What Is Conversion Cost? - Formula, Examples, Calculation

Conversion cost is the sum of direct labour and manufacturing overhead costs incurred during production. It is crucial in determining the total cost of manufacturing a product. The formula for calculating conversion cost is: Conversion Cost = Direct Labor Cost + Manufacturing Overhead Cost

Generally, a business is looked upon as developing and selling products and earning profits. The raw materials required for the product are transformed through specific processes, and finally, products are developed for sale in the market. This transformation requires money, utilities and many other factors. The expenses involved in this transformation are known as the conversion cost of a product.  From the definition, the conversion cost is a term used to refer to the costs incurred by a company while converting raw materials into furnished products that are up for sale in the market. Conversion costs include labour, raw material, machinery, etc, and other manufacturing overheads in the product's manufacturing. In short, it is the cost of a product incurred by a company while manufacturing it. 

Did you know? In some industries, conversion costs, including labour expenses, can exceed the total expenses on raw materials. In the food industry, converting raw food materials into edible food items is labour-intensive and requires specialised machinery.

What Is Conversion Cost?

The expenses incurred when turning raw materials into final products are called conversion costs. Direct labour costs and manufacturing overhead costs are included. The pay and benefits paid to workers directly involved in the production process, such as machine operators or assembly line workers, are referred to as direct labour costs. Other indirect costs associated with manufacturing, such as factory rent, utilities, maintenance, supervision, and equipment depreciation, are included in the term "manufacturing overhead cost." For assessing the entire cost of production and figuring out the profitability of industrial activities, conversion costs are crucial.

The Formula of Conversion Cost

The formula used for the calculation of conversion cost is given by Conversion Costs =  Labour Costs(Direct) Manufacturing Overheads 

Let us understand the terminologies in detail:

1. Manufacturing Overheads: Expenses like the rent of machinery, electricity, taxes, insurance, etc., cannot be imposed on a single production unit or single process. They comprise the total running cost of the industry and can’t be traced down to a single process. All such expenses indirectly affecting the production process are generally expressed as Manufacturing Overheads. 
2. Labour Costs: It is the cost of the employees directly involved in manufacturing the product. It includes the wages of the employees, bonuses, etc. This cost can be minimised by bringing up automation in the production process. 

Why Are Conversion Costs Important?

Conversion costs are very useful in a company’s financial management. Here’s how:

1. Conversion costs help the company calculate their product manufacturing expenses and inventory costs. They can help the company plan and financially manage its product production process beforehand to avoid problems.
2. They can help calculate the manufacturing process's financial efficiency and thus help the company maximise its profits. 
3. They can be used to avoid any waste of money as it helps the company to figure out the day-to-day costs of the process and identify the unwanted expenses, thus saving money for the company. 
4. They play an essential role in preparing a company’s balance sheet. Conversion costs are an essential part of the company’s total expenses during the financial year. 

How Are Conversion Costs Different from Prime Costs? 

Both conversion and prime costs are accounting terminologies widely used in business and financial planning. Prime costs are directly associated with the manufacturing system, such as the direct labour cost and the cost of raw materials used in the process. They can be calculated using a simple formula as follows: Prime Costs = Raw Material cost Labor costs.
The definition and formula of both terms look similar, but the key difference between prime and conversion costs is the inclusion of overhead costs and raw material costs. Prime costs do not consider overhead costs, whereas conversion costs do. Instead, prime costs include the raw material cost, which is not added up in conversion costs. The main objective of prime costs is to help the company to decide the maximum retail price (MRP) of the product and thus help the company to decide their profit margin. In contrast, conversion costs help the company to manage the expenses involved in manufacturing and production and bring efficiency to the process. 

Advantages of Conversion Cost

There are several advantages of conversion cost. Some of them are discussed below.

1. They help to design an efficient production plan and help to determine the accurate amount required to convert raw materials into fully-furnished products.
2. They help eliminate unwanted expenses in the production process and streamline it.
3. It makes it easy for the production in charge to keep track of the current expenses involved in the production process. 
4. Combined with prime costs, they can provide accurate statistics about the company’s total expenses. 

