Conversion Cost: How It Is Calculated And Examples

The conversion cost is the amount that is incurred for expenses during the transformation of the inventory of raw materials into finished products. In other words, it is the amount of direct labor and overhead costs that are required to convert the raw materials into an actual product.

Therefore, conversion cost is a term used in cost accounting that represents the combination of direct labor costs and general manufacturing costs. That is, they are the costs of production other than the cost of direct materials of a product.

The conversion cost is calculated to estimate production expenses, develop product pricing models, and estimate the value of finished product inventory. Managers also use this cost to evaluate the efficiency of the production process.

If a company incurs unusual conversion costs when performing a specific production, such as reconditioning parts due to incorrect tolerances, it makes sense to exclude these additional costs from the conversion cost calculation, as they do not represent daily costs.

What is the conversion cost?

The production department of a company is full of costs. Each cost represents a portion of the materials, labor, or overhead required to make finished products.

Conversion costs include all direct or indirect production costs incurred in activities that convert raw materials into finished products.

There are two main components to the cost of conversion, the general costs of production and the cost of direct labor.

General production costs

Overheads are defined as those expenses that cannot be charged directly to the production process, but are necessary for the operation, such as electricity or other utilities necessary to keep a manufacturing plant operational throughout the day.

Factories must use electricity to power their machines and make products, but the dollar amount of electrical costs cannot be directly linked to the products that were manufactured. They must be assigned and estimated.

Direct labor cost

Direct labor is the cost associated with the workers actively making the products. This includes wages and salaries paid to assembly line workers, machinists, painters, and anyone who helps make products.

Direct labor costs are the same as those used in the prime cost calculations.

Uses of conversion cost

Conversion costs are used as a measure to calculate efficiency in production processes, but taking into account overheads, which are outside the calculation of prime costs.

Operations managers also use conversion costs to determine where there may be waste within the manufacturing process. Both the production-by-work-order and cost-per-process systems can use conversion costs to produce goods.

However, companies may be more willing to apply this concept to the cost per process system. This is due to the inherent characteristics found in this production method.

How is it calculated?

Companies often have different methods of calculating this cost and thus applying it to the goods produced.

Since conversion activities involve labor and manufacturing expenses, the conversion cost calculation is:

Conversion cost = direct labor + manufacturing overhead.

Component calculation

On the one hand, the labor required to transform raw materials into finished products must be tracked. To do this, all production employees are required to enter and leave the plant with an established time sheet document.

In this way, all the hours worked can be added, and then multiplied by the cost of labor. Thus, direct labor costs for production can be determined.

On the other hand, all indirect expenses associated with the operation of the production department are identified. These costs include utilities, maintenance, quality control products, production facility security, depreciation, and minor supplies.

The totals for these manufacturing overhead are added together. A common method of doing this is to include all of these expenses over a set period of time, such as a month.

Final calculation

Then the total direct labor costs and total manufacturing overhead are added. This results in the total cost.

Finally, this total cost is divided by the quantity of goods produced during the same period of time. This value represents the conversion cost per unit for all manufactured products.

Alternate formula

Since total manufacturing costs have three components: direct materials, direct labor, and manufacturing overhead, conversion costs can also be calculated using the following formula:

Conversion costs = Total manufacturing costs – Direct materials.

Examples

An example of direct labor is employees who work on a manufacturer’s assembly line.

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

Company A

During the month of April, Company A had a total cost of $ 50,000 in direct labor and related costs, as well as $ 86,000 in general manufacturing costs.

Company A produced 20,000 units during April. Therefore, the conversion cost per unit for the month was $ 6.80 per unit. This is the result of the following calculation: $ 136,000 corresponding to the total conversion cost ($ 50,000 + $ 86,000), divided by the 20,000 units produced.

XYZ Company

The following information is used to calculate the conversion cost per unit for an accounting period of Company XYZ:

– Units produced: 50,000

– Direct Salaries: $ 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

Suppose there was no WIP inventory at the beginning and end of the accounting period.

Direct labor = $ 38,000.

Factory overhead = $ 5,000 + 1,000 + 6,500 + 2,000 = 14,500.

Total Conversion Cost = Direct Labor + Factory Expenses = $ 38,000 + $ 14,500 = $ 52,500.

Therefore, the conversion cost per unit will then be equal to: $ 52,500 / 50,000 units = $ 1.05

References

  1. Melissa Horton (2018). Understanding the Difference Between Prime Costs and Conversion Costs. Investopedia. Taken from: investopedia.com.
  2. Kirk Thomason (2017). How to Calculate Conversion Costs in Accounting. Bizfluent. Taken from: bizfluent.com.
  3. Harold Averkamp (2019). What are conversion costs? Accounting Coach. Taken from: accountingcoach.com.
  4. Steven Bragg (2019). Conversion costs. Accounting Tools. Taken from: accountingtools.com.
  5. My Accounting Course (2019). What are Conversion Costs? Taken from: myaccountingcourse.com.
  6. Irfanullah Jan (2018). Conversion Costs. Xplaind. Taken from: xplaind.com.

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