Companies that manufacture inventory rely largely on metrics to track production and analyze the efficiency with which inventory is manufactured and sold. Conversion costs are one of the most widely used metrics for this.
This indicator refers to the costs of converting raw materials into sellable goods. In this post, we will define conversion cost, describe common ones that a business may face, the formula for calculating it, and provide examples of how to use it for accounting in your firm.
What is Conversion Cost?
Conversion cost is the cost incurred by any manufacturing entity in the process of converting raw materials into finished goods that can be sold in the market, and it typically includes the total value of labor cost as well as other applied overheads such as factory overheads, administrative overhead, and so on.
Conversion Cost Formula
Manufacturing Overheads + Direct Labor = Conversion Cost Formula
Conversion cost formula
Here,
- Manufacturing Overheads
This refers to the costs that may be directly attributed to each unit of product or process. These include things like electricity costs, rent, depreciation, plant insurance, plant repairs and maintenance, and so on.
- Direct Labour
This is the cost of directly manufacturing the product, such as wages, salaries to workers, pension funds for workers, production staff insurance, supervision, and so on.
List of Common Business Conversion Costs
Any manufacturing cost that does not include the direct cost of raw materials is considered a conversion cost. The following are some of the most frequent conversion costs that a business may face:
- Employee advantages
- Salary
- Wages
- Salaries taxes
- Production utility costs
- Depreciation of equipment
- Maintenance costs for equipment
- Renting a factory or an office
- Production insurance, such as factory insurance
- Supervision
- Inspection costs
- Machining
- Employee incentives
- Contributions to a pension
- Small instruments that are priced separately
Conversion Cost Examples
Consider the following examples of how to determine conversion costs:
Example#1
During the production period, Company A incurred the following costs:
- $50,000 in direct labor costs
- Machine depreciation: $6,000
- $12,000 in insurance costs
- $6,000 in maintenance costs
- $14,000 for electricity
Calculate the conversion of Company A using the costs shown above.
Company A’s conversion cost will be:
= Direct labor + maintenance costs + insurance costs + power costs
=$50,000 plus $6,000 plus $12,000 plus $6,000 plus $14,000 = $88,000
Please keep in mind that depreciation charges, insurance expenses, cost expenses, and electricity expenses are all considered manufacturing overhead. Hence, they must be included in our calculation with direct labor costs.
Example#2
During a month, Company B spends $55,000 on direct labor and $66,000 on plant overhead. During the month, Company B manufactured 24,000 units.
Conversion costs are $55,000 + $66,000 = $121,000.
The cost of conversion per unit would be 121,000/24,000= $5.04 per unit.
Prime costs
The amount spent on direct materials and direct labor is included in the calculation of prime costs. Direct materials comprise tangible components, such as raw materials, that are required to generate a final product. The engine of a car, for example, and the spokes of a bicycle are both included in direct material costs. This is because they are both required to complete the production of that specific item.
The pay, wages, or perks provided to an employee who works on the completion of all final items are considered direct labor costs. Prime costs are frequently calculated using compensation provided to machinists, painters, or welders. Prime costs, unlike conversion costs, do not contain any indirect costs.
Operations managers examine prime costs to ensure that the company’s production process is efficient. The calculation of prime costs also assists firms in setting prices that create an acceptable amount of profit.
Example of Prime Costs in Action
Consider a professional furniture builder who is commissioned to build a coffee table for a customer. The primary costs for making the table include both the cost of the furniture maker’s labor and the raw materials needed to build the table, such as lumber, hardware, and paint.
Assume that the raw materials—lumber, hardware, and paint—cost $200. The furniture maker charges $50 per hour for labor, and this project takes three hours. The total cost of manufacturing the table is:
$200 for raw materials + $150(50 x 3 hours of labor) in direct labor= $350
To make a profit, the table’s price should be set higher than its prime cost. To be profitable, the furniture manufacturer must charge at least $351.
