# What is Conversion Cost? Definition, Formula, Example, And Importance

## Overview

Costing for any business holds tantamount value because it helps to make significant strategic decisions regarding pricing, as well as profitability.

In this regard, it is important to consider the fact that costing for production concerns is even more important in comparison to trading concerns because it provides a baseline on which the company decides the way forward.

Therefore, when it comes to manufacturing concerns, there are numerous different terminologies that are used, so that the decision makers can gauge and assess the performance of the existing business set up, and the way forward for the company.

Conversion Costs are one such concept that is widely used in manufacturing companies, and it is important from a managerial perspective to have a clear idea regarding conversion costs, and why are they important from the perspective of the company.

## Definition

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.

Conversion costs, therefore, show the monetary value that is associated with converting raw materials into products. It is an integral part of the process costing system, and hence, it is considered to be an extremely useful metric in determining the inputs, as well as the costs that are associated with converting the product into something that is marketable and eventually sustainable.

Conversion costs only include direct labor and manufacturing overheads because of the reason that these two variables are rudimentary to execute the overall process.

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They are overheads, that cannot always be directly associated with the per-unit produce of the company. Hence, both of these figures are combined and amalgamated in order to get a clear understanding regarding the costs that are borne by the company to process the raw materials (or direct material).

From a company’s perspective, the lower the conversion cost, the higher the profit margins. Therefore, in order to achieve optimization of the production process, companies strive to keep the conversion costs minimum.

## Formula

Conversion Costs are calculated using the following formula:

Conversion Costs = Direct Labor + Manufacturing Overheads

Both these components are added together in order to arrive at the figure for conversion costs for the company for the particular year.

## Example

The concept of Conversion Costs can be illustrated using the following example:

Hardy Inc. is a manufacturing concern, which converts raw paper into finished sheets. They have a manufacturing set up, for which they incur the following costs.

In the example above, it can be seen that the Conversion Costs of Hardy Inc. can be defined as follows:

Conversion Costs = Factory Labor (Direct Labor) + Manufacturing Overheads

Conversion Costs = \$(15,000 + 7000 + 3000 + 2500 +2500) = \$ 30,000

On the other hand, Prime Cost for Hardy Inc. would be as following:

Prime Cost = Direct Material + Direct Labor + Manufacturing Overheads

Prime Cost = \$60,000

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.