Introduction
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.
As we are aware of, Typically businesses exist to make profits. These profits are generated by selling goods or services in exchange for revenues. Revenues are sale proceeds obtained from the sale of the aforementioned goods or services known as the products of those businesses. After business generate revenues, all the costs related to the products that are sold are subtracted from the revenues, to determine the profit that is generated by the business. This profit is also known as the gross profit of the business. Subsequently, all other expenses are subtracted from the gross profit to calculate the net profit of the business.
To find the profits related to specific products, it is important that the costs of these products are known. Finding the cost of a product is the main focus of cost accounting, a branch of accountancy. 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.
Cost
The cost of a product is all the expenditures borne on the production of the product. These expenditures might include expenditure related to, but not limited to, raw materials, labor, supplies, equipment, etc. All these expenditures are aggregated and divided on the number of units produced to find the cost per unit of a single product. For complex production setups, other methods such as batch costing and process costing may be used to determine the cost per unit produced.
Apart from determining the cost of a product to make pricing decisions or pricing strategies or defining the cost per unit of a product, the cost of a product can be used in many different summaries. These may include being used in external reports to the stakeholders of the business, using in evaluation of performance of different departments, used as a planning and control tool, etc.
Classifying Costs
There are many different ways used to classify costs, these are as below:
By Behavior
When costs are classified by their behavior, they are grouped together based on how these costs change in relation to the level of activity of the business. These costs can be classified into fixed, variable, semi-fixed or semi-variable and stepped fixed costs. Costs classified by behavior can be used in the decision-making process of a business. This classification can also be helpful in the budgeting process of a business.
By Element
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. This information can also be used to control the cost of elements which take up a major proportion of the total cost of the product.
By Function
When costs are classified by whether they relate to the production of the product or are simply non-production expenses, it is known as classification by function. Costs are classified by functions mainly for financial reporting purposes. This classification by cost is used to categorize costs into different functions such as the cost of sales, operating expenses, etc. for financial reporting purposes.
By Nature
Cost classified by their nature are grouped together on the basis of their relationship to the production process of the business. The relationship can either be direct or indirect. Direct costs are costs that are directly related to the production such as raw material used in the production of a product. Indirect costs are those which are not directly related to the production of a product, for example, machine oil used for the machinery.
Prime Costs vs Conversion Costs
Once costs can be classified by nature, these can be used to find the prime costs and conversions costs of a product. Prime costs and conversion costs are used in production-based businesses to determine the efficiency of the process of production for different products.
Prime Costs
The prime costs consist of all the direct costs related to the production of a specific product. This includes direct materials, direct labor and direct expenses related to a specific product. Any costs that are not directly a part of the product are not a part of the prime costs of the product. These are variable costs that depend on the level of activity of a business. These costs will be high for higher number of units produced and low for a lower level of activity. The formula for calculating prime costs is as below:
Prime costs = Direct Materials + Direct Labor + Direct Expenses
For example, in the production of a watch, direct materials are all costs related to materials that go directly into the watch such as the components that go inside the watch, the exterior frame or the straps. 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 the production of the watch, such as any royalties paid for the production of the watch. Direct expenses are very rare.
Prime costs are a great tool to measure the efficiency of the production process. The management of the business regularly check the prime costs related to production to ensure that the production process is efficient. These costs are checked against certain standards set at the start of the year. Tools such as variance analysis are used to see if any favorable or adverse variances exist against the set standards.
Example
A company, ABC Co. manufactures bicycles. To produce these bicycles, a frame is purchased from a supplier costing $10. Two tires are purchased from a different supplier for $5 each. Furthermore, a seat is purchased from another supplier for $3. Paint and other smaller parts are purchased for $2. These are the materials that go directly into the production of the bicycle. Other materials are also purchased for $7 but they do not contribute directly to the production of the bicycle.
To put these parts together, a worker is paid $10 per bicycle assembled. Another worker is paid $8 per hour to paint the bikes. The worker paints 4 bicycles in one hour. Once the bicycles are assembled and painted, they are sent to the warehouse. A warehouse keeper is paid $5 per hour to ensure the bicycles are not stolen.
