In the world of business, numbers are everything. They are the very heart of a company’s success. They are what put food on the table and clothes on backs. They are what makes the world go ’round. But numbers can be tricky things.
Conversion costs use a formula to just make businesses’ lives easier when trying to calculate both the direct labor in their company and the manufacturing overhead.
This is all the types of jargon you need to know when running a business that is especially manufacturing.
This is all about how much a company has to spend on overhead and the labor which your employees work. When turning raw materials into an end product, there are so many different processes in the middle of this which need to be paid for.
Here are a few example of what might need to be paid for:
- Equipment depreciation
- Equipment maintenance costs
- Factory or office rent
Companies that are in manufacturing are the most likely to use this formula the most but every company which produces goods will use this at some point.
But why is it used? It is a great way of making your company run more effectively and also help the big business decision in terms of financials.
You want a healthy company on all levels and the financials are always really important to be stable and running well.
Direct labor is the term given to service, trade, and manufacturing jobs that are performed by workers who are paid by the hour and are not directly supervised by a supervisor who is on-site.
The direct labor method of manufacturing involves the application of labor on a product in order to produce a finished product. This is an online course on the subject.
Manufacturing overhead(MOQ) is a concept that refers to the costs that a company incurs in order to produce a single unit. It differs from other overhead costs in that it is only incurred once and remains constant per unit produced.
This article explains what MOQ is and how it can be controlled
Prime costs and conversion costs can be mixed up really easily because they are quite similar but not exactly the same.
While conversion costs is a term used to describe all of the costs associated with the making of the products, the prime costs are only related to the costs to make the end product.
These two can cross over at times because the cost of the end product process and everything else can be pretty similar. The formula for prime costs is:
Prime cost = raw materials + direct labor
Conversion Cost Formula
Conversion cost = direct labor + manufacturing overhead costs
This formula is very similar to the other one above but has the difference of the manufacturing overhead cost.
The direct labor part of the formula is talking about the people who work for the company and how much you have to pay them every year in total.
This includes their salaries which can be different for different roles. You might also hire external help from contractors which will be a one off payment which you need to include as well.
You also have the manufacturing overhead costs which links to everything else you spend money on to maintain the equipment and where everyone is working.
Everything costs in this industry which is why you need to know what you’re spending and track it.
Why Track Conversion Costs?
There are several advantages to using conversion costs for your business and most will because it just makes your business run more effectively overall.
- It can help you track how much you are spending in every area and can show you exactly where you need to improve to save on costs. It will also show you how much you are wasting in certain areas that can be saved instead of spending.
- It is important to always keep an eye on how much you are spending on production because there will always be ways to reduce this.
- Keeping track of these expenses will make it more obvious what needs to be changed in order to save more money and put it into something else that might need it.
- This process can also allow you to figure out pricing models for your products. It is always good to look towards the end product, the future, so you can estimate end values.
Overall, if you’re someone starting out their new business or are just interested in learning different terms in the business world, this is a great place to start.
All of the jargon can be a little bit confusing, but this is a simplified article which hopefully explains everything you need to know about both conversion costs and prime costs.
Knowing them both is important because they are quite similar and some people don’t know the difference between them.
Most companies have people to create and look through this information for them and create reports based on this information.
It helps people massively understand where they are going wrong in how much they are sending in certain areas and then helps them reduce these costs across the board.
Frequently Asked Questions
How Do You Calculate Conversion Costs?
It is Direct labor + Manufacturing overhead. The direct labor is linking directly to the people who work for the company which could be either salary or wages for contractors.
This is an important element to track as well as the manufacturing overhead because you need to know how much you’re paying people and how much it is to keep the production running.
The manufacturing overhead is how much you’re spending on the place you’re working in and the equipment maintenance.
What Is The Purpose Of Using Conversion Costs?
It is a great way to keep the equivalent costs together instead of trying to calculate them all separately. These can be grouped together and seen as one price instead of confusing everyone by having lots of numbers spread out everywhere.