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 into an actual product ready to be sold.
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 costs rather than separately calculating direct labor and manufacturing overheads.
Conversion cost is used by the production management, budget controller, and other leadership teams of the company for the efficiency and effectiveness analysis of the labor and overhead costs purpose rather than valuing the inventories for financial reporting purposes.
Formula:
The formula for conversion costs is as follows:
Conversion costs= Direct Labor + Manufacturing Overheads.
Where,
Manufacturing overheads:
Manufacturing overheads used in calculating conversion costs are the overheads that cannot be attributed to the production process or 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.
TThese direct labor costs are the same ones used in calculating the prime cost in manufacturing.
Importance:
A company’s accounts managers and production managers calculate these conversion costs to estimate the production expenses, and 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 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 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 noted that depreciation expenses, insurance expenses, maintnain expenses and electricity expenses are considered as manufactoruing overhead and we have to include all of these cost for our calculation with direct labor cots.
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 since it is a line item reported on both the income statement and the company’s balance sheet.
