CONVERSION COST: Definition, Formula, and Calculations

Overhead costs are factored into a company’s conversion costs because they are required for the transition of raw resources into final costs. During a month, Company B spends $55,000 on direct labor and $66,000 on plant overhead. Conversion costs are calculated in order to know the cost per unit, which assists the company in deciding a price for the product. For example, during the month of July, Rock City Percussion purchased raw material inventory of $25,000 for the shaping department.

  • Operations managers use conversion costs to help identify waste within the manufacturing process.
  • Management often uses the cost information generated to set the sales price; to set standard usage data and price for material, labor, and overhead; and to allow management to evaluate the efficiency of production and plan for the future.
  • The manufacturing sector analyses both prime costs and conversion costs to measure efficiency in the production of a product.
  • For example, during the month of July, Rock City Percussion purchased raw material inventory of $25,000 for the shaping department.

The 1,200 ending work in process units are 100% complete with regard to material and have 1,200 (1,200 × 100%) equivalent units for material. The 1,200 ending work in process units are only 35% complete with regard to conversion costs and represent 420 (1,200 × 35%) equivalent units. Conversion costs are a cost accounting phrase that refers to the sum of direct labor costs and manufacturing overhead costs. In other words, conversion costs accounting for consignment are costs incurred by a manufacturer other than the cost of direct materials. Conversion cost is a costing word that describes the expenditures incurred in the form of direct labor and overhead to transform basic raw materials into completed items. Simultaneously, the prime cost is another costing phrase that quantifies the value of direct material, direct labor, and other direct expenses incurred in the manufacture of a certain product.

Prime Costs: Definition, Formula, Explanation, and Example

Prime costs and conversion costs are relied upon heavily in the manufacturing sector to measure efficiency in the production of a product. Prime costs are expenditures directly related to creating finished products, while conversion costs are expenses incurred when turning raw materials into a product. The amount spent on direct materials and direct labor is included in the calculation of prime costs. Direct materials comprise tangible components, such as raw materials, that are required to generate a final product. The engine of a car, for example, and the spokes of a bicycle are both included in direct material costs.

  • Conversion costs are the labor and overhead expenses that “convert” raw materials into a completed unit.
  • In a processing environment, there are two concepts important to determining the cost of products produced.
  • A cost unit is a product or service unit to which manufacturing costs can be assigned.

A cost unit is a product or service unit to which manufacturing costs can be assigned. For example, in the case of a phone manufacturer, the cost unit would be “per unit of phone.” It is critical to define cost units in order to accurately charge the costs incurred in all manufacturing processes. This refers to the costs that may be directly attributed to each unit of product or process. These include things like electricity costs, rent, depreciation, plant insurance, plant repairs and maintenance, and so on. The shaping department completed 7,500 units and transferred them to the testing and sorting department. No units were lost to spoilage, which consists of any units that are not fit for sale due to breakage or other imperfections.

Operations managers examine prime costs to ensure that the company’s production process is efficient. The calculation of prime costs also assists firms in setting prices that create an acceptable amount of profit. Conversion costs are also used as a way to measure the efficiencies in the production processes but they also take into account the overheads in the production process, which are not calculated in prime costs. These costs can’t be traced back to a single unit in the production process. Some other examples of manufacturing overheads are insurance, building maintenance, machine maintenance, taxes, equipment depreciation, machining, and inspection.

Pls noted that depreciation expenses, insurance expenses, maintnain expenses and electricity expenses are considered as manufactoruing overhead and we have to include all of these cost for our calculation with direct labor cots. TThese direct labor costs are the same ones used in calculating the prime cost in manufacturing. Suppose that the cost of the raw materials—lumber, hardware, and paint—totals $200. The furniture maker charges $50 per hour for labor, and the project takes three hours to complete. Conversion costs must be determined by each organization since they are critical for making significant business decisions and performing basic accounting procedures. It is calculated to determine the cost per unit, which aids the corporation in determining a price for the product.

Example of Prime Costs in Action

Compensation paid to machinists, painters, or welders is common in calculating prime costs. The pay, wages, or perks provided to an employee who works on the completion of all final items are considered direct labor costs. Prime costs are frequently calculated using compensation provided to machinists, painters, or welders. Management needs to understand its costs in order to set prices, budget for the upcoming year, and evaluate performance. Sometimes individuals become managers due to their knowledge of the production process but not necessarily the costs.

10 Conversion Costs

The primary difference between the two is that the formula for conversion costs takes overhead into account. For this reason, it’s a more relevant number for operations managers, who may be looking at ways to reduce the indirect expenses of production. 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.

List of Common Business Conversion Costs

Often there is a different percentage of completion for materials than there is for labor. Companies that manufacture inventory rely largely on metrics to track production and analyze the efficiency with which inventory is manufactured and sold. Conversion costs are one of the most widely used metrics for this.This indicator refers to the costs of converting raw materials into sellable goods. In this post, we will define conversion cost, describe common ones that a business may face, the formula for calculating it, and provide examples of how to use it for accounting in your firm. As described previously, process costing can have more than one work in process account.

The calculation for prime costs includes the amounts spent on direct materials and direct labor. Tangible components—such as raw materials—that are needed to create a finished product are included in direct materials. ABC International incurs a total of $50,000 during March in direct labor and related costs, as well as $86,000 in factory overhead costs. Therefore, the conversion cost per unit for the month was $6.80 per unit (calculated as $136,000 of total conversion costs divided by the 20,000 units produced). Conversion costs include the direct labor and overhead expenses incurred as raw materials are transformed into finished products.

Disadvantages of Conversion Cost

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. Direct labor and manufacturing overhead are used to test, weigh, and sound-match the drumsticks into pairs.

Once the equivalent units for materials and conversion are known, the cost per equivalent unit is computed in a similar manner as the units accounted for. The costs for material and conversion need to reconcile with the total beginning inventory and the costs incurred for the department during that month. Thus, conversion costs are all manufacturing costs except for the cost of raw materials. The calculation for conversion costs includes direct labor in addition to overhead expenses. It is the direct labor plus any manufacturing overheads needed to convert raw materials into a finished product. Direct material is added in stages, such as the beginning, middle, or end of the process, while conversion costs are expensed evenly over the process.

Since the maximum number of units that could possibly be completed is 8,700, the number of units in the shaping department’s ending inventory must be 1,200. The total of the 7,500 units completed and transferred out and the 1,200 units in ending inventory equal the 8,700 possible units in the shaping department. Operations managers use conversion costs to help identify waste within the manufacturing process.

The total of the cost per unit for material ($1.17) and for conversion costs ($2.80) is the total cost of each unit transferred to the finishing department ($3.97). 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. Now you can determine the cost of the units transferred out and the cost of the units still in process in the shaping department. 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 conversion costs.