Prime and Conversion Cost

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These lectures contain practice CPA questions covering basic cost accounting terminology such prime cost, conversion cost, direct material, manufacturing overhead and direct labor.

Prime and Conversion Cost

Prime Cost and Conversion Cost

Two more cost categories are often used in discussions of manufacturing costs—prime cost and conversion cost. Prime cost is the sum of direct materials cost and direct labor cost. Conversion cost is the sum of direct labor cost and manufacturing overhead cost. The term conversion cost is used to describe direct labor and manufacturing overhead because these costs are incurred to convert materials into the finished product.

Cost behavior refers to how a cost reacts to changes in the level of activity. As the activity level rises and falls, a particular cost may rise and fall as well—or it may remain constant. For planning purposes, a manager must be able to anticipate which of these will happen; and if a cost can be expected to change, the manager must be able to estimate how much it will change. To help make such distinctions, costs are often categorized as variable, fixed, or mixed. The relative proportion of each type of cost in an organization is known as its cost structure. For example, an organization might have many fixed costs but few variable or mixed costs. Alternatively, it might have many variable costs but few fixed or mixed costs.

For purposes of assigning costs to cost objects such as products or departments, costs are classified as direct or indirect. Direct costs can be conveniently traced to cost objects. Indirect costs cannot be conveniently traced to cost objects.

For external reporting purposes, costs are classified as either product costs or period costs. Product costs are assigned to inventories and are considered assets until the products are sold. At the point of sale, product costs become cost of goods sold on the income statement. In contrast, period costs are taken directly to the income statement as expenses in the period in which they are incurred.

For purposes of predicting how costs will react to changes in activity, costs are classified into three categories—variable, fixed, and mixed. Variable costs, in total, are strictly proportional to activity. The variable cost per unit is constant. Fixed costs, in total, remain the same as the activity level changes within the relevant range. The average fixed cost per unit decreases as the activity level increases. Mixed costs consist of variable and fixed elements and can be expressed in equation form as Y = a + bX, where X is the activity, Y is the total cost, a is the fixed cost element, and b is the variable cost per unit of activity.

If the relation between cost and activity appears to be linear based on a scattergraph plot, then the variable and fixed components of a mixed cost can be estimated using the high-low method, which implicitly draws a straight line through the points of lowest activity and highest activity, or the least-squares regression method, which uses all of the data points to compute a regression line that minimizes the sum of the squares errors.

The traditional income statement format is used primarily for external reporting purposes. It organizes costs using product and period cost classifications. The contribution format income statement aids decision making because it organizes costs using variable and fixed cost classifications.

For purposes of making decisions, the concepts of differential cost and revenue, opportunity cost, and sunk cost are vitally important. Differential costs and revenues are the costs and revenues that differ between alternatives. Opportunity cost is the benefit that is forgone when one alternative is selected over another. Sunk cost is a cost that occurred in the past and cannot be altered. Differential costs and opportunity costs should be carefully considered in decisions. Sunk costs are always irrelevant in decisions and should be ignored