What are conversion costs?: Definition, Formula, and Example

Conversion costs are a term used in cost accounting that represents the combination of direct labor costs and manufacturing overhead costs. In other words, conversion costs are a manufacturer’s product or production costs other than the cost of a product’s direct materials.

Expressed another way, conversion costs are the manufacturing or production costs necessary to convert raw materials into products.

The term conversion costs often appear in the calculation of the cost of an equivalent unit in a process costing system.

Definition of Conversion Costs

Conversion costs are costs a company spends on overhead and labor when turning raw material into a finished product. Calculating and being aware of your business’ conversion costs can provide you with a clearer picture of how much you spend on inventory production.

The manufacturing industry is typically the industry in which conversion costs are most frequently used, but any company that produces goods can use this metric when making business decisions related to their products.

Additionally, a company may be required to calculate its conversion costs to determine its cost of sales to report on an income statement.

Formula

Conversion Cost Formula = Manufacturing Overheads + Direct Labour

Here,

  • Manufacturing Overheads means the expenses which can be directly attributed to each unit of product or the process. These include electricity bills, rent, depreciation, plant insurance, repairs and maintenance of plants, etc.
  • Direct Labor is the cost associated with manufacturing the product directly such as wages, salaries to workers, pension funds for workers, insurance of production staff, supervision, etc.

What Does Conversion Cost offer?

  • Conversion costs allow managers and other supervisors to accurately measure and keep track of the expenses of production.
  • Conversion costs can also be used in the development of product-pricing models as well as when estimating the end value of finished products.
  • Business owners or managers may also look at conversion costs to determine if there is waste that can be eliminated and to better understand the efficiency of their production process.

Examples of Conversion Costs

An example of direct labor is the employees working on the assembly line of a manufacturer.

Examples of manufacturing overhead include the utilities, indirect labor, repairs, maintenance, depreciation, etc. that are occurring within a company’s manufacturing facilities.

Thus, conversion costs are all manufacturing costs except for the cost of raw materials. Examples of costs that may be considered conversion costs are:

  • Direct labor and related benefits and payroll taxes
  • Equipment depreciation
  • Equipment maintenance
  • Factory rent
  • Factory supplies
  • Factory insurance
  • Machining
  • Inspection
  • Production utilities
  • Production supervision
  • Small tools charged to expense

As can be seen from the list, the bulk of all conversion costs are likely to be in the manufacturing overhead classification.

What are Conversion Costs?

Since conversion activities involve labor and manufacturing overhead, the calculation of conversion costs is:

Conversion costs = Direct labor + Manufacturing overhead

If a business incurs unusual conversion costs for a specific production run (such as reworking parts due to incorrect tolerances on the first pass), it may make sense to exclude these extra costs from the conversion cost calculation, on the grounds that the cost is not representative of day-to-day cost levels.

Direct Labor Costs

  • Direct labor costs may seem to be pretty straightforward; however, these costs don’t just include wages.
  • You want totally all of the costs that must be paid for the labor needed to actually manufacture a product.
  • This means you have to add in insurance (including life, medical, short-term disability, long-term disability, workers’ compensation, vision, hearing, and dental), payroll taxes, pension contributions, benefits costs, recruitment fees, and training costs.
  • Direct labor costs should also include all of the expenses necessary to hire and retain an employee who physically works to turn the raw materials into a product.

Manufacturing Overhead Costs

  • Manufacturing overhead costs are those manufacturing costs necessary to produce a product, excluding the direct labor costs.
  • This includes indirect labor costs, which are labor costs incurred by a company for those employees who are not directly involved in producing the actual well.
  • Examples of employees in this category are managers, nurses, security guards, janitors, cooks, maintenance workers, accountants, executives, trainers, parking attendants, and secretaries.

Example of How Conversion Costs Work

Consider the example of Company A: The company has a total cost of $50,000 in direct labor and related expenses, in addition to $86,000 in factory overhead costs, during the month of April.

Suppose that Company A produces 20,000 units during the month of April. Thus, the company’s conversion costs per unit for the month of April are $6.80 per unit ($136,000 of total conversion costs / by 20,000 units produced = $6.80).

Conversion Cost vs Prime Cost

  • Conversion cost can be defined as a costing terminology that provides information regarding expenditure incurred in the form of direct labour and overhead to convert basic raw material into finished goods.
  • At the same time, the prime cost is another costing term that quantifies the value of direct material, direct labour, and other direct expenses incurred in manufacturing any particular product. Conversion cost and prime cost both are manufacturing sector terminology and used as a tool to determine the effectiveness in the production of a particular product.
  • Both conversion and prime cost use many of the same production factors, but each has a different opinion on product efficiency. Prime cost uses both direct material and direct labour to complete a product while conversion cost does not include a direct material cost. Certain cost elements are included in one and excluded on another like prime cost does not include overhead expenses which are applied in conversion cost.
  • The main objective of the prime cost is to set the price of a product with the desired profits. In contrast, the conversion cost is calculated in order, to sum up, and resolve any manufacturing inefficiency. Prime cost is calculated and presented at the beginning of the cost sheet, but there is a set a standard that required the calculation of conversion cost until and unless the manger desires it.

Example

Use the following information to calculate conversion cost per unit:

Completed Units50,000
Direct Wages$38,000
Indirect Wages$5,000
Direct Material$29,000
Indirect Material$1,000
Equipment Depreciation$6,500
Office Expenses$10,000
Factory Insurance$2,000

Assume that there was no work in process inventory at the beginning and at the end of the accounting period.

Solution

Direct Labor = 38,000

Manufacturing Overheads = 5,000 + 1,000 + 6,500 + 2,000 = 14,500

Conversion Costs = Direct Labor + Manufacturing Overheads = 38,000 + 14,500 = 52,500

Example 2

Company A incurred the following costs during the production period:

  • Direct labor expenses: $50,000
  • Depreciation on machinery: $6,000
  • Insurance expenses: $12,000
  • Maintenance expenses: $6,000
  • Electricity: $14,000

Based on the costs are provided above, calculate the conversion of Company A.

The conversion cost for company A will be:

= Direct labor + maintenance expenses + insurance expenses + electricity

=$50,000+ $6,000+ $12,000+ $6,000+ $14,000 = $88,000.

Pls, note that depreciation expenses, insurance expenses, maintenance expenses, and electricity expenses are considered as manufacturing overhead and we have to include all of these costs for our calculation with direct labor costs.

Key Concepts and Summary

  • Conversion costs are the costs of direct labor and manufacturing overhead used to convert raw materials into a finished product.
  • Materials are added during various stages of the manufacturing process, such as the beginning or end, while conversion of the product from raw material into finished goods is considered to occur uniformly through the process. Thus, it is possible for a product to have all of its materials and not be complete.
  • Equivalent units for direct materials can be different than the equivalent units for conversion costs because materials are added in steps through the manufacturing process, while conversion costs are incurred evenly throughout the process.

Leave a Comment