Prime Costs and Conversion Costs

Prime costs are all the direct costs of a product i.e. those costs that can be traced conveniently to each unit. These include direct materials cost and direct labor cost. On the other hand, conversion costs are all manufacturing costs other than direct materials cost. These include direct labor costs and manufacturing overhead costs.

Direct material and direct labor costs are prime cost because they are the main incremental costs of a product. The greater the proportion of prime costs in total costs of a product, the more reliable is the cost estimate of the product. Conversion costs are the costs that are incurred in converting direct raw material into finished goods and hence the name.

Prime costs and conversion costs have direct labor cost as an overlapping item.

Formula

Prime costs and conversion costs can be calculated using the following equations:

Prime costs = direct materials cost + direct labor cost

Conversion costs = direct labor cost + manufacturing overhead costs

Manufacturing overhead costs are all indirect manufacturing costs.

Example

Elite Furniture is a small furniture manufacturer. In the first week of December, they worked exclusively on an order to build 5 conference tables. Costs incurred are as follows:

Opening stock of timber$50
Timber purchased during the week2,000
Closing stock of timber250
Glass purchased for table tops500
Labor hours worked100
Wages per hour40
Design engineer salary allocated to the job2,500
Indirect materials and utilities cost allocated to the job3,000

Solution

Timber consumed = opening stock + purchases − closing stock = $50 + $2,000 − $250 = $1,800

Other direct materials used (glass) = $500

Total direct materials cost = $1,800 + $500 = $2,300

Direct manufacturing labor cost = hours worked × hourly wage = 100 * $40 = $4,000

Manufacturing overhead costs = design engineer salary + indirect materials and utilities = $2,500 + $3,000 = $5,500

Prime costs = direct materials cost + direct labor cost = $2,300 + $4,000 = $6,300

Conversion costs = direct labor cost + manufacturing overhead costs = $4,000 + $5,500 = $9,500

by Obaidullah Jan, ACA, CFA and last modified on

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