Definition:

Conversion costs are the costs that are incurred by manufacturing companies when converting raw materials into finished goods.

It is the direct labor plus any manufacturing overheads needed to convert raw materials into a finished product.

In other words, conversion costs are associated with converting direct materials to an actual product.

It is mainly used in calculating the cost of production report in process costing, where the percentage of completion of unfinished manufactured units at the end of an accounting period is usually the same for direct labor and manufacturing overheads.

Hence, using conversion costs is an efficient way of calculating equivalent units and per unit cost rather than separately calculating for direct labor and manufacturing overheads.

Formula:

The formula for conversion costs is as follows:

Conversion costs= Direct Labor + Manufacturing Overheads.

Manufacturing overheads:

Manufacturing overheads used in the calculation of conversion costs are the overheads that cannot be attributed to the production process or to a single unit in production, for example, rent, or electricity. We can’t attribute these costs to one unit of production.

These costs can’t be traced back to a single unit in the production process. Some other examples of manufacturing overheads are insurance, building maintenance, machine maintenance, taxes, equipment depreciation, machining, and inspection.

Direct labor:

On the contrary, direct labor costs are the costs associated with the workers making the product.

This may include wages, insurance costs for the workers, pension fund contributions, bonuses and every other cost associated with the employed workers involved in the manufacturing process.

These direct labor costs are the same ones used in calculating the prime cost in manufacturing.

Importance:

Accounts managers and production managers of a company calculate these conversion costs to estimate the production expenses, the value of the finished and unfinished inventory and make product-pricing models.

Conversion costs are also used as a way to measure the efficiencies in the production processes but they also take into account the overheads in the production process, which are not calculated in prime costs.

Operation managers also use conversion costs to figure out any wastage in the production process.

If a business meets with an unusual cost while calculating the conversion cost, it should not include it, as it is not a day-to-day cost. 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

Let’s look at some examples of how to calculate conversion costs:

Example#1

Company A has the following costs:

Direct labor expenses: $50,000
Depreciation on machinery: $6,000

Insurance expenses: $12,000

Maintenance expenses: $6,000

Electricity: $14,000

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.

Example#2

During a month, Company B has a total cost of $55,000 in direct labor and $66,000 in factory overhead costs. Company B produced 24,000 units during the month. Conversion costs equal to $55,000+$66,000= $121,000.

Conversion cost per unit would be: 121,000/24,000= $5.04 per unit.

Conclusion:

Conversion costs are vital to be calculated by each company since they are fundamental for making important business decisions and carrying out basic accounting tasks.

Conversion costs are calculated in order to know the cost per unit which assists the company in deciding a price for the product.

The calculation of the cost of sales, which is reported on the income statement, also depends on the conversion cost.

It is rudimentary to gauge the value of closing inventory as well since it is a line item reported on both, the income statement and the balance sheet of the company.