Cost may be classified according to their relationship to production. This classification is closely related to the cost elements of a product (direct materials, direct labor, and factory overhead) and the major objectives of planning and control.

The two categories, on the basis of their relationship to production, are prime costs and conversion costs.

Prime costs. Prime costs are direct materials and direct labor. Prime costs are directly related to production.

Conversion costs. These are costs concerned with transforming direct materials into finished products. Conversion costs are direct labor and factory overhead.

Note that direct labor is included in both categories. This does not result in double counting because this classification is used for planning and control, not for cost accumulation.

For example, if the costs presented were classified according to their relationship to production, prime costs and conversion costs would be computed as follows:

Prime Costs:

Direct materials …….$260,000

Direct labor ………… 540,000

Total ………………..$800,000

Conversion Costs:

Direct Labor ………$540,000

Factory overhead … 142.800

Total ……………. $682,800