Conversion costs are those production costs required to convert raw materials into completed products. The concept is used in cost accounting to derive the value of ending inventory, which is then reported in the financial statements. It can also be used to determine the incremental cost of creating a product, which could be useful for price setting purposes. Since conversion activities involve labor and manufacturing overhead, the calculation of conversion costs is:
Thus, conversion costs are all manufacturing costs except for the cost of raw materials. Examples of costs that may be considered conversion costs are:
- Direct labor and related benefits and payroll taxes
- Equipment depreciation
- Equipment maintenance
- Factory rent
- Factory supplies
- Factory insurance
- Production utilities
- Production supervision
- Small tools charged to expense
As can be seen from the list, the bulk of all conversion costs are likely to be in the manufacturing overhead classification.
If a business incurs unusual conversion costs for a specific production run (such as reworking parts due to incorrect tolerances on the first pass), it may make sense to exclude these extra costs from the conversion cost calculation, on the grounds that the cost is not representative of day-to-day cost levels.
Example of Conversion Costs
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. ABC produced 20,000 units during March. 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).