The comparison of prime costs vs. conversion costs is very useful in manufacturing industries to figure out expenses in each process and calculate accurate costs of the finished goods. This helps manufacturers set selling prices of finished goods that can be profitable for their businesses.
Many business owners and managers struggle with differentiating between prime costs and conversion costs. This confusion can result in inaccurate pricing, budget overruns, and problems in production
Manufacturing companies may find themselves underestimating the actual production expenses or misallocating resources. This will eventually negativevly impact profitability and scalability. By comparing prime vs conversion cost, small-scale businesses find areas that cause extra expenses to reduce waste and improve their production management and financial management.
In this blog post, we will learn about both prime and conversion costs, including their formula and examples, and understand their differences. You can use this comparison of prime costs vs. conversion costs to improve cost calculations and invest your money wisely in your manufacturing operations.
Understanding Prime Costs
Prime cost is the expense directly involved in manufacturing finished goods. It helps manufacturers calculate the basic costs of certain finished goods and set profitable prices.
The prime cost includes direct material and direct labour required to manufacture certain products. Prime cost does not include overhead costs like electricity bills and other utilities needed in the manufacturing processes.
The calculation of prime cost does not provide the total production costs for finished goods. You can calculate prime cost to find out how much you spend on raw materials and workers directly involved in manufacturing finished goods.
You can use a simple prime cost formula to improve your cost calculations, which is given below:
Prime cost = Direct material costs + Direct labour costs
Read here What Is Prime Cost?
After learning about the prime cost meaning and its formula, let’s understand this with an example of prime cost. Suppose you own a manufacturing business that makes machinery gears.
- You spend Rs.500 on raw materials to make one gear.
- The direct labour cost is Rs. 300 to make the gear according to the required standards.
Using the above-mentioned prime cost method formula to calculate direct expenses for manufacturing one gear.
Prime cost = Rs.500 (Direct materials cost) + Rs.300 (Direct labor cost) = Rs.800
Your prime cost to manufacture one gear is Rs.800.
Understanding Conversion Costs
Conversion cost is the money you spend to convert raw materials into finished goods. The conversion cost include direct labor and overhead expenses involved in manufacturing processes. Conversion cost does not include the prices of raw materials used to manufacture finished goods.
The calculation of conversion cost helps you find out overhead expenses like electricity and gas bills, factory supplies, rents, inventory holding costs, etc, involved in manufacturing finished goods. Using a simple conversion cost formula can improve your costing process and help you set profitable prices for finished goods.
Here is the conversion cost equation to improve your calculation:
Conversion costs = Direct labour costs + Manufacturing overhead expenses
After learning about the conversion cost meaning and its formula, let’s understand it with a practical example of conversion cost. Suppose you own a manufacturing business that makes ceiling fans.
- Your total overhead costs are Rs.400, whether related to electricity or machine maintenance.
- You also pay Rs.100 to the labour to make one fan.
Now, we will use the formula to calculate conversion costs.
Conversion Costs = Rs.100 (Direct labor cost) + Rs.400 (Overhead expenses) = Rs.500
Your conversion cost to manufacture one ceiling fan is Rs.500.
Key Differences Between Prime Costs And Conversion Costs
When you understand the difference between prime cost and conversion cost, you can easily calculate the prices of your finished goods. Let’s learn about the key differences.
| Prime Cost | Conversion Cost |
|---|---|
| It includes the costs of raw materials used in manufacturing. | It includes expenses for converting raw materials to finished goods. |
| It helps you focus on reducing the costs of raw materials. | It helps you analyze overheads and improve operational efficiency. |
| It is spent before the start of the production. | It is spent throughout the production processes. |
Calculating Prime Costs And Conversion Costs
The comparison of prime costs vs. conversion costs helps you purchase raw materials from the best suppliers and improve production efficiency as well. Let’s learn to calculate them separately.
How To Calculate Prime Cost?
- Make a list of all raw materials used to manufacture certain products.
- Find out the total amounts you spent to procure raw materials.
- Identify all the workers directly involved in manufacturing those products.
- Find out how many hours workers were involved in manufacturing and calculate their wages.
- Use the prime cost equation (mentioned in the above section) by adding the direct material and labour costs → Prime cost = Direct material costs + Direct labour costs.
- You can also use a digital prime cost calculator to speed up your calculation while reducing errors.
How To Calculate Conversion Cost?
- Collect all the details of production processes involved in manufacturing finished goods.
- Calculate the total costs of labourers directly involved in manufacturing processes.
- Calculate the total overhead costs, such as utilities, maintenance charges, inventory costs, etc., needed to manufacture certain products.
- Put all the details in the conversion cost equation (as mentioned in the above section) → Conversion costs = Direct labour costs + Manufacturing overhead expenses
- You can also use digital conversion cost calculators to simplify your calculations.
Applications Of Prime And Conversion Costs In Accounting
Let’s learn about their applications that can help you analyze areas to work on and simplify your operational costs.
Prime Cost In Accounting
Prime cost is very helpful in identifying direct expenses to manufacture certain products. You can use prime cost in cost accounting to set prices of the finished goods and analyze profit margins.
Since prime cost in accounting focuses on direct material costs, it also helps you analyze the performances of your suppliers to improve your procurement process.
Conversion Cost In Accounting
Conversion cost helps you analyze the efficiency of your production processes. You can use conversion cost in cost accounting to calculate accurate production costs of finished goods. This helps you set appropriate prices with decent profit margins.
Since conversion cost in accounting focuses on overhead costs, it helps you identify areas in production processes that can be improved, whether through predictive maintenance, inventory management techniques, or others.
Prime And Conversion Costs In Managerial Accounting
Prime cost in managerial accounting improves cost control, forecasting, and profit analysis. It helps managers analyze if materials are not used properly or if labourers are causing downtime so that they can take relevant actions.
On the other hand, conversion cost in managerial accounting improves overhead management and pricing decisions. It helps you invest in automated tools to reduce labour needs and overhead expenses. By comparing these two, managers can focus on increasing overall productivity.
Summary And Conclusion
Both prime and conversion costs play an important role in calculating the cost of goods sold (COGS). This, in turn, affects profitability. By clearly defining these costs, manufacturers can more accurately reflect COGS in their financial statements.
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TranZact cloud solution also helps you calculate overhead costs, whether electricity bills or sub-contracting expenses, within no time. It further allows you to create multi-level bills of materials (BOMs) to improve your production and financial management.
Learn about Implementing Best Practices For Prime Cost Management With TranZact.
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FAQs
1. What is the difference between prime costs and conversion costs?
Prime costs include expenses in direct labour and direct materials used for manufacturing finished goods. On the other hand, conversion costs include cost of converting raw material to finished good and overhead expenses in doing that.
2. How do you calculate prime cost?
You can use the below given easy prime cost formula for the calculation:
Prime costs = Direct labour costs + Direct material costs
3. How do you calculate conversion cost?
You can use the below-given conversion cost formula for easy calculation:
Conversion cost = Direct labour costs + Manufacturing overhead costs
4. Why is it important to differentiate between prime costs and conversion costs?
It is important to differentiate between prime costs and conversion costs to identify direct and overhead expenses and make informed decisions for reducing overall production costs.
5. What is the importance of understanding prime and conversion costs in accounting?
It is important to understand prime and conversion costs in accounting to find out the total production costs in manufacturing certain goods and set their prices with profitable margins.
6. Why is direct labor included in both prime costs and conversion costs?
Direct labour is included in both prime cost and conversion cost because labourers are directly involved in handling raw materials and converting them into finished goods.
