Companies that produce inventory rely heavily on certain metrics to track production as well as to evaluate the efficiency of how inventory is produced and sold. One of the metrics commonly used to do this is conversion costs.

This metric refers to the expenses that go into turning raw materials into sellable inventory. In this article, we discuss what conversion costs are, common conversion costs that a company may incur and examples of how to use and track conversion costs in your business.

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What are conversion costs?

Conversion costs are costs a company spends on overhead and labor when turning raw material into a finished product. Calculating and being aware of your business' conversion costs can provide you with a clearer picture of how much you spend on inventory production.

Conversion costs allow managers and other supervisors to accurately measure and keep track of the expenses of production. Conversion costs can also be used in the development of product-pricing models as well as when estimating the end value of finished products. Business owners or managers may also look at conversion costs to determine if there is waste that can be eliminated and to better understand the efficiency of their production process.

The manufacturing industry is typically the industry in which conversion costs are most frequently used, but any company that produces goods can use this metric when making business decisions related to their products. Additionally, a company may be required to calculate its conversion costs to determine its cost of sales to report on an income statement.

How to calculate conversion costs

Here’s the formula used for calculating conversion costs:

Conversion costs = direct labor + manufacturing overhead costs

In the conversion cost calculation, direct labor refers to money spent on employees or other workers who directly work on production. For example, the salaries of the employees who are responsible for manufacturing goods, such as machinists or assembly-line workers, are considered direct labor costs. If you hire contract workers for a particular project, the wages you pay them would also be counted as direct labor expenses.

The overhead costs that are part of conversion costs are any expenses that aren't directly tied to the production of inventory but that are still necessary. For example, the cost to maintain the equipment that produces goods would be considered an overhead cost.

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List of common conversion costs in business

Conversion costs are considered any manufacturing cost that does not include the direct cost of raw materials. The following are a few of the most common conversion costs a company may incur:

Employee benefits

Salary

Wages

Payroll taxes

Production utility expenses

Equipment depreciation

Equipment maintenance costs

Factory or office rent

Insurance related to production, such as factory insurance

Supervision

Inspection expenses

Machining

Employee bonuses

Pension contributions

Smalls tools that are charged at expense

Related: Cost Avoidance and Cost Savings: What’s the Difference?

Prime costs vs. conversion costs

While prime costs and conversion costs are closely related, they are not the same. A prime cost is any expense that is directly related to the creation of finished inventory, while conversion costs are the expenses incurred when turning raw material into finished products.

Prime costs include both direct materials and direct labor expenses that are required to create complete products. Direct materials include the purchase of raw materials or any tangible part that is needed to complete a product. For example, the axle of a car would be considered a direct material because it is required to build a complete car.

Here’s the formula for calculating prime cost:

Prime costs = raw materials + direct labor​Direct labor costs include only costs related directly to the workers who took part in the creation of finished products. For example, if a painter was hired to paint the car being created, the wages paid to the painter would be included in the prime costs.

Both prime costs and conversion costs include some of the same expenses. For example, both prime costs and conversion costs will include direct labor costs into their calculations.

However, unlike conversion costs, prime costs do not include any indirect labor costs that may relate to production. Both of these metrics can be used to analyze the efficiency of a company's production process, but offer different information related to it.

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Related: Definitive Guide To Direct vs. Indirect Materials

Examples of using conversion costs

The following are examples of how conversion costs are used to measure the efficiency of their manufacturing process:

Example 1

During the month of March, Brayton Company has the following expenses related to the production of their products:


Particular Cost
Direct labor wages $50,000
Machinery depreciation $6,000
Utilities $5,000
Maintenance expenses $4,000
Factory rent $2,000

This means that the company had a total of $130,000 in conversion costs in January. The company was able to produce 25,000 units of product in the same month. The conversion cost per unit for the month of January was $5.20 ($130,000 in conversion costs divided by 25,000 units produced equals 5.2).