to machinists, foremen, and direct supervisors are common in calculating prime costs. Hence, using conversion costs is an efficient way of calculating equivalent units and per unit costs rather than separately calculating direct labor and manufacturing overheads. The primary difference between the two is that the formula for conversion costs takes overhead into account. For this reason, it’s a more relevant number for operations managers, who may be looking at ways to reduce the indirect expenses of production. Consider a professional furniture maker who is hired to make a coffee table for a customer. The prime costs for creating the table include the cost of the furniture maker’s labor and the raw materials required to construct the table, including the lumber, hardware, and paint.

• Calculating a product’s prime cost is important because it can be used to determine a product’s minimum sales price.
• To find the profits related to specific products, it is important that the costs of these products are known.
• 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.
• Similarly, when calculating the conversion cost of a product, the production or factory overheads of the product are considered.
• Unlike prime costs, conversion costs are somewhat avoidable because they aren’t related to your actual inventory.

The manufacturing sector relies on prime costs and conversion costs to measure the efficiency in the production of a product. 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. 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.

Classifying Costs

It also important to determine the cost of a product to make decisions about the price of the product. There are many different methods of determining the cost of a product, such as marginal costing, absorption costing, activity-based costing, target costing, etc. In this article, we will cover the prime and conversion costs of a business. This includes the key definitions, examples and key differences between the tow costs. First, let’s understand some overview of the basic costs structures as below. Allocation of overhead costs ensures proper monitoring and cost planning.

Use of Conversion Costs

The total conversion cost for the chair production process is $3,000 which includes $1,000 electricity expense and $2,000 rent expense attributed to the chair production. Since the company produced 500 units of chairs per month, the conversion cost per unit of a single chair will be $6. To calculate the prime cost of a bicycle, all its direct material and direct labor expenses must be aggregated. The total direct materials cost for a single bicycle will include $10 for the bicycle frame, $10 ($5 x 2) for the tires, $3 for the seat and $2 for the paint and other small items.

Conversion costs comprise all expenses of turning raw materials into the desired product. Like prime costs, conversion costs are used to gauge the efficiency of a production process, but conversion cost also takes into account overhead expenses that are left out of prime cost calculations. Conversion cost, as the name implies, is the total cost that a manufacturing entity incurs to transform or convert its direct materials into salable or finished product. Typically, it is equal to the sum of entity’s total direct labor cost and total manufacturing overhead cost. These other expenses are considered manufacturing overhead expenses and are included in the calculation of the conversion cost.

Examples of prime cost and conversion cost

Direct labor costs include the wages and other benefit costs of all personnel who work directly in the production process and whose efforts can be directly traced to the products manufactured. For example, wages and other costs related to machine operators, assembly line workers and packers etc. These prime costs are the essential expenses required to make your products.

Formula for Calculating Prime Costs

The $7 material costs that do no relate to the production of the bicycle are not considered. Calculating Conversion Cost involves adding up the direct labor costs and manufacturing overhead costs. For example, if a company incurs $10,000 in direct labor costs and $5,000 in manufacturing overhead costs during a specific period, the Conversion Cost would be $15,000. On the other hand, calculating Prime Cost involves adding up the cost of raw materials and direct labor. For instance, if a company spends $8,000 on raw materials and $12,000 on direct labor during a specific period, the Prime Cost would be $20,000. Prime costs and conversion costs are relied upon heavily in the manufacturing sector to measure efficiency in the production of a product.

Direct labor costs include the salaries, wages, and benefits paid to employees who work on the finished products. Direct labor includes costs such as salaries or wages of the employees that are involved in the production process. The direct expenses are expenses that are directly related to grants management process the production of the watch, such as any royalties paid for the production of the watch. The objective of calculating conversion cost is to depict or measure the efficiencies in production processes while taking into account overhead costs which are excluded from prime cost calculations.