Prime Costs and Conversion Costs

Manufacturing costs (direct materials, direct labor, and factory overhead) can be classified further into:
  1. prime costs and
  2. conversion costs.

Prime Costs

Prime costs refer to the total cost of direct materials and direct labor.

Direct materials pertain to cost of items that form an integral or major part of the finished product. Examples are steel in automobiles, rubber in tires, fabric in clothing, etc. Direct labor refers to the salaries and wages of workers who transform the materials into finished goods.

Conversion Costs

Conversion costs refer to those that are spent to transform raw materials into finished goods, i.e. direct labor and factory overhead.

Direct labor, as mentioned above, refers to the salaries of production workers. Factory overhead refers to costs incurred in production other than direct materials and direct labor. Factory overhead includes indirect materials (such as nails, staples, adhesives, etc.), indirect labor (such supervisor's salary), and factory expenses (factory supplies, utilities, depreciation, and all other expenses incurred in the factory).

Example 1

During the month of December, MGM Company used materials costing $360,000. Direct labor cost amounted to $200,000 and factory overhead is estimated at $250,000 based on direct labor hours. Compute for the prime costs and conversion costs.

Solution:

Prime costs = Direct materials + Direct labor
$360,000 + $200,000 = $560,000

Conversion costs = Direct labor + Factory overhead
$200,000 + 250,000 = $450,000

Example 2

ABC Company's prime costs amount to $650,000 while conversion costs amount to $600,000. Total factory overhead is equal to $320,000. Compute for the cost of direct materials.

Solution:

Conversion costs = Direct labor + Factory overhead
$600,000 = Direct labor + $320,000
Direct labor = $280,000

Prime costs = Direct materials + Direct labor
$650,000 = Direct materials + $280,000 (from above)
Direct materials = $370,000

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