What Are Conversion Costs in Accounting?
Conversion Costs Definition
Conversion costs in accounting are the costs incurred by companies when converting raw materials into finished products that are then ready to be sold in the market.
For example, in a furniture business that produces bespoke wooden tables, the conversion costs would be all of the costs involved in turning wood into a table.
This would include costs associated with the labour required and any overheads incurred in operating machinery used to build the table. Put simply, conversion costs are the sum of direct labour and manufacturing overheads expenses.
Conversion costs are prevalent in cost accounting, to calculate the value of a finished product in a business’s inventory, which is then recorded on the balance sheet as an asset.
Management can also benefit from using conversion costs, as they can be incorporated into the price setting process of a product to ensure that the target profit margin is achieved.
Conversion Costs Formula
Conversion costs consist of all of the manufacturing costs excluding for the cost of raw materials.
Therefore, to calculate conversion cost, the following formula is used:
Conversion costs = Direct Labour + Manufacturing Overheads
We can also elaborate on the two elements of the conversion costs formula:
- Direct Labour is the direct staffing costs associated with manufacturing the product. For example, wages/salaries, pension payments, insurance costs, supervision etc.
- Manufacturing Overheads is all of the indirect costs involved in manufacturing a product. For example, utilities bills, indirect labour, repairs and maintenance, depreciation etc
Conversion Costs Per Unit Formula
Conversion costs per unit = Number of Units Produced / (Direct Labour + Manufacturing Overheads)
Conversion Cost Types
The types of costs that may be classified as conversion costs are:
- Direct labour
- Machinery depreciation
- Machinery maintenance
- Factory rent
- Factory supplies
- Factory insurance
- Utillity bills
- Inspection costs
- Production supervision
- Salary of other staff related to production
Conversion Costs Examples
ABC Ltd has a manufacturing factory with a production capacity of 100,000 units per month. The company incurs the following costs:
Direct Labour | £50,000 |
Indirect Labour | £12,000 |
Supervision Costs | £10,000 |
Indirect Materials | £30,000 |
Factory Insurance | £5,000 |
Electricity Bill | £3,000 |
Water Bill | £1,000 |
Plant and Machinery Maintenance | £4,000 |
ABC Ltd wants to calculate what the conversion cost is.
Conversion costs = Direct Labour + Manufacturing Overheads
Direct Labour Costs
Direct Labour | £50,000 |
Supervision Costs | £10,000 |
| |
TOTAL | £60,000 |
Manufacturing Overheads
Indirect Labour | £12,000 |
Indirect Materials | £30,000 |
Factory Insurance | £5,000 |
Electricity Bill | £3,000 |
Water Bill | £1,000 |
Plant and Machinery Maintenance | £4,000 |
|
|
TOTAL | £55,000 |
Therefore, the conversion costs for the month are £115,000.
Per unit, this works out at 100,000 units / £115,000 = £1.15 per unit.
Advantages and Disadvantages of Conversion Costs
There are a number of advantages and disadvantages of using and tracking conversion costs, as specified below:
Advantages
- Help to establish the cost of turning raw material into a product.
- Helps managers to monitor and track expenses associated with production and manufacturing.
- Can be used in pricing the final product, as a business would know the costs of production
- Conversion costs can be used to ascertain whether any waste can be eliminated
- Helps to determine the cost of sales, for reporting on the financial statements
Disadvantages
- Does not give a full picture of all the costs incurred in production or manufacturing as it considers only two elements – direct labour and overheads.
- Can be irrelevant in some instances where the product does not undergo any conversion and can be sold with minimal processing.