Conversion Cost vs. Prime Cost
Conversion cost is a costing word that describes the expenditures incurred in the form of direct labor and overhead to transform basic raw materials into completed items. Simultaneously, the prime cost is another costing phrase that quantifies the value of direct material, direct labor, and other direct expenses incurred in the manufacture of a certain product. Conversion cost and prime cost are both manufacturing sector terms. They are used to measure the efficiency of a certain product’s production.
Many of the same production characteristics are used by both conversion and prime cost, but each has a distinct perspective on product efficiency. To complete a product, prime cost includes both direct material and direct cost, whereas conversion cost does not. Certain cost factors are included in one but not in the other. For example, prime cost does not contain overhead charges that are applied in conversion cost. The prime cost’s major goal is to set the price of a product with the intended profits. The conversion cost, on the other hand, is estimated to total and resolve any production inefficiency. Although the prime cost is computed and given at the start of the cost sheet, there is a fixed standard that requires the computation of conversion cost until and unless the manager demands it.
Prime Cost Formula
The prime cost formula is as follows:
Prime costs = Raw materials + direct labor
Direct labor costs only comprise costs directly related to the workers who participated in the manufacture of completed items. For example, if a painter was hired to paint a car under construction, the painter’s salary would be included in the prime costs.
Some of the same expenses are included in both prime costs and conversion costs. Prime costs and conversion costs, for example, will both include direct labor costs in their estimates.
However, unlike conversion costs, prime costs exclude all indirect labor costs associated with production. Both of these indicators can be used to assess the efficiency of a company’s manufacturing process. However, they provide different information.
Advantages of Conversion Cost
- It aids in calculating the cost of converting raw materials into finished goods.
- It aids in the elimination of deficiencies in the cost process as well as the reduction of production costs.
- It’s used to create a pricing model for a product and estimate the final cost.
- It assists managers in supervising and tracking production expenses.
- They are also used by managers and, in some cases, business owners to determine if there is any waste that can be avoided.
- This is used to calculate the cost of sales for reporting on financial accounts (if applicable).
Disadvantages of Conversion Cost
- It does not provide an accurate picture of all production/manufacturing costs. This is because it only analyzes two factors: direct labor and overheads.
- This concept is less important when the product does not need to be converted and maybe sold directly with minimal processing.
- This approach cannot be depended on entirely for cost management and reduction programs because it does not cover all cost aspects. There are better costing processes available, such as marginal costing, process costing, and so on, that provide better insights into the costs incurred.
Overhead Cost Calculation Using Prime Costs, Conversion Costs, and Direct Materials
Overhead costs are the costs incurred by a business in order for it to continue operating; in other words, overhead costs are the costs of day-to-day business operations. Overhead costs include:
- Rent and utility bills
- Maintenance and repairs
- Insurance
- Office furniture and supplies
- Certain levies
- Management salaries
Overhead costs are corporate costs that are relatively constant. As a result, they are occasionally referred to as fixed costs. Overhead costs are factored into a company’s conversion costs because they are required for the transition of raw resources into final costs.
Conclusion
Conversion costs must be determined by each organization since they are critical for making significant business decisions and performing basic accounting procedures. It is calculated to determine the cost per unit, which aids the corporation in determining a price for the product.
The conversion cost is also used to calculate the cost of sales, which is reported on the income statement. Because closing inventory is a line item on both the income statement and the balance sheet, estimating its value is simple.
Conversion Cost FAQs
What is a cost unit?
A cost unit is a product or service unit to which manufacturing costs can be assigned. For example, in the case of a phone manufacturer, the cost unit would be “per unit of phone.” It is critical to define cost units in order to accurately charge the costs incurred in all manufacturing processes.
How do you calculate conversion cost?
Conversion Costs = Direct Labor Costs + Manufacturing Overheads is the overall conversion cost formula.
What is conversion in financial accounting?
Conversion costs are a cost accounting phrase that refers to the sum of direct labor costs and manufacturing overhead costs. In other words, conversion costs are costs incurred by a manufacturer other than the cost of direct materials.
