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.

ParticularAmount
Factory Employee Wages$15,000
Depreciation (Factory Equipment)$7000
Maintenance Fee$3000
Factory Rent Factory Supplies$2500
Factory Insurance$2500
  
Direct Material$30,000
  

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.

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Why is it important to calculate Conversion Costs?

Prime Cost is considered to be a resourceful tool because of the following reasons:

  • Calculation of Prime Costs help in evaluation of the cost of equivalent units. Manufacturing Overheads, and Direct Labor cannot be directly attributable to products. Therefore, calculating conversion costs would help to show the amount that is paid for converting this into finished products.
  • Conversion Cost calculation is simple. It does not require intensive calculations. Therefore, this can be an important metric that can be used in order to set targets for the forthcoming years.
  • Conversion Costs help to assess the value of the finished stock. Based on the conversion costs, the company is able to record finished goods in their inventory using the lower of cost or net realizable value concept.
  • Conversion Costs greatly help in assessment of wastages during the production process.

Therefore, it can be seen that the main premise of calculating conversion costs is to ensure that organizations are able to estimate the amount of input (in financial terms) that is required to bring the inventory to a finished state.

Hence, it is a crucial metric that can be termed as essential in helping organizations plan, and direct their efforts towards achieving higher levels of efficiency.

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