What is the difference between prime cost and

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.

Example of Prime cost

In business accounting, prime cost refers to the total expense that can be directly
attributed to the production of a manufactured item. The formula used to calculate
prime cost is simple despite the significance of the concept behind it. There are just
two components of prime cost: raw materials and direct labor.
Prime Cost = Raw Materials + Direct Labor
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 individual item. Raw materials include
the basic items used to create the product, such as lumber, glass, paint, hardware or
fabric. Direct labor includes only wages paid to workers who directly contribute to the
formation, assembly or creation of the product. This does not include, for example,
salaries for factory managers or fees paid to engineers or designers. These employees
are involved in the creation of the product concept and in the day-to-day operation of
the business rather than the hands-on assembly of items for sale. However,
commissions paid to salespeople who act as intermediaries between the manufacturer
and the consumer are included in the prime cost equation.
For example, assume a company produces 40 decorative mirrors over the period of
two weeks and incurs the following costs: $1,500 for glass, $700 for framing
materials and paints, and $300 in specialized hardware for assembly. The company
also employs three workers for 20 hours each to build and assemble the mirrors at $10
per hour. Further assume a salesperson sells all 40 mirrors at $150 each for 2%
commission. The prime cost of each mirror is ($1,500 + $700 + $300 + (3 * 20 * $10)
+ (40 * $150 * 2%)) / 40, or $80.50.

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.

Carrying Cost/Carrying Value

Carrying cost is used interchangeable with carrying value. A carrying value is an
accounting measure of value, where the value of an asset or a company is based on
the figures in the company's balance sheet. For assets, the value is based on
the original cost of the asset less any depreciation, amortization or impairment costs
made against the asset. For a company, carrying value is a company's total assets
minus intangible assets and liabilities such as debt. Also known as "book value".
The concept is only used to denote the remaining amount of an asset recorded in a
company's books - it has nothing to do with the underlying market value (if any) of an
asset. Market value is based on supply and demand and perceived value, and so could
vary substantially from the carrying value of an asset. For instance, a building may
have been purchased many years ago and has since appreciated in value, while the
owner has been depreciating it for a number of years; the result is a wide disparity
between the carrying value and market value of the building.
Also, a business that engages in excellent equipment maintenance practices may find
that the market value of its assets are significantly higher than those of a company that
does not invest a sufficient amount in asset maintenance. The result can be a wide
divergence between carrying value and market value for the same assets owned by
different entities.
The carrying value of an entire business may be divided by the number of shares
outstanding to arrive at carrying value per share. This amount is sometimes
considered to be the baseline value per share, below which the market price of a share
should not drop. However, since there is not necessarily any connection between
market value and carrying value, the baseline assertion can be difficult to justify.
For example, a company may subject a fixed asset to an accelerated rate of
depreciation, which rapidly reduces its carrying value. However, the market value of
the asset is much higher, since market participants believe that the asset carries value

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.