What are conversion costs?

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. For example, four units that are one-fourth finished would equal one equivalent unit. Conversion costs are the labor and overhead expenses that “convert” raw materials into a completed unit.

1. 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.
2. Some other examples of manufacturing overheads are insurance, building maintenance, machine maintenance, taxes, equipment depreciation, machining, and inspection.
3. Prime costs and conversion costs are relied upon heavily in the manufacturing sector to measure efficiency in the production of a product.
4. In cost accounting, conversion costs are all the costs incurred to convert raw materials into a finished good.

Raw materials are not included in conversion costs but are included in prime costs, which are direct materials and direct labor. The formula for calculating conversion costs is the sum of all direct labor and manufacturing overhead costs. Conversion costs can be used to determine production efficiencies. This is because conversion costs are all the costs it takes to turn the raw materials into the product that you sell. Additionally, knowing what it will cost a firm to turn materials into a finished product assists with product pricing. Finally, knowing how to calculate conversion costs is a must for public manufacturing companies that mass produce products.

Therefore, in order to achieve optimization of the production process, companies strive to keep the conversion costs minimum. Bruce’s Bike Company is a bicycle manufacturer that specializes in high-end 10-speed bikes. Bruce is trying to figure out what his conversion costs are for the quarter in order to estimate his finished inventory for the interim financial statements. It takes labor, electricity, water, a refrigerator, equipment, and other supplies. Let’s come back to our banana split later and learn about what makes up conversion costs.

Factories must use electricity to power their machines and produce products, but each dollar of electrical costs can’t be directly tied back to the products that were produced. Direct labor costs may seem to be pretty straightforward; however, these costs don’t just include wages. You want to tally all of the costs that must be paid for the labor needed to actually manufacture a product. Direct labor costs should also include all of the expenses necessary to hire and retain an employee who physically works to turn the raw materials into a product. During a month, Company B has a total cost of $55,000 in direct labor and $66,000 in factory overhead costs.

The more complex and sophisticated the products become, though the higher this cost can potentially go up. 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. The calculation for prime costs includes the amounts spent on direct materials and direct labor.

https://www.wave-accounting.net/s is a term used in cost accounting that represents the combination of direct labor costs and manufacturing overhead costs. In other words, conversion costs are a manufacturer’s product or production costs other than the cost of a product’s direct materials. In cost accounting, conversion costs are all the costs incurred to convert raw materials into a finished good.

Example of How Conversion Costs Work

Thus, conversion costs are all manufacturing costs except for the cost of raw materials. Like prime costs, conversion costs are used to gauge the efficiency of a production process, but conversion cost also takes into account overhead expenses that are left out of prime cost calculations. Conversion costs include all direct or indirect production costs incurred on activities that convert raw material to finished goods.

2 Explain and Identify Conversion Costs

The manufacturing sector analyses both prime costs and conversion costs to measure efficiency in the production of a product. 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. Assume that direct materials cost $700, direct labor is $500, and factory overhead is $300 for cabinets that have been manufactured.

How to Calculate Conversion Cost Formula Example

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 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.

Say we are looking to find Lotsa Fabrication’s conversion costs for a widget. Lotsa Fabrication incurred $30,000 during November in direct labor and related costs. If we want to know conversion costs per widget for the month, we divide $85,000 by 30,000 and get $2.83 per unit. 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.

The calculation of the cost of sales, which is reported on the income statement, also depends on the conversion cost. Assume that there was no work in process inventory at the beginning and at the end of the accounting period. Conversion costs are vital to be calculated by each companysince they are fundamental for making important business decisions and carryingout basic accounting tasks. It excludes the salary of management, office staff, and other people who are not working directly with the products. 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. An example of direct labor are the employees working on the assembly line of a manufacturer.

Most firms incur three types of costs in the production of their products. These costs are direct materials, direct labor, and manufacturing overhead. Direct materials are the actual raw materials that make up the finished product. Direct labor is the cost of the production floor workers that can be directly traced to the manufactured product. Manufacturing overhead includes all other production costs that can’t be easily identified or traced directly to the product, such as indirect materials, rent, utilities, and the production floor manager’s salary.

The cost of a product is determined by the amount of labor and overhead needed to convert raw materials into finished goods. To make the frames for the glasses, workers must cut the appropriate length of material and then shape the material into the frame with the help of a frame mold. Once the nose piece is attached and the frame is completely assembled, the frames get sent to the lens station where workers place the appropriate lens inside the appropriate frames and then fasten them with small screws. At the end of every year, after the firm’s inventory count, the firm looks at production costs. The calculation for conversion costs includes direct labor in addition to overhead expenses. Direct labor costs include the salaries, wages, and benefits paid to employees who work on the finished 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. Thus, each cost concept provides a somewhat different view of the costs incurred to create products. In a processing environment, there are two concepts important to determining the cost of products produced.

The actual wood and metal used for the chair are considered direct materials. The workers who get paid hourly to assemble a chair out of the wood and metal are considered direct labor. The cost of the indirect materials such as screws, stain, powder, and wire are indirect materials that are included as a manufacturing overhead cost.

Compensation paid to machinists, painters, or welders is common in calculating prime costs. In the Peep-making process, the direct materials of sugar, corn syrup, gelatin, color, and packaging materials are added at the beginning of steps 1, 2, and 5. While the fully automated production does not need direct labor, it does need indirect labor in each step to ensure the machines are operating properly and to perform inspections (step 4). Overhead costs are expenses used to produce products that can’t be attributed directly to a production process.

It is the direct labor plus any manufacturing overheads needed to convert raw materials into a finished product. Direct materials are added at the beginning of shaping and packaging departments, so the work in process inventory for those departments is 100% complete with regard to materials, but it is not complete with regard to using cash flow surpluses for investment or to pay down debts. If they were \(100\%\) complete with regard to conversion costs, then they would have been transferred to the next department. If they were 100% complete with regard to conversion costs, then they would have been transferred to the next department. Expressed another way, conversion costs are the manufacturing or production costs necessary to convert raw materials into products.