Conversion Costs Explained: Formula, Classification & Importance

How do companies keep track of their expenses, production, sales, and efficiency? Companies largely depend on different metrics to monitor these essential parameters. One such unit is called the ‘conversion costs’ and it refers to the expenses incurred in turning raw materials into inventory that is sellable. Those responsible for the accounting and financial aspects of a company will be able to understand the conversion costs and help you precisely determine, track, and measure the production expense. 

This blog details all there is to know about conversion costs including its classification, formula for calculation, real-world examples, significance, merits, demerits, and more.

Deciphering Conversion Cost

The expenses incurred in transforming raw materials into completed products are known as conversion costs. This concept is used in accounting costs to deduce the value of ending inventory reported in the balance sheet. Conversion costs are a metric that can also be used to understand the incremental costs of creating a product. Hence, it is very useful for setting the prices of products. When the component costs and the conversion costs of a product are combined, they represent a lower threshold value at which the product is generally sold. This enables the producer to at least earn back the cost incurred while making the product. 

Conversion costs are most often used in the manufacturing sector. All companies that produce any product will be well familiar with this term. Conversion costs are an important metric that enables businesses to make effective decisions that can result in enhancing the financial health of any organisation. Moreover, This metric enables the deduction of the sales costs on the income statement of the company. 

Classification of Conversion Costs

Conversions costs can be classified into the following expenses:

• Direct labour, along with benefits and other payroll taxes
• Depreciation of equipment costs
• Maintenance cost of equipment
• Rent of factory space
• Supplies of the factory
• Insurance of the factory
• Inspection
• Utilities and supervision
• Tools that are charged to expense

Businesses generally employ several metrics to monitor these critical factors. The people in charge of a company’s accounting and finances will be able to comprehend conversion costs and assist you in accurately calculating, monitoring, and measuring the costs incurred throughout manufacturing. This helps in setting prices for goods. Combining a product’s component costs with conversion expenses results in a lower threshold value. This is the price at which the goods are typically sold. This allows the manufacturer to recoup some of the expenses spent in producing the items. 

Formula for Conversion Cost

The calculation of conversion costs is rather simple. The formula is written as:

Conversion costs=  Direct Labor + Manufacturing Overhead Costs

All costs are included in the manufacturing costs apart from that of the raw materials. When additional expenses are incurred during a certain production run like reworking, it might make sense to remove these added costs from the conversion cost calculations. It is excluded as the costs are not incurred on a daily basis. 

Practical Examples of Conversion Cost

Consider a typical example of a company called PQR which has a total cost of approximately Rs. 50,000 in labour and other related expenses. Rs. 80,000 are factory overhead costs incurred in the month of March. If Company PQR makes approximately 30,000 units during the month of March, the conversion cost per unit would be (50,000+ 80,000)/30,000= Rs.4.33 per unit. 

Significance of Conversion Cost

Conversion costs hold a great deal of importance while making essential business decisions. The significances are elaborated below:

• Keeping your finances in check: Conversion costs enable a business to monitor its expenses closely during the production cycle. This enables a clear understanding of the costs incurred, thereby creating a way to manage money properly. This also helps avoid surprises that might hinder the company’s financial health.
• Setting the correct prices: Understanding conversion costs is a primary need to decide how much to charge your customers for your product. Businesses need to ensure they cover all the costs encountered during the production cycle along with a sufficient gain margin. Conversion costs help in making these decisions.
• Using resources wisely: Conversion costs allow efficient resource planning. They make sure that the workers, machines, and funds are not wasted and everything is used in the right manner to keep the production going without any roadblocks.
• Profitability: Conversion costs enable your company to run smoothly. It allows you to draw parallels between the making and selling costs to see if you are making a reasonable profit or not. It helps you to keep tabs while making sure the business can keep going in the long run.

Comparison: Conversion Cost vs Prime Cost

The table below highlights the key differences between conversion costs and prime costs. 

Pros and Cons of Conversion Cost

The pros of conversion cost include the following:

• Helps with the calculation of equivalent units of production while referring to the value of products that are partially completed.
• Enables the tracing of production-related expenses while minimising the amount of money spent on production.
• Allows the creation of product pricing models.
• Enables the identification and resolution of areas of improvement in the process of production. 

The cons of conversion cost include the following:

• Fails to provide information relevant to cost control.
• The use of conversion rate is restricted to the manufacturing domain that needs loads of conversion and processing.
• Conversion costs fail to recognise the outside influences that can affect business, such as market trends and economic shifts.
• Conversion costs provide only a limited view that represents only one portion of the entire business. It does not include the other aspects like marketing, administration, etc

Conclusion

Conversion costs, which include direct labour and manufacturing overhead, are fundamental to the manufacturing process. They provide a clear picture of the expenses involved in turning raw materials into finished products, essential for accurate financial reporting and strategic pricing decisions. By regularly tracking and analysing these costs, businesses can improve their production efficiency, optimise pricing strategies, and ultimately enhance their profitability. Understanding and managing conversion costs goes beyond accounting. It involves making informed decisions that drive success for your business. ​