Conversion Cost

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What is Conversion Cost?

Conversion cost is the cost incurred by any manufacturing entity in the process of converting its raw material into finished goods capable of being sold in the market and usually includes total value of labor cost and other applied overheads like factory overheads, administrative overhead, etc.

Formula

Here,

• Manufacturing OverheadsManufacturing OverheadsManufacturing Overhead is the total of all the indirect costs involved in manufacturing a product like Property Tax on the production premise, Remunerations of maintenance personnel, Rent of the manufacturing building, etc. read more means the expenses which can be directly attributed to each unit of product or the process. These include electricity bills, rent, depreciation, plant insurance, repairs and maintenance of plants, etc.
• Direct LaborDirect LaborDirect labor costs refer to the total cost incurred by the company for paying the wages and other benefits to its employees against the task performed by them, which are straight away related to the manufacturing of the products or provision of the services.read more is the cost associated with manufacturing the product directly such as wages, salaries to workers, pension fundsPension FundsA pension fund refers to any plan or scheme set up by an employer which generates regular income for employees after their retirement. This pooled contribution from the pension plan is invested conservatively in government securities, blue-chip stocks, and investment-grade bonds to ensure that it generates sufficient returns.read more for workers, insurance of production staff, supervision, etc.

Conversion Cost Examples

Some examples of conversion cost are as follows –

• Machinery depreciation
• Plant and machinery maintenance
• Salary to production staff
• Direct labour benefits
• Rent of factory
• Utility bills
• Factory insurance
• Production supervision
• Salary of staff related to production

Let us take an example to understand this concept.

Samsung has a cell phone production unit with a production capacity of 10,000 daily it incurs day to day expenses to carry on its business running. The company wants to know its conversion cost from the following mentioned information.

Solution:

Direct Labour = $3,00,000

Manufacturing Overheads = 10,000 (Equipment Depreciation) + 5,000 (Factory Insurance) + 80,000( Indirect Material) + 20,000(Factory Rent) + 90,000(Electricity expense) + 1,00,000(Maintenance expense) + 5,000(Inspection expense)

• Manufacturing Overheads = $3,10,000
• = $3,00,000 + $3,10,000
• Conversion Cost = $6,10,000
• = $6,10,000 / 10,000
• Conversion Cost per Unit = $610

Importance

• This is a measure used to allocate unallocated overhead cost to products manufactured for better cost planning and monitoring,
• It helps business to ascertain the cost of inventory which needs to be reported in the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more as an asset.
• The proper application helps businesses to determine the selling price per unit, thereby achieving its profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more.
• In the case of inefficiencies, it helps in redesigning and reengineering of the production.

Conversion Cost vs Prime Cost

• Conversion cost can be defined as a costing terminology that provides information regarding expenditure incurred in the form of direct labour and overhead to convert basic raw material into finished goods. At the same time, the prime costPrime CostPrime cost is the direct cost incurred in manufacturing a product and typically includes the direct production cost of goods, raw material and direct labour costs. It is an essential part of total manufacturing expenses. Costing and effective pricing of the goods are primarily determined on their basis.read more is another costing term that quantifies the value of direct material, direct labour, and other direct expenses incurred in manufacturing any particular product. Conversion cost and prime cost both are manufacturing sector terminology and used as a tool to determine the effectiveness in the production of a particular product.
• Both conversion and prime cost use many of the same production factors, but each has a different opinion on product efficiency. Prime cost uses both direct material and direct labour to complete a product while conversion cost does not include a direct material cost. Certain cost elements are included in one and excluded on another like prime cost does not include overhead expenses which are applied in conversion cost. The main objective of the prime cost is to set the price of a product with the desired profits. In contrast, the conversion cost is calculated in order, to sum up, and resolve any manufacturing inefficiency. Prime cost is calculated and presented at the beginning of the cost sheet, but there is a set a standard that required the calculation of conversion cost until and unless the manger desires it.

Advantages

• It helps to determine the amount spent in turning raw material into a product.
• It helps in eradicating any deficiency in the production process and helps in reducing the cost of productionCost Of ProductionProduction Cost is the total capital amount that a Company spends in producing finished goods or offering specific services. You can calculate it by adding Direct Material cost, Direct Labor Cost, & Manufacturing Overhead Cost. read more.
• It helps managers to supervise and keep track of expenses of production.
• It is used in developing a price model for a product and estimating the cost of the final product.
• Managers and sometimes, business owners use conversion costs to find out if there is any wastage that can be eliminated.
• This is used to determine the cost of salesCost Of SalesThe costs directly attributable to the production of the goods that are sold in the firm or organization are referred to as the cost of sales.read more to report it on the financial statements (if applicable).

Disadvantages

• It does not give an idea about all the costs incurredCosts IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. read more in production/ manufacturing as it considers only two elements – direct labour and overheads.
• This concept is not much relevant in cases where the product does not undergo any conversion and can be sold directly with minimal processing.
• This concept cannot solely be relied on for cost controlCost ControlCost control is a tool used by an organization in regulating and controlling the functioning of a manufacturing concern by limiting the costs within a planned level. It begins with preparing a budget, evaluating the actual performance, and implementing the necessary actions required to rectify any discrepancies.read more and reduction program as it does not cover all elements of cost. There are better costing mechanisms like marginal costing, process costingProcess CostingProcess costing is a method of costing wherein the products go through two or more processes and the costs are assigned/charged to individual operations averaged over the number of units produced during that time. It is used commonly in manufacturing units like paper, steel, soaps, medicines, vegetable oils, paints, rubber, and chemicals.read more, etc. which provides better insights into the cost incurred.

Recommended Articles

This has been a guide to What is Conversion Cost & its Definition. Here we discuss its formula, calculations, examples along with advantages, and disadvantages. You can learn more about from the following articles –

• Committed Cost
• Contract Costing
• Step Cost
• Semi-Fixed Cost