Prime Costs vs Conversion Costs: What’s the Difference?

Management needs to understand its costs in order to set prices, budget for the upcoming year, and evaluate performance. Sometimes individuals become managers due to their knowledge of the production process but not necessarily the costs. Managers can view this information on the importance of identifying prime and conversion costsfrom Investopedia, a resource for managers. Managers can view this information on the importance of identifying prime and conversion costs from Investopedia, a resource for managers. Conversion costs are the sum of direct labor and manufacturing overheads. By using conversion costs, we can calculate an efficient way of determining equivalent units and unit costs.

  1. Manufacturing overhead costs are things like indirect labor, utilities, supplies, equipment, insurance, taxes, tools, and regulatory obligations.
  2. Thus, conversion costs are all manufacturing costs except for the cost of raw materials.
  3. Managers also use these costs to evaluate the efficiency of the production process and identify waste.
  4. Assume that there was no work in process inventory at the beginning and at the end of the accounting period.

The frames and lenses are direct materials and are not included in conversion costs. The $200,000 paid to production workers is direct labor, which is a conversion cost. The $50,000 paid to the production manager is manufacturing overhead, which is a conversion cost. The $200,000 cost for renting the production facility is part of manufacturing overhead costs, which are conversion costs. The $20,000 cost for utilities and insurances related to production are also manufacturing overhead, which are production costs.

The more complex and sophisticated the products become, though the higher this cost can potentially go up. The use of this ratio in process costing is to calculate the cost for both direct labor and manufacturing overheads. It’s important because it will become the cost of the inventory which will impact the selling price. The calculation for prime costs includes the amounts spent on direct materials and direct labor.

Prime Cost vs. Conversion Cost in Accounting

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. Based on the costs provided above, calculate the conversion of Company A. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole https://www.wave-accounting.net/ author of all the materials on AccountingCoach.com. They refer to the worker wage, bonus, workers’ salary, pension fund, and insurance for these workers. My Accounting Course  is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers.

Manufacturing overheads used in calculating bookkeeper360s are the overheads that cannot be attributed to the production process or a single unit in production, for example, rent or electricity. Conversion costs are the costs that are incurred by manufacturing companies when converting raw materials into finished goods. The cost of direct labor is included in both prime and conversion costs. 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. Manufacturing cost is the cost that company spends to support the production process but they cannot allocate to each product.

Prime Costs: Definition, Formula, Explanation, and Example

Direct labor and manufacturing overhead are used to test, weigh, and sound-match the drumsticks into pairs. 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.

From this, we can set our price, fill in our balance sheet, and complete our income statements. Manufacturing overhead costs are those manufacturing costs necessary to produce a product, excluding the direct labor costs. This includes indirect labor costs, which are labor costs incurred by a company for those employees who are not directly involved in producing the actual good. Examples of employees in this category are managers, nurses, security guards, janitors, cooks, maintenance workers, accountants, executives, trainers, parking attendants, and secretaries. The conversion of materials into a finished product is what we call “conversion.” It’s an important process that happens at every stage in the manufacturing cycle.

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Direct Labor Costs

Some costs, notably labor, are included in each, so adding them together would overstate manufacturing cost. Therefore, it can be seen that the main premise of calculating conversion costs is to ensure that organizations are able to estimate the amount of input (in financial terms) that is required to bring the inventory to a finished state. 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. For instance, the engine of a car and the spokes of a bicycle are considered direct material costs because they are necessary to complete the production of those items. Conversion costs are calculated in order to know the cost per unit, which assists the company in deciding a price for the product.

A company’s accounts managers and production managers calculate these conversion costs to estimate the production expenses, and the value of the finished and unfinished inventory, and make product-pricing models. 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. This information helps managers know where to focus their attention when planning, directing and controlling costs. Conversion costs only include direct labor and manufacturing overheads because of the reason that these two variables are rudimentary to execute the overall process.

Say we are looking to find Lotsa Fabrication’s conversion costs for a widget. Lotsa Fabrication incurred $30,000 during November in direct labor and related costs. If we want to know conversion costs per widget for the month, we divide $85,000 by 30,000 and get $2.83 per unit. However, a difference between prime costs and conversion costs that has not been incorporated in the analysis above is the fact that conversion costs also include indirect labor.

Conversion costs are direct labor costs combined with manufacturing overhead costs. Direct labor costs are just the costs to employ those who actually make a product. Manufacturing overhead costs are things like indirect labor, utilities, supplies, equipment, insurance, taxes, tools, and regulatory obligations. Conversion cost gets its name because the costs that make up conversion cost are all the costs incurred to convert raw material into a finished good.

It is easier to track the materials and conversion costs for one batch and have those costs follow the batch to the next process. Examples of manufacturing overhead include the utilities, indirect labor, repairs and maintenance, depreciation, etc. that is occurring within a company’s manufacturing facilities. The term conversion costs often appears in the calculation of the cost of an equivalent unit in a process costing system. TThese direct labor costs are the same ones used in calculating the prime cost in manufacturing. 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.