Also Read: A Detailed Guide About What is a Cash Conversion Cycle

Disadvantages of Conversion Cost

With several advantages, there are some disadvantages of conversion cost, which are as follows:

1. It does not take into consideration all the types of costs incurred in the production of a product. 
2. In cases where the raw material conversion is minimal, conversion costs are of no use as, in such cases, it may give inaccurate results.
3. They cannot be a  reliable source for the company's financial management as it does not consider direct costs like raw material cost. Thus it cannot provide inaccurate results about the actual financial needs of the manufacturing and production department. 
4. As conversion costs are calculated on paper, they sometimes fail to capture the real-world problems that may arise during the actual conversion of raw materials. 

Examples of Conversion Costs 

Here are a few examples of expenses that can be included under conversion costs:

• Machinery maintenance and rent
• Factory rent 
• Employee wages and bonuses 
• Inspection costs 
• Electricity and fossil fuel expenses 
• Machinery depreciation costs 
• Inspection expenses 
• Equipment or factory insurance

Example 1- Consider a smartphone company XYZ. It produced 15,000 units in March 2023. The expenses list for the same is as follows:

1. Direct Labour Costs - ₹45,000
2. Electricity cost - ₹40,000
3. Raw Material (Metal frames, semiconductor chips, etc.)  - ₹80,000
4. Assembly plant rent - ₹50,000 
5. Transportation charges - ₹35,000

For the following list of expenses, the conversion cost can be calculated as follows: The electricity bill, transportation charges, and assembly plant rent are all considered Manufacturing overheads as they are indirectly involved in producing and selling the final product. 

Conversion cost = Direct Labour Costs Manufacturing overheads = ₹45,000 ₹(40,000 50,000 35,000)= ₹1,70,000

Therefore the conversion cost per unit is = Total conversion cost / No. of units produced = ₹1,70,000 / 15,000 = ₹11.33 If the figure is too high considering the market's current situation, the company XYZ can take appropriate decisions to lower the cost and thus bring financial stability and efficiency to the production process. If we look at the prime cost calculation for the same example, it will be as follows: 

Prime costs = Direct labour Cost Raw Material cost = ₹45,000 ₹80,000 = ₹1,25,000 

Example 2 - A car company ABC produced 100 units in Feb 2023. They invested ₹2,00,000 in galvanised iron sheets, ₹1,50,00 in aluminium sheets, ₹80,000 on SBR tyres, and paid ₹1,00,000 as employee wages. 

For shipping the raw materials to the desired location, they paid ₹30,000 to the transportation company. To speed up the production process, they rented an assembly plant for ₹1,50,000/Month. For the final assembly of cars, they rented heavy-duty machinery for ₹80,000 and paid ₹50,000 as the electricity bill.

The iron, aluminium, and SBR tyres expenses are considered raw material charges in the example.

Raw Material cost = ₹(2,00,000 1,50,000 80,000) = ₹4,30,000

Direct labour costs = ₹1,00,000

Charges paid for transportation, electricity bills, machinery rentals, and factory rent are considered Manufacturing overheads. 
Manufacturing Overheads = ₹(30,000 1,50,000 80,000 50,000) = ₹3,10,000

Therefore, Conversion cost = Direct labour cost Manufacturing overheads = ₹1,00,00 ₹3,10,000 = ₹4,10,000 

Conversion cost per unit = Total conversion cost / No. of units produced = ₹4,10,000 / 100 = ₹4,100 

Also Read: What is Process Costing?

Conclusion

Conversion cost is one of the most basic accounting tasks in almost all the major business sectors. Conversion costs reflect a company’s total amount spent converting raw materials into fully-furbished products. It includes the direct labour costs and the amount spent on indirect factors like electricity bills, factory rent, etc., which cannot be directly traced down to the production of a single unit. Conversion costs are beneficial, especially for manufacturing businesses which have to deal with conversion on a large scale daily. They help the company to take important financial decisions and help them to bring efficiency to the production system. 
 

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