If your company makes and sells products, it is important to track the types of expenses that go into making the products. Two types of expenses are prime costs and conversion costs. These groups of costs can give you information about how your company is doing and how it can improve.
Prime costs are the direct materials and direct labour that go into making your products. They are the total amount of expenses that are directly tied to making a specific product. Common examples of prime costs include lumber, metals, plastics, fabric, paint, and the labour necessary to turn these items into your products. Your prime costs are the expenses that are required to make your products. Without the materials or labour, you would not have goods to sell. You should monitor your prime costs and try to reduce them by lowering what you pay. You will not be able to eliminate these types of expenses, so your strategy should be to pay less for materials or improve operations to use less.
Conversion costs are your expenses that turn raw materials into finished goods. It is the sum of labour and overhead costs that go into making your products. Your labour costs are the compensation needed to make your products. Overhead costs are your expenses that do not directly relate to any single product. Utilities or rent are overhead expenses, because they’re necessary to make your products but dont actually contribute to the final product. Your company should focus on minimizing conversion costs whenever possible. Unlike prime costs, conversion costs are somewhat avoidable because they arent related to your actual inventory. While some conversion costs are unavoidable, you should try to reduce what you pay in overhead because these are just the costs to run your business.
Pricing Your Goods
When figuring out how to price your goods, consider using prime costs and conversion costs. Prime costs are all of the expenses that go directly into the product. Therefore, the price you set for your inventory should be at least the total of your prime costs. This will make sure you at least recuperate the cost of what you sell. If your selling price is not above your prime cost per inventory item, your business will not be able to be successful.
Prime costs and conversion costs can be used to evaluate your operations, too. It is a good way to see how much waste is going on with your company. Plus, it lets you measure how much unnecessary spending occurs. By digging into conversion costs, you can see exactly what you are paying that does not going into your product. If you determine that you’re spending $100 per month on gasoline to transport goods, you can begin to plan ways to reduce or eliminate this conversion cost. Knowing your prime costs and conversion costs is the first step to getting a better sense of how your company operates and how you can improve your spending, pricing, and general operations.