Conversion costs definition

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What are Conversion Costs?

Conversion costs are those production costs required to convert raw materials into completed products. The concept is used in cost accounting to derive the value of ending inventory, which is then reported in the balance sheet. It can also be used to determine the incremental cost of creating a product, which could be useful for price setting purposes. Thus, the component costs and conversion costs of a product, when combined, represent the lower threshold price at which a product should be sold, so that the producer at least earns back the costs associated with the product.

How to Calculate Conversion Costs

Since conversion activities involve labor and manufacturing overhead, the calculation of conversion costs is:

Conversion costs = Direct labor + Manufacturing overhead

Thus, conversion costs are all manufacturing costs except for the cost of raw materials. If a business incurs unusual conversion costs for a specific production run (such as reworking parts due to incorrect tolerances on the first pass), it may make sense to exclude these extra costs from the conversion cost calculation, on the grounds that the cost is not representative of day-to-day cost levels.

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Types of Conversion Costs

Examples of costs that may be considered conversion costs are as follows:

  • 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

As can be seen from the list, the bulk of all conversion costs are likely to be in the manufacturing overhead classification. In a business that uses a high degree of automation, it is likely that manufacturing overhead costs will comprise the bulk of all conversion costs.

Example of Conversion Costs

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. ABC produced 20,000 units during March. Therefore, the conversion cost per unit for the month was $6.80 per unit (calculated as $136,000 of total conversion costs divided by the 20,000 units produced).

Conversion Costs vs. Prime Costs

Conversion costs are not the same as prime costs. 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, the differences between the two concepts are as follows:

  • Manufacturing overhead is only included in conversion costs. It is not included in prime costs.

  • The cost of direct materials is only included in prime costs.

Thus, each cost concept provides a somewhat different view of the costs incurred to create products, though both concepts include the cost of direct labor.