Learn the definition of a conversion cost. Discover how to calculate conversion costs by using the conversion cost formula and seeing examples and walkthroughs.
Updated: 11/21/2023
Conversion Cost | Definition, Formula & Examples
Table of Contents
- What is Conversion Cost?
- Conversion Cost Formula
- Calculating Conversion Cost Examples
- Lesson Summary
Frequently Asked Questions
What is conversion cost in cost accounting?
In cost accounting, conversion costs are all the costs incurred to convert raw materials into a finished good. Conversion costs include direct labor and manufacturing overhead.
What is conversion cost example?
A chair manufacturing firm incurs the following costs: $50,000 for wood, $100,000 for production workers, $50,000 for production manager, $100,000 rent for manufacturing building. Total conversion costs are $250,000.
Conversion costs = direct labor + manufacturing overhead
Conversion costs = $100,000 production workers + ($50,000 production manager + $100,000 rent for manufacturing building)
Conversion costs = $250,000
Why it is called conversion cost?
Conversion cost gets its name because the costs that make up conversion cost are all the costs incurred to convert raw material into a finished good. These costs are direct labor and manufacturing overhead.
How do you calculate conversion costs?
Conversion costs are calculated by simply adding up all direct labor costs and manufacturing overhead costs. Direct labor costs are the labor costs that can be directly traced to a product. Manufacturing overhead costs include all costs associated with the manufacturing process, but can't be easily traced to any one product.
Table of Contents
- What is Conversion Cost?
- Conversion Cost Formula
- Calculating Conversion Cost Examples
- Lesson Summary
A firm manufactures prefabricated stairs, and their manufacturing process begins with a production floor employee cutting the wood to the correct dimensions. Once they are cut the production floor worker starts assembling the stairs with screws and wood glue. This process is overseen by a production floor manager. The firm is trying to lower the costs of the manufacturing process, so they start by looking at the conversion cost. The conversion cost is the cost incurred to turn the wood into the finished prefabricated stair. In this case, the costs would include: the labor costs for the production floor workers to cut and assemble the stairs, the screws and wood glue used for assembly, the cost of utilities, insurance, and rent for the manufacturing facility. The conversion costs would not include the wood used.
Conversion Cost Definition
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. For example, a firm manufactures wooden and metal chairs. 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. Additionally, the utilities, rent, and cost of the production floor manager are also classified as manufacturing overhead costs. The conversion cost definition is the direct labor and manufacturing overhead costs needed to convert raw materials into a finished product. The chair manufacturing company's conversion costs would be the cost of the hourly production floor workers, the manufacturing facility's rent and utilities, and the indirect materials considered manufacturing overhead costs such as the screws, stain, powder, and wire. Conversion cost accounting is a cost evaluation mechanism used most often to evaluate manufacturing efficiencies, help price products, and used in process costing to calculate the cost of goods sold on the income statement and inventory on the balance sheet.
Prime Cost vs. Conversion Cost in Accounting
Prime costs are all the direct costs of production. In other words, prime costs are the direct materials and direct labor costs incurred in the manufacturing process. Prime costs are mainly used to reassure managers about product pricing. The greater the ratio of prime costs over total costs the higher the chance a firm's product cost accuracy is. This is because manufacturing overhead can't be directly traced to any one product and must be allocated. Often the allocation of manufacturing overhead is inaccurate or misleading and can result in poor product pricing which leads to decreased profitability and poor decision-making.
| Conversion Cost | Prime Cost | |
| Definition | All costs needed to convert raw materials to a finished product | All direct costs of production |
| Main Use | Evaluate efficiency, product pricing, financial statements | Product pricing |
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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. This is because process costing is the costing system used under generally accepted accounting principles for this type of manufacturer. Notice that the direct materials are not included in conversion costs. This is because conversion costs give us information on what it costs a firm to transform that raw material into a finished product.
Advantages and Disadvantages of Conversion Cost
| Advantages | Disadvantages |
| Helps with product pricing | Cost errors when used in process costing |
| Helps evaluate production efficiency | Doesn't give enough information for effective cost control |
| Inexpensive and easy to calculate | Only useful for manufacturing processes with lots of conversion and processing needed |
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A firm manufactures glasses. 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. Workers then build the nose piece. 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. For the year, the firm spent $50,000 on material for the frames, $200,000 for the lenses, paid production workers $200,000, paid the production manager $50,000, spent $200,000 on rent for the production facility, and spent $20,000 on rent and insurances related to the production facility.
The firm wants to figure out the conversion costs so they can adjust prices for next year. The frames and lenses are direct materials and are not included in conversion costs. The $200,000 paid to production workers is direct labor, which is a conversion cost. The $50,000 paid to the production manager is manufacturing overhead, which is a conversion cost. The $200,000 cost for renting the production facility is part of manufacturing overhead costs, which are conversion costs. The $20,000 cost for utilities and insurances related to production are also manufacturing overhead, which are production costs. Total conversion costs for the year are $470,000.
