Conversion Costs: Formula and Examples

Manufacturing companies incur various costs within different processes. These costs are vital in helping companies generate revenues and make profits. One of the essential items for those companies includes raw materials, which contribute to a significant portion of the overall expenses. However, there are other costs as well, which can be substantial. One of these includes conversions costs.

What are Conversion Costs?

Conversion costs are all costs sustained by a company that relate to converting raw materials into finished goods. Similarly, the finished goods need to be sellable in the market for the conversion cost to be capitalizable. Conversion costs do not include raw materials or any direct material expenses. Instead, it consists of labour costs and manufacturing overheads.

Conversion costs involve a combination of both direct and indirect production costs. With these costs, companies can get better insights into their production costs. Similarly, removing direct material costs from the overall production costs provides better metrics to measure operational efficiency. These costs can also help companies identify any wastage within the production process.

What are the components of Conversion Costs?

As mentioned, there are two components that contribute to the conversion costs that companies incur. These include direct labour costs and manufacturing overheads. An explanation of what each of these is is as below.

Direct Labor Costs

Direct labour costs are total costs incurred by companies in expenses paid to production workers. For these costs to be direct, it is crucial for the workers to have directly contributed to the manufacturing process. Payroll expenses outside of this process, for example, administrative staff salaries, do not fall under direct labour costs. Direct labour costs may include salaries, wages, bonuses, taxes, benefits, overtime, etc., paid to production workers.

Manufacturing Overheads

Apart from direct labour expenses, conversion costs also incorporate manufacturing overheads. These include indirect overheads that are a part of the production process. However, these do not directly contribute to a single cost unit. Therefore, companies have to allocate these expenses based on an appropriate metric. Manufacturing overheads may include utilities, taxes, depreciation, maintenance, etc.

What is the difference between Conversion Costs and Prime Costs?

Some people often confuse conversion costs with prime costs. Although both of these relate to the production process, they are different from each other. As mentioned, conversion costs include direct labour costs and manufacturing overheads. These costs exclude any expenses incurred on acquiring raw materials.

On the other hand, prime costs include all direct costs that contribute to a production unit’s costs. These will primarily include direct material and direct labour. In some cases, it will also contain direct expenses. Therefore, prime costs include direct material but do not consider manufacturing overheads.

How to calculate Conversion Costs?

Conversions costs are the sum of a company’s direct labour costs and manufacturing overheads. Based on the definition, companies can use the following formula for conversions costs.

Conversion Costs = Direct Labor Costs + Manufacturing Overheads

Example

A company, Aqua Co., produced 10,000 units of its product in a year. The company incurred $10 on raw materials per unit. Similarly, it paid salaries and wages to its workers, which amounted to $5 per unit. Lastly, the company also incurred $100,000 in manufacturing overheads. Based on the above data, Aqua Co.’s conversion costs for the year will be as follows.

Conversion Costs = Direct Labor Costs + Manufacturing Overheads

Conversion Costs = (10,000 units x $5 per unit) + $100,000

Conversion Costs = $150,000

Conclusion

Conversion costs are the sum of all expenses incurred by a company to convert raw materials into finished goods. There are two components that contribute to these costs, direct labour costs and manufacturing overheads. Conversion costs are different from prime costs due to the inclusion of manufacturing overheads and the exclusion of raw material costs.

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