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

Prime Costs vs. Conversion Costs: An Overview

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.

Prime costs and conversion costs include some of the same factors of production expenses, but each provides a different perspective when it comes to evaluating production efficiency.

Prime Costs

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.

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.

Direct labor costs include the salaries, wages, and benefits paid to employees who work on the finished products. Compensation paid to machinists, painters, or welders is common in calculating prime costs.

Omit ‘Indirect’ Costs

Prime costs do not include any indirect costs.

Prime costs are reviewed by operations managers to ensure that the company is maintaining an efficient production process.

Calculating prime costs also helps organizations set prices at a level that produces an acceptable profit.

Example of How Prime Costs Work

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.

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.

The prime cost to produce the table is $350 ($200 for the raw materials + (50 x 3 hours of labor = $150 in direct labor).

To generate a profit, the table’s price must be set above its prime cost. The furniture maker, to be profitable, must charge at least $351.

Conversion Costs

Conversion costs include the direct labor and overhead expenses incurred as raw materials are transformed into finished products.

Overhead costs are expenses that cannot be directly attributed to the production process but are necessary for operations, such as the electricity required to keep a manufacturing plant functioning throughout the day.

Direct labor costs are the same as those used in prime cost calculations.

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.

Operations managers use conversion costs to help identify waste within the manufacturing process.

Example of How Conversion Costs Work

Consider the example of Company A: The company has a total cost of $50,000 in direct labor and related expenses, in addition to $86,000 in factory overhead costs, during the month of April.

Suppose that Company A produces 20,000 units during the month of April. Thus, the company’s conversion costs per unit for the month of April are $6.80 per unit ($136,000 of total conversion costs / by 20,000 units produced = $6.80).

The Bottom Line

Prime costs and conversion costs are two methods that businesses use to measure the efficiency of their production operations.

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.