Conversion costs = direct labor + manufacturing overhead
Direct labor = $200,000 for production workers
Manufacturing overhead = $50,000 for production manager, $200,000 for production facility rent, $20,000 for utilities and insurances related to the production facility
Conversion costs = $200,000 + ($50,000 + $200,000 + $20,000)
Conversion costs = $470,000
A table manufacturer makes tables by cutting and welding metal into tables. During the year the firm incurred $100,000 cost for the metal, $200,000 cost for welders, $50,000 cost for indirect materials, and $100,000 for renting the manufacturing building. The firm calculates conversion costs of $350,000
Conversion costs = direct labor + manufacturing overhead
Direct labor = $200,000 for welders
Manufacturing overhead = $50,000 for indirect materials and $100,000 for manufacturing facility rent
Conversion costs = $200,000 + ($50,000 + $100,000)
Conversion costs = $350,000
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Conversion cost is the sum of direct labor and manufacturing overhead costs incurred to turn raw materials into a finished product. Conversion costs are used in the generation of a manufacturing firm's income statement and balance sheet if process costing is used as well as assist in product pricing. Raw materials are not included in conversion costs but are included in prime costs, which are direct materials and direct labor.
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Video Transcript
Conversion Costs in Accounting
If you cook, you already know all about conversion costs. When you make your favorite dessert, do you follow a recipe? Do you go to the store and purchase your ingredients? Do you need tools to make your dish? Imagine you are making a banana split. It takes labor, electricity, water, a refrigerator, equipment, and other supplies. Plus, we have those delicious ingredients. Let's come back to our banana split later and learn about what makes up conversion costs.
Conversion costs are direct labor costs combined with manufacturing overhead costs. Direct labor costs are just the costs to employ those who actually make a product. Manufacturing overhead costs are things like indirect labor, utilities, supplies, equipment, insurance, taxes, tools, and regulatory obligations. We will look at these costs in more detail later in the lesson.
So when we think of the costs that must be incurred to take raw materials and turn them into products, we are referring to conversion costs. The formula for conversion costs is:
Conversion Costs = Direct Labor Costs + Manufacturing Overhead Costs
Conversion costs may also be called production costs. We need to know these costs in order to determine:
- The cost of creating one unit of a product, which is used to set a price for a good
- The total costs of existing inventory, which is needed for balance sheets
- The costs of goods sold, which is required for income statements
Notice that the actual costs of the necessary raw materials are not included in conversion costs. But we want to focus on what is included in conversion costs, so let's look into what makes up direct labor costs and manufacturing overhead costs.
Direct Labor Costs
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. This means you have to add in insurance (including life, medical, short-term disability, long-term disability, workers' compensation, vision, hearing, and dental), payroll taxes, pension contributions, benefits costs, recruitment fees, and training costs. 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.
Manufacturing Overhead Costs
Manufacturing overhead costs are those manufacturing costs necessary to produce a product, excluding the direct labor costs. This includes indirect labor costs, which are labor costs incurred by a company for those employees who are not directly involved in producing the actual good. Examples of employees in this category are managers, nurses, security guards, janitors, cooks, maintenance workers, accountants, executives, trainers, parking attendants, and secretaries.
Manufacturing overhead costs that don't include labor are pretty comprehensive. These include:
- Utilities necessary for production, such as fuel, natural gas, oil, water, Internet, telephone, and sewer
- Equipment costs, which also includes repairs, depreciation, replacement, and disposal
- Factory costs, including taxes, rent, insurance, and maintenance
- Tools and machinery, like hand and pneumatic tools; lifting, pushing, and pulling devices
- Supplies: paper towels, cleaning materials, soap
Finding Conversion Costs
Let's go back and look at making our banana split. Let's say it takes us two hours to get everything together and thirty minutes to make the banana split. At $10 an hour, what are the direct and indirect labor costs?
Direct labor costs would be 0.50 x 10 = $5
Indirect labor costs would be 2 x 10 = $20
So we have one part of our formula for conversion costs and one part for our manufacturing overhead costs. Let's look at the rest of our manufacturing overhead costs. Do we include the costs of our bananas, whipped cream, nuts, cherries, and hot fudge? We don't include raw materials, so we don't include these. But we have to include the costs of the utilities, equipment, tools, and supplies needed to keep all of our raw materials fresh and put them together. If we say these costs come out to $15, then we have everything we need for our conversion cost: 5+35 = $40. The $35 comes from our indirect labor costs ($20) combined with our other manufacturing overhead costs ($15).
Let's look at a business example. 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. The company also incurred $55,000 in factory overhead costs. Lotsa made 30,000 widgets during November. This made the conversion cost $85,000. 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.
Lesson Summary
To summarize our lesson on conversion costs in accounting, we learned about direct and indirect labor costs. We used a formula for conversion costs where direct labor is added to manufacturing overhead costs. Indirect labor costs are included in manufacturing overhead costs along with other things such as utilities, equipment and factory costs, tools and machinery, and supplies. The formula is:
Conversion Costs = Direct Labor Costs + Manufacturing Overhead Costs
We used this formula to calculate conversion costs, but it can also be used to find one of the missing variables, such as direct labor costs or manufacturing overhead costs. From this, we can set our price, fill in our balance sheet, and complete our income statements.
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Conversion Cost | Definition, Formula & Examples
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