Manufacturing companies keep track of production and expenses by following specific accounting measures. Conversion cost is one such method in cost accounting that helps understand direct labour and manufacturing overhead costs.
If you are an accountant or finance manager, then knowing the conversion costs can help you accurately measure the production estimates. It also allows you to develop a product pricing model and the value of finished goods.
But, if you need a detailed idea about conversion costs, how they differ from prime costs, their examples, advantages, and others, then this is the right article for you. Let’s understand conversion costs better.
What is Conversion Cost?
Conversion cost is the cost the company spends on unusual expenses and direct labour when turning raw materials into finished products. This costing formula is used in cost accounting by those running manufacturing businesses or any company producing goods. It is used to derive the value of ending inventory and show it in the balance sheet.
What Is The Conversion Cost Formula?
Calculating conversion costs helps the business to measure the exact value of its production processes and expenses. Here is the simple conversion cost formula. Conversion Cost = Direct Labour Cost + Manufacturing Overhead Costs It is the cost of labour and running costs, except for raw materials.
- Here, direct labour involves the money spent on those engaged in direct production.
- It includes salaries, wages of the employees or workers, pension funds, insurance of production staff, employee supervision, and more.
- Manufacturing overhead/running cost involves any necessary expenses to maintain the equipment used in the production.
- It includes electricity bills, depreciation, rent, plant insurance, maintenance of plants, repairs, and more.
Knowing what it will cost to turn finished goods will help the manufacturers' product pricing.
Read Also How Is the Economic Order Quantity Model Used in Inventory Management?
Types Of Conversion Costs
Most conversion costs are likely to be classified as manufacturing overhead, while others are in direct labour or the cost of regular working hours. Some of the conversion costs that the company may incur are-
- Factory or office rent
- Production Supervision
- Inspection expenses
- Machining
- Employees bonus
- Equipment depreciation
- Payroll taxes
- Salary to production staff
- Production utilities
- Factory Insurance
- Equipment maintenance like plant and machinery
- Small tools are charged to expense
- Factory supplies
- Employees benefits and more.
Conversion Cost Examples
The examples of conversion cost will let you understand its calculation and usage more efficiently. Furthermore, it helps you to make favourable financial decisions that benefit you in the future.
The following are the examples to understand conversion costs- Example-
XYZ Ltd Co. incurred the following expenses in December while producing 20,000 units. The expenses list for the same are-
- Electricity costs- Rs-10,000
- Transportation charges- Rs-25,000
- Raw materials- Rs-20,000
- Assembly plant rent- Rs-35,000
- Direct labour costs- Rs-50,000
So, with the help of the formula,
Conversion cost = Direct labour + manufacturing expenses
Thus, Conversion Cost = Rs-50,000+ Rs (10,000 +25,000 +35,000) =Rs 50,000+ 70,000 =Rs 120,000
Again, conversion cost per unit is the total conversion cost/no of units produced =Rs. 120,000/20,000 = Rs. 6
Read Also Production Possibility Frontier (PPF)
Importance Of Calculating Conversion Cost
If the company understands the value of calculating conversion costs, it will help them to manage the accounting part more accurately. Some of the importance of calculating conversion costs are the following-
- It helps the business find out the inventory cost for further reporting in the balance sheet as an asset value.
- It determines the selling price per unit, which helps to achieve a profit margin.
- It helps to redesign and re-engineer the production if there are any flaws.
- It helps the company calculate its product manufacturing expenses and inventory costs, which helps it boost its production processes.
Conversion Cost vs. Prime Cost
Conversion cost and prime cost are important factors that help businesses make smart decisions related to their production and expenses. Let’s understand some basic differences between these two costs-
| Differences | Conversion Cost | Prime Cost |
|---|---|---|
| Meaning | Conversion cost involves manufacturing overhead expenses and direct labour costs. These are necessary to convert raw materials to finished goods. It helps in tracking the expenses of your production process. | Prime costs are directly associated with the manufacturing system. It considers the value of direct labour, materials, and expenses that happen in the manufacturing of any product |
| Components | Conversion costs include direct materials costs and manufacturing overheads. | The components of prime costs include direct labour and direct materials. |
| Example | An example of conversion cost includes manufacturing products. For example, in furniture, costs related to wages of labourers, wooden planks, and more. | If you consider furniture again, examples of prime cost include paints required for furniture, screws required to hold tight planks, wages of labourers, and more. |
| Formula | Conversion cost= Direct labour cost + manufacturing overhead costs | Prime cost = Raw Materials + Direct Labour |
| Reason for Calculation | The main aim of calculating prime costs is to know the maximum retail price for the company. | Prime cost is estimated to manage expenses incurred during the production cycle and bring efficiency. |
| The Essence Of Price | Conversion costs do not include direct material costs. | The prime costs cover the price of direct materials for their calculation |
| Presentation In The Cost Sheet | The calculation of conversions depends on the requirements of the managers and the company. | It is calculated at the beginning of the cost sheet. |
Advantages Of Calculating Conversion Cost
Some advantages of conversion costs are-
- It helps companies decide on effective production plans to get profits.
- It can further determine the accurate amounts required to convert raw materials to finished products.
- It makes it easy for the production in charge to track the current expenses involved during the manufacturing process or planning.
- It helps streamline production expenses that occur frequently during the production process.
- It is used to determine the cost of sales to report on financial statements.
- It is used in developing the price model of the product manufacturers and estimating the cost of final products.
Calculate Conversion Costs To Boost Your Manufacturing Business
Conversion costs are an easy way to know the production expenses of direct labour and manufacturing overhead. Also, it helps the company to make effective business decisions that suit its profit margin. Moreover, understanding conversion costs will help to set targets for revenue, expenses, and profits for the manufacturing business. You can assess the effectiveness of your ad campaigns and determine the success of your marketing strategy.
For better results, you can trust TranZact, which effectively handles manufacturing business, easily converts raw materials into finished goods, and saves your time. Also, various services like production processes, production reports, and others are done smartly with cost-effectiveness.
FAQs
Q1. Why is it called Conversion Cost?
It is called conversion costs because it helps to convert the raw material into finished goods with combined direct labour and manufacturing overhead costs. It helps to make pricing decisions for finished goods to gain profits.
Q2. How do conversion costs differ from other types of costs?
Conversion costs are the expenses of manufacturing overhead and direct labour that are needed to produce raw materials into finished products. It differs from prime cost as it includes direct labour and materials. Also, measuring conversion helps to set the desired level of profits, while prime costs control the efficiencies of the manufacturing process.
Q3. How can a company manage and reduce conversion costs?
A company manages and reduces conversion costs by increasing production efficiency and reducing labour costs in the production process. Also, they follow specific strategies like investing in technology, reducing material waste, and others to help them reduce conversion costs and improve efficiency.
Q4. Why is tracking conversion costs important for businesses?
There are many advantages to tracking conversion costs. Some are-
- It is important for businesses as it helps them analyse the cost per unit and accordingly make decisions.
- It helps them to analyse the success of marketing campaigns and provides valuable data about user interaction.
- It helps to determine the marketing budget for their business.
- It helps to maximise the return on investment(ROI) by informing your budget.
- It helps to determine which pages are driving traffic and conversions.Knowing the average price of sales helps you to set pricing priorities for your manufacturing products.
