Conversion Costs: Definition, Formula, and Example

Tangible components—such as raw materials—that are needed to create a finished product are included in direct materials. Conversion cost, as the name implies, is the total cost that a manufacturing entity incurs to transform or convert its direct materials into salable or finished product. Typically, it is equal to the sum of entity’s total direct labor cost and total manufacturing overhead cost. The conversion of materials into a finished product is what we call “conversion.” It’s an important process that happens at every stage in the manufacturing cycle. The more complex and sophisticated the products become, though the higher this cost can potentially go up.

Compensation paid to machinists, painters, or welders is common in calculating prime costs. In manufacturing sector, the basic production costs can be categorized differently depending on the purpose and use of categorization. This categorization is helpful in determining the efficiency of manufacturing facilities and processes in producing their output.

1. Therefore, in order to achieve optimization of the production process, companies strive to keep the conversion costs minimum.
2. Thus, each cost concept provides a somewhat different view of the costs incurred to create products.
3. Therefore, one difference between the two concepts is that manufacturing overhead is only included in conversion costs.
4. Overhead costs are expenses that cannot be directly attributed to the production process but are necessary for operations, such as the electricity required to keep a manufacturing plant functioning throughout the day.

Conversion costs are restricted to direct labor and manufacturing overhead, which are needed to convert raw materials into completed products. Prime costs are the direct labor and direct materials costs incurred to build a product. Therefore, one difference between the two concepts is that manufacturing overhead is only included in conversion costs. The other difference is that the cost of direct materials is only included in prime costs.

Conversion costs are the costs that are incurred in converting direct raw material into finished goods and hence the name. Thus, conversion costs are all manufacturing costs except for the cost of raw materials. 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. It is the direct labor plus any manufacturing overheads needed to convert raw materials into a finished product. However, a difference between prime costs and conversion costs that has not been incorporated in the analysis above is the fact that conversion costs also include indirect labor. Numerous manufacturing overhead costs are encountered in manufacturing facilities and processes.

Mechanics of Applying Conversion Costs

As can be seen from the list, the bulk of all conversion costs are likely to be in the manufacturing overhead classification. Conversion costs are calculated in order to know the cost per unit, which assists the company in deciding a price for the product. By using conversion costs, we can calculate an efficient way of determining equivalent units and unit costs. The conversion cost, when used in conjunction with prime cost, helps reduce waste and gauge other operational inefficiencies that may be present within the manufacturing facility. Prime costs are reviewed by operations managers to ensure that the company is maintaining an efficient production process. For instance, the engine of a car and the spokes of a bicycle are considered direct material costs because they are necessary to complete the production of those items.

What are Conversion Costs?

The use of this ratio in process costing is to calculate the cost for both direct labor and manufacturing overheads. It’s important because it will become the cost of the inventory which will impact the selling price. In a typical manufacturing process, direct manufacturing costs include direct materials and direct labor. However, they may also include the cost of supplies that are directly used in production process, and any other direct expenses that don’t fall under direct materials and direct labor categories. Conversion costs include the direct labor and overhead expenses incurred as raw materials are transformed into finished products. ABC International incurs a total of $50,000 during March in direct labor and related costs, as well as $86,000 in factory overhead costs.

The 5A uses only packaging sleeves as its direct material, while other types may also include nylon, felt, and/or the ingredients for the proprietary handgrip. Direct labor and manufacturing overhead are used to test, weigh, and sound-match the drumsticks into pairs. Conversion cost is the cost incurred by any manufacturing entity in converting its raw material into finished goods capable of being sold in the market.

Examples of such expenses include the salaries of production supervisor and factory watchman etc. Prime costs and conversion costs are relied upon heavily in the manufacturing sector to measure efficiency in the production of a product. Prime costs are expenditures directly related to creating finished products, while conversion costs are expenses incurred when turning raw materials into a product. Conversion Costs can be defined as the aggregated costs that include direct labor, and manufacturing overhead costs. They are referred to as the manufacturer’s production related cost, which does not include the costs incurred in production of direct materials. The calculation for prime costs includes the amounts spent on direct materials and direct labor.

Consider a professional furniture maker who is hired to make a coffee table for a customer. The prime costs for creating the table include the cost of the furniture maker’s labor and the raw materials required to construct the balance sheet definition and examples assets = liabilities + equity table, including the lumber, hardware, and paint. 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. Some other examples of manufacturing overheads are insurance, building maintenance, machine maintenance, taxes, equipment depreciation, machining, and inspection.

Both these components are added together in order to arrive at the figure for conversion costs for the company for the particular year. Timber, glue, nails, glass and finishing materials have been treated as direct materials because they all become part of finished and ready to sell table. Some common examples are insurance, building maintenance, machine breakup, and taxes on equipment or machining.

Prime cost formula

Therefore, once the batch of sticks gets to the second process—the packaging department—it already has costs attached to it. In other words, the packaging department receives both the drumsticks and their related costs from the shaping department. For the basic size 5A stick, the packaging department adds material at the beginning of the process.

The computational responsibility lies with the factory manager who collects the relevant data, calculates the prime cost figure for the period and reports the same to operations manager for review. 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. Management needs to understand its costs in order to set prices, budget for the upcoming year, and evaluate performance.

Thus, each cost concept provides a somewhat different view of the costs incurred to create products. Prime costs are all the direct costs of a product i.e. those costs that can be traced conveniently to each unit. On the other hand, conversion costs are all manufacturing costs other than direct materials cost. In a processing environment, there are two concepts important to determining the cost of products produced. As you have learned, equivalent units are the number of units that would have been produced if one unit was completed before starting a second unit.

It usually includes the total value of labor cost and other applied overheads like factory overheads, administrative overheads, etc. Prime costs and conversion costs include some of the same factors of production expenses, but each provides a different perspective when it comes to evaluating production efficiency. During a month, Company B has a retirement of bonds total cost of $55,000 in direct labor and $66,000 in factory overhead costs. TThese direct labor costs are the same ones used in calculating the prime cost in manufacturing.