14 julio, 2024

Conversion cost: what it is, how it is calculated, examples

What is the conversion cost?

He conversion cost It is the amount incurred for expenses during the transformation of raw materials into finished products. In other words, it is the amount of direct labor and overhead costs required to turn raw materials into an actual product.

Conversion cost is a term used in cost accounting that represents the combination of direct labor costs and manufacturing overhead costs. That is, they are the costs of production other than the cost of direct materials of a product.

Conversion cost is calculated to find out production costs, develop product pricing models, and find out the value of finished goods inventory. Managers also use this cost to assess the efficiency of the production process.

If a company incurs unusual conversion costs when running a specific production run, such as reconditioning parts due to incorrect tolerances, it makes sense to exclude these additional costs from the conversion cost calculation, as they do not represent day-to-day costs.

Conversion Cost Components

The production department of a company is full of costs. Each cost represents a portion of the materials, labor, or overhead needed to make finished products.

Conversion costs include all direct or indirect production costs incurred in activities that convert raw materials into finished products.

There are two main components to conversion cost, production overhead costs and direct labor cost.

General production costs

Overhead costs are defined as those expenses that cannot be directly attributed to the production process, but are necessary for the operation, such as electricity or other utilities necessary to keep a manufacturing plant operating around the clock.

Factories must use electricity to power their machines and make products, but the dollar amount of electrical costs cannot be tied directly to the products that were made. They must be assigned and calculated.

Direct labor cost

Direct labor is the cost associated with workers actively manufacturing the products. This includes wages and salaries paid to assembly line workers, machinists, painters, and anyone who helps make products.

Direct labor costs are the same as those used in the prime cost calculations.

Conversion Cost Uses

Conversion costs are used as a measure to calculate efficiency in production processes, but taking into account overhead costs, which are left out of the prime cost calculation.

Operations managers also use conversion costs to determine where there may be waste within the manufacturing process. Both the job production and process cost systems can use conversion costs to produce goods.

However, companies may be more willing to apply this concept to the cost per process system. This is due to the inherent characteristics found in this method of production.

How is it calculated?

Companies often have different methods to calculate this cost and thus apply it to the goods produced. Since conversion activities involve labor and manufacturing costs, the conversion cost calculation is:

Conversion cost = direct labor + manufacturing overhead.

component calculation

On the one hand, the labor required to transform raw materials into finished products must be monitored. To do this, all production employees are required to enter and leave the plant with an established time sheet document.

In this way, all the hours worked can be added, and then multiplied by the cost of labor. Thus, direct labor costs for production can be determined.

On the other hand, all indirect expenses associated with the operation of the production department are identified. Among these costs are utilities, maintenance, quality control products, production facility security, depreciation, and minor supplies.

The totals of these manufacturing overheads are added up. A common method of doing this is to include all of these expenses for a set period of time, such as a month.

final calculation

Subsequently, total direct labor costs and total manufacturing overhead are added together. This results in the total cost.

Finally, this total cost is divided by the quantity of goods produced during the same period of time. This value represents the conversion cost per unit for all manufactured products.

alternate formula

Since total manufacturing costs have three components: direct materials, direct labor, and manufacturing overhead, conversion costs can also be calculated using the following formula:

Conversion Costs = Total Manufacturing Costs – Direct Materials.

examples

An example of direct labor is the employees who work on a manufacturer’s assembly line.

Examples of manufacturing overhead include utilities, indirect labor, repairs and maintenance, depreciation, etc., that occur within the company’s manufacturing facilities.

Company A

During the month of April, Company A had a total cost of $50,000 in direct labor and related costs, as well as $86,000 in general manufacturing costs.

Company A produced 20,000 units during April. Therefore, the conversion cost per unit for the month was $6.80 per unit. This is the result of the following calculation: $136,000 corresponding to the total conversion cost ($50,000 + $86,000), divided by the 20,000 units produced.

XYZ Company

The following information is used in order to calculate the conversion cost per unit for an accounting period of Company XYZ:

Units produced: 50,000.
Direct salaries: $38,000.
Indirect salaries: $5,000.
Direct material: $29,000.
Indirect material: $1,000.
Equipment depreciation: $6,500.
Office expenses: $10,000.
Factory insurance: $2,000.

Suppose there was no work-in-process inventory at the beginning and end of the accounting period.

Direct labor = $38,000.

Factory overhead = $5,000 + 1,000 + 6,500 + 2,000 = 14,500.

Total Conversion Cost = Direct Labor + Factory Expenses = $38,000 + $14,500 = $52,500.

Therefore, the conversion cost per unit will then be equal to: $52,500 / 50,000 units = $1.05.

References

Kirk Thomason. How to Calculate Conversion Costs in Accounting. Retrieved from bizfluent.com.
Steven Bragg. Conversion cost. Retrieved from accountingtools.com.
What are Conversion Costs? Retrieved from myaccountingcourse.com.

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