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Prime Cost, Conversion Cost and Carrying Cost
Prime Cost, Conversion Cost and Carrying Cost
Prime Cost, Conversion Cost and Carrying Cost
conversion cost?
By Melissa Horton
Prime costs and conversion costs are relied upon heavily in the manufacturing sector
as a metric to determine efficiency in production of a specific product. Prime cost is
defined as the expenditures directly related to creating finished products, while
conversion costs are the 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 into production efficiency.
Prime Costs
The calculation for prime cost includes the total amount spent on direct materials in
addition to direct labor. Tangible components such as raw materials necessary to
create a finished product are included in direct materials. For instance, the engine of a
car or the spokes of a bicycle are included in direct material costs because they are
each necessary to complete production of that specific item. Direct labor costs include
the salary, wages or benefits paid to an employee who works on the completion of
finished products. Compensation paid to machinists, painters or welders is common in
calculating prime costs. Unlike conversion costs, prime costs do not include any
indirect costs.
Prime costs are reviewed by operations managers to ensure the company has an
efficient production process. The calculation of prime costs also helps organizations
set prices at a level that produce an acceptable amount of profit.
Conversion Costs
Conversion costs include direct labor and overhead expenses incurred due to the
transformation of raw materials into finished products. Overhead costs are defined as
the expenses that cannot be directly attributed to the production process but are
necessary for operations, such as electricity or other utilities required to keep a
manufacturing plant functioning throughout the day. Direct labor costs are the same
as those used in prime cost calculations.
Conversion costs are also used as a measure to gauge the efficiencies in production
processes but take into account the overhead expenses left out of prime cost
calculations. Operations managers also use conversion costs to determine where there
may be waste within the manufacturing process.
The prime cost concept has a huge impact on a business' finances because it dictates
the minimum sales price the company must charge for its goods to turn a profit. The
difference between sales revenue and prime costs directly affects a company's bottom
line.
better over the long term than would be reflected by the use of an accelerated
depreciation method.
As an example of the calculation of carrying value, ABC International purchases a
widget stamper for $50,000, and has recorded accumulated depreciation against it of
$20,000. It has also recorded accumulated impairment charges of $12,000 against the
stamper. Thus, the carrying value of the widget stamper is $18,000, which is
calculated as:
$50,000 Purchase price - $20,000 Depreciation - $12,000 Impairment
= $18,000 Carrying value
From the perspective of an entire business, you can consider carrying value to be the
net recorded amount of all assets, less the net recorded amount of all liabilities. A
more restrictive view that results in a lower carrying value is to also remove the
recorded net amount of all intangible assets and goodwill from the calculation.