Bruce is trying to figure out what his conversion costs are for the quarter in order to estimate his finished inventory for the interim financial statements. Conversion costs are the costs that are incurred by manufacturing companies when converting conversion cost formula raw materials into finished goods. This report shows the costs used in the preparation of a product, including the cost per unit for materials and conversion costs, and the amount of work in process and finished goods inventory.

Period costs are recorded in the profit and loss statement of an organization. One can arrive at total period costs by closely monitoring and reporting the expenses that aren’t related to manufacturing a product. The conversion costs would also help in calculating the cost of goods sold (COGS) accurately. Conversion costs must be determined by each organization since they are critical for making significant business decisions and performing basic accounting procedures. It is calculated to determine the cost per unit, which aids the corporation in determining a price for the product.

Example of Prime Costs in Action

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 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. Organizations should also calculate prime costs, in addition to conversion costs, to understand the efficiency of the production environment. Prime costs refer to all the direct expenses related to producing a finished product. So direct labor costs appear commonly in both prime costs and conversion costs. Conversion costs are a cost accounting phrase that refers to the sum of direct labor costs and manufacturing overhead costs.

Direct materials comprise tangible components, such as raw materials, that are required to generate a final product. The engine of a car, for example, and the spokes of a bicycle are both included in direct material costs. This is because they are both required to complete the production of that specific item.

Difference between Conversion Cost and Prime Cost

Conversion is a type of word formation process in which a word is assigned to a new word class or part of speech without any change in form. They refer to the worker wage, bonus, workers’ salary, pension fund, and insurance for these workers. Just keep in mind that you may not want to exclude keywords for brands you do not carry if you have successfully converted people with other brand loyalties in the past.

• Simultaneously, the prime cost is another costing phrase that quantifies the value of direct material, direct labor, and other direct expenses incurred in the manufacture of a certain product.
• It is easier to track the materials and conversion costs for one batch and have those costs follow the batch to the next process.
• Direct labor examples might include assembly line workers, welders, carpenters, glass workers, painters, and cooks.
• Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License .

Once you assess conversion, you can use the information to better allocate your budget and improve returns. Or you can use the conversion cost to confirm that your changes to campaigns were effective. Prime costs and conversion costs are two methods that businesses use to measure the efficiency of their production operations. Prime costs and conversion costs have direct labor cost as an overlapping item. Though the production of goods and services involves many different kinds of expenses, the prime cost formula only takes into account those variable expenses directly connected to the production of each item. From a company’s perspective, the lower the conversion cost, the higher the profit margins.

Defining Labor

The calculation for conversion costs includes direct labor in addition to overhead expenses. The manufacturing sector analyses both prime costs and conversion costs to measure efficiency in the production of a product. Management needs to understand its costs in order to set prices, budget for the upcoming year, and evaluate performance.

Each department tracks its conversion costs in order to determine the quantity and cost per unit (see TBD; we discuss this concept in more detail later). Conversion costs are restricted to direct labor and manufacturing overhead, which are needed to convert raw materials into completed products. Prime costs are the direct labor and direct materials costs incurred to build a product. The 1,200 ending work in process units are only 35% complete with regard to conversion costs and represent 420 (1,200 × 35%) equivalent units.

Prime Costs: Definition, Formula, Explanation, and Example

Both these components are added together in order to arrive at the figure for conversion costs for the company for the particular year. This is the cost of directly manufacturing the product, such as wages, salaries to workers, pension funds for workers, production staff insurance, supervision, and so on. The conversion cost is also used to calculate the cost of sales, which is reported on the income statement. Because closing inventory is a line item on both the income statement and the balance sheet, estimating its value is simple. During a month, Company B spends $55,000 on direct labor and $66,000 on plant overhead.

The value of ending inventory that appears in the balance sheet of the preceding year is carried forward as the beginning inventory for the current year. Consider a professional furniture builder who is commissioned to build a coffee table for a customer. The primary costs for making the table include both the cost of the furniture maker’s labor and the raw materials needed to build the table, such as lumber, hardware, and paint.