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. The $7 material costs that do no relate to the production of the bicycle are not considered. This makes the total direct material expense of the bicycle $25.
Similarly, the direct labor cost of a single bicycle will include $10 paid to the assembly worker, $2 ($8 per hour / 4 bicycles) paid to the worker that paints the bicycles. The compensation paid to the warehouse keeper is not considered as direct labor as it is not attributable to a single bicycle. This will make the total direct labor expense of a single bicycle $12.
Finally, the prime cost of a single bicycle can be calculated as follows:
| Direct Material | $25 |
| Direct Labor | $12 |
| Prime cost | $37 |
Conversion Costs
Conversion costs consist of all the costs related to converting raw materials to finished goods. These consist of labor costs related to the production of a specific product and any factory overheads that must be borne to convert the raw materials into finished goods. Factory overheads are costs that cannot be directly attributed to a specific product but are need to borne for the product to be manufactured. Factory overheads may include electricity expenses, fuel expenses, etc. or any expenses that must be incurred to keep the factory and its operations running. The formula to calculate conversion costs is as below:
Conversion costs = Direct Labor + Factory Overheads
The conversion costs can also be used as a measure of the efficiency of the production process. Conversion costs can also be helpful in identifying any wastages during the manufacturing process. The conversion cost of a product can be measured against a set standard or past conversion costs to identify any irregularities in the production process.
Example
A company, ABC Co., that manufactures furniture, wants to calculate the conversion cost for the production of a single chair. The company pays $5 for wood that is used in the production of a chair. Moreover, it pays $4 for the frame of a chair. The company pays a further $3 for paint and other small materials for a chair.
Once the materials are available, one worker is paid $5 to assemble a single chair while another is paid $2 to paint and polish a chair. After the chairs are assembled and painted, the chairs are sent to the warehouse. The warehouse keeper is paid $5 per hour.
The electricity expense of the factory for a month is $5,000 of which $1,000 is attributed to the chair production process. Furthermore, the rent paid on the factory is $10,000 of which $2,000 is attributable to chair production. The company produces 500 chairs in a month.
To conversion cost of the chair will neglect any costs related to the material that goes into the production of the chairs. These include the $5 for wood, $4 for the frame of the chair and $3 for paint and other small materials.
The direct labor costs are taken fully when calculating the conversion cost of a chair. The direct material cost of the chair will include $5 paid to the assembly worker and $2 paid to the paint and polish worker. The cost related to the warehouse keeper is still indirect labor and is ignored when calculating conversion costs. The direct labor cost for a single, therefore, will be $7.
Finally, the factory overheads are also considered when calculating the conversion cost of the chair. 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. These costs are converted to per unit cost. Since the company produced 500 units of chairs per month, the conversion cost per unit of a single chair will be $6.
Finally, the conversion cost of a single chair can be calculated as:
| Direct Labor | $7 |
| Factory overheads | $6 |
| Conversion Cost | $13 |
Key Differences between Prime and Conversion Costs
The key difference between prime and conversion costs is the calculation of both the costs. The prime cost of a product is calculated by adding all of its direct expenses together. This includes direct material costs of a product which are ignored when calculating the conversion cost of the product. Similarly, when calculating the conversion cost of a product, the production or factory overheads of the product are considered. These production overheads are ignored when calculating the prime cost of the product.
Prime costs and conversion costs are also different due to their presentations. Prime costs are presented in the cost sheet of a product. The cost sheet is a document that is used to calculate the cost of a product. Conversion costs, however, are not presented on the cost sheet of a product. Conversion costs are calculated separately.
The objective of calculating prime costs and conversion costs are also different. Prime costs are calculated to determine the price of a product and the proportion of direct expenses in the total cost of a product. This can be used in pricing decisions when deciding the price of a product. Conversion costs are mainly calculated to identify any inefficiencies or wastages within the production process.
Conclusion
Prime costs are the sum of all direct costs related to a single product. Conversion costs are the sum of the direct labor costs and factory overheads of a single product. Conversion costs are all the costs that are borne to convert raw material into finished goods. Both these costs can be used by the management to evaluate the efficiency of the production process in different ways. Prime costs ad conversion costs are different in their calculation, presentation and objective.
