Conversion costs can be defined as costs incurred by companies that convert raw materials into finished products. It is essentially the cost of direct labor in addition to the manufacturing overheads that are required to make these conversions.
In this sense, conversion costs are typically associated with the process of converting direct materials into finished physical products that are ready to hit the market.
It is usually used in calculating the overall cost of production report that is generated in process costing.
This is where the percentage of completion of unfinished manufactured units is typically the same percentage issued for direct labor costs in addition to the cost of manufacturing overheads.
Thus, using conversion costs is a highly productive means of calculating costs per unit as opposed to calculating labor and manufacturing cost separately.
Conversion costs are also normally utilized by production management, and other leaders within the company to enhance the overall efficiency of the company.
Thorough calculations and analysis of the overhead and labor costs ensure that inventories are appropriately valued for reporting purposes.
The formula for calculating conversion costs is the following:
Direct Labor + Manufacturing Overheads = Conversion Costs.
What Are Manufacturing Overheads?
Manufacturing overheads are used when calculating conversion costs and refer to the overheads that are not able to be accurately attributed to the overall production process.
For instance, electricity or rent These costs cannot be directly attributed to a single unit of production. Thus, they cannot be traced back to one unit.
Some examples of overheads include building maintenance, taxes, equipment depreciation, inspection, and machine maintenance.
What Is Direct Labor?
To contrast, direct labor costs are those costs that are associated with workers making the finished product.
These costs may include insurance costs, pension funds contributions, bonuses, wages, and all of the other costs that are associated with employing workers within your business.
What Is The Importance Of Calculating Conversion Costs?
Conversion costs are calculated by the account and production managers within a company in order to provide an insight into the production expenses and the profitability of the products.
Conversion costs also ascertain the value of both unfinished and finished inventories while making product-pricing models.
Conversion costs are also calculated in order to measure the overall efficiency of the production process while taking into account the manufacturing overheads included in the wider production process.
These are the overheads that have not been previously calculated in the prime costs.
Operation managers will also utilize conversion costs in order to work out any excess wastage that is occurring during the production process.
For instance, if a business encounters an unusual cost while the conversion cost is being calculated, then it should be included in the calculation as a day-to-day cost.
Here are some examples of costs that can be considered to be conversion costs:
- Factory Rent
- Factory Insurance
- Direct Labor
- Equipment Depreciation
- Equipment Maintenance
- Factory Supplies
- Machining
- Inspection
- Production Supervision
- Production Utilities
- Small Tools Charged To Expense
Here are some examples of how to accurately calculate conversion costs:
Example 1
Company A has incurred the following costs during the period of time relating to production:
- Depreciation on machinery: $6000
- Insurance Expenses: $12000
- Electricity: $14000
- Maintenance Expenses: $6000
- Direct Labor: $50000
When considering the costs that are provided above in order to calculate the conversion of Company A, you will need to follow this formula:
Direct labor + maintenance expenses + insurance expenses + electricity
= $50,000+ $6,000+ $12,000+ $6,000+ $14,000 = $88,000.
You should also note that depreciation expenses, maintenance expenses, electricity expenses, and insurance expenses are considered to be overheads and will need to be included when calculating direct labor costs.
Example 2
During a single month, Company B has spent $55000 in direct labor costs and $66000 in overhead-related costs.
As company B has produced 24000 units during a single month, the conversion costs will equal to $55000 + $66000 = $121000. In order to work out conversion costs per unit, you would need to divide 121000 by 24000.
Thus, the cost per unit would be $5.04.
Conclusion
To conclude, calculating conversion costs is an essential process for each company as they play a fundamental part in making essential business decisions and implementing basic accounting tasks.
Conversion costs can also easily be calculated to ascertain the overall cost per unit, which directly assists the company in specifying a price for their products.
The calculation that is made for the cost of sales (and is reported on the income statement) is also dependent on the conversion cost having been accurately calculated. Thus, it is imperative to gauge the overall value of a closing inventory and the cost of conversions is a line item on the company’s balance sheet and the income statement.
Therefore, you should follow the calculations that have been outlined above in order to appropriately ascertain your conversion costs. You should also ensure that you have taken any direct labor costs into consideration alongside overhead costs.
This will ensure that you are provided with an accurate figure in regards to your conversion costs.
Conversion costs are normally calculated by the account and production managers within a company in order to provide a highly efficient insight into the production expenses and the profitability of the products that they are selling.
Conversion costs also help to ascertain the value of both unfinished and finished inventories while making productive product-pricing models.
Conversion costs are also calculated in order to measure the overall efficiency of the production process while taking into account the manufacturing overheads included in the wider production process.
These are the overheads that have not been previously calculated in the prime costs and you should ensure that you are only including overhead costs that are relevant to conversion costs.
I hope that you have found this article to be informative. Thank you for reading.
Hello, my name is Jack O’Neil and I have been in the marketing industry for almost 10 years. I focus on online marketing, SEO, advertising, and more.
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