News & Events

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 costs from Investopedia, a resource for managers. 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. From a edsel dope company’s perspective, the lower the conversion cost, the higher the profit margins. Therefore, in order to achieve optimization of the production process, companies strive to keep the conversion costs minimum. The terms prime cost and conversion cost are mainly used in a manufacturing environment; they are not relevant to merchandising companies because they just buy and sell ready to use product inventory and don’t produce anything.

1. Conversion costs are also used as a way to measure the efficiencies in the production processes but they also take into account the overheads in the production process, which are not calculated in prime costs.
2. Conversion costs are vital to be calculated by each companysince they are fundamental for making important business decisions and carryingout basic accounting tasks.
3. Prime costs and conversion costs are two methods that businesses use to measure the efficiency of their production operations.
4. 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.
5. While the fully automated production does not need direct labor, it does need indirect labor in each step to ensure the machines are operating properly and to perform inspections (step 4).

Conversion costs are the labor and overhead expenses that “convert” raw materials into a completed unit. Management often uses the cost information generated to set the sales price; to set standard usage data and price for material, labor, and overhead; and to allow management to evaluate the efficiency of production and plan for the future. The expenses and remunerations attached to workers and employees who merely support the production facility and are not actively involved in converting materials into ultimate product are not included in direct labor cost. Rather, such expenses are considered as indirect labor which goes to the entity’s total manufacturing overhead cost (discussed later in this article).

Conversion costs are vital to be calculated by each companysince they are fundamental for making important business decisions and carryingout basic accounting tasks. The calculation of the cost of sales, which is reported on the income statement, also depends on the conversion cost. In this regard, it is important to consider the fact that costing for production concerns is even more important in comparison to trading concerns because it provides a baseline on which the company decides the way forward. It excludes the salary of management, office staff, and other people who are not working directly with the products.

Direct materials are added at the beginning of shaping and packaging departments, so the work in process inventory for those departments is 100% complete with regard to materials, but it is not complete with regard to conversion costs. If they were 100% complete with regard to conversion costs, then they would have been transferred to the next department. In the Peep-making process, the direct materials of sugar, corn syrup, gelatin, color, and packaging materials are added at the beginning of steps 1, 2, and 5. While the fully automated production does not need direct labor, it does need indirect labor in each step to ensure the machines are operating properly and to perform inspections (step 4). Manufacturing cost is the cost that company spends to support the production process but they cannot allocate to each product.

Manufacturing Cost

Therefore, the conversion cost per unit for the month was $6.80 per unit (calculated as $136,000 of total conversion costs divided by the 20,000 units produced). 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.

Prime Costs 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. 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. Some other examples of manufacturing overheads are insurance, building maintenance, machine maintenance, taxes, equipment depreciation, machining, and inspection.

Prime Costs Vs. Conversion Costs – What are the Key Difference?

Manufacturing overheads used in calculating conversion costs are the overheads that cannot be attributed to the production process or a single unit in production, for example, rent or electricity. Direct labor is the cost that a manufacturing entity incurs for wages, salaries and benefits provided to production workers i.e., the workers who directly and physically handle the manufacturing process in a facility. Examples of direct labor workers include welders, machine operators, assemblers and painters etc. Direct materials is the basic physical ingredient, matter or substance which the company processes to make a salable product. Plastic, rubber, steel, iron, timber and many agricultural outputs like sugarcane, sugar beets, jute and cotton etc. are examples of direct materials that are processed to produce salable 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. The furniture maker charges $50 per hour for labor, and the project takes three hours to complete. Some costs, notably labor, are included in each, so adding them together would overstate manufacturing cost.

The cost of a product is determined by the amount of labor and overhead needed to convert raw materials into finished goods. 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. The calculation for conversion costs includes direct labor in addition to overhead expenses. Direct labor costs include the salaries, wages, and benefits paid to employees who work on the finished products.

Both these components are added together in order to arrive at the figure for conversion costs for the company for the particular year. Timber, glue, nails, glass and finishing materials have been treated as direct materials because they all become part of finished and ready to sell table. Some common examples are insurance, building maintenance, machine breakup, and taxes on equipment or machining.

It is easier to track the materials and conversion costs for one batch and have those costs follow the batch to the next process. Samsung has a cell phone production unit with a production capacity of 10,000 daily it incurs day-to-day expenses to keep its business running. The company wants to know its conversion cost from the following mentioned information. Operations managers use conversion costs to help identify waste within the manufacturing process.

What are Conversion Costs?

They are the indirect cost that incurs to support the manufacturing, but it is very challenging to apply the cost to each production unit. Prime costs and conversion costs are two methods that businesses use to measure the efficiency of their production operations. Conversion costs are also used as a way to measure the efficiencies in the production processes but they also take into account the overheads in the production process, which are not calculated in prime costs. Conversion costs are the costs that are incurred by manufacturing companies when converting raw materials into finished goods. During June, Excite Company’s prime cost was $325,000 and conversion cost was $300,000. A periodical review of the firm’s prime cost is crucial to ensure the efficiency of its manufacturing process.

Rent of factory building, electricity, gas and coal used in production, salaries of production managers, depreciation of production machines and equipment are a few examples of these costs. 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. The manufacturing sector analyses both prime costs and conversion costs to measure efficiency in the production of a product. Conversion costs only include direct labor and manufacturing overheads because of the reason that these two variables are rudimentary to execute the overall process. Indirect materials, electricity charges and salaries of engineer and supervisor are all indirect costs and have, therefore, been added together to obtain total manufacturing overhead cost.

Best Internal Source of Fund That Company Could Benefit From (Example and Explanation)

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. They refer to the worker wage, bonus, workers’ salary, pension fund, and insurance for these workers. Without proper control, it can lead businesses into financial ruin if not managed properly by management teams who know what’s best about how much each item should retail for. Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018. Thomas’ experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning.

Thus, each cost concept provides a somewhat different view of the costs incurred to create products. Prime costs are all the direct costs of a product i.e. those costs that can be traced conveniently to each unit. On the other hand, conversion costs are all manufacturing costs other than direct materials cost. In a processing environment, there are two concepts important to determining the cost of products produced. As you have learned, equivalent units are the number of units that would have been produced if one unit was fob shipping point completed before starting a second unit.