What is Conversion Cost?

What is Conversion Cost?

Definition

Conversion costs are the costs incurred for turning raw materials into finished products. If you add direct labor costs and manufacturing costs, the sum that you get will be the conversion cost. In other words, conversion costs equal the cost of production minus raw material cost.

What does conversion cost mean?

Think of conversion costs as the costs associated with transforming raw materials into products. The formula for conversion costs is:

Conversion costs = direct labor costs + manufacturing overhead costs

In this formula:

⇨ Direct labor costs are the cost of employing workers to make the product. This will include wages, insurance costs for workers, pension contributions, and every other cost associated with employing workers involved in the manufacturing process.

⇨ Manufacturing overhead costs include indirect labor, electricity, manufacturing supplies, and insurance. In this category, it will also be necessary to include the cost of renting the factory where goods are produced.

Why are conversion costs important? They help a business to determine the cost at which inventory is to be valued. Additionally, knowledge of conversion costs can provide a business with the information that it needs to set the selling price of a product.

Example of conversion cost

Newton Electric Company is a producer of circuit breakers. It calculates its conversion costs by totaling the following expenses for the month of April 2018:

⇨ Direct labor expenses for manufacturing circuit breakers = $50,000

⇨ Depreciation on machinery = $10,000

⇨ Inspection expenses = $1,000

⇨ Electricity = $4,000

⇨ Maintenance expenses = $5,000

The company manufactures 1,000 circuit breakers in April. The total conversion costs are equal to $70,000 ($50,000 + $10,000 + $1,000 + $4,000 + $5,000). The conversion cost per unit is $7 ($70,000 divided by 7,000).

Summary

Conversion costs are the costs incurred to convert raw materials into finished products.