January 26, 2022

SB-Accounting

Accounting + Finance Blog

Conversion Cost Meaning and Key Explanations

Conversion cost is the expenses incurred to change the form of raw materials into useful products that are consumed by you and me.
Shares

Conversion cost is an important term to any manufacturing business. You might be a shoe cobbler (someone who makes shoes), bakes cakes, or cooks foods for consumers, you are manufacturing something. You need to know the conversion cost of that product you make.

Definition of Conversion Cost

1. Conversion cost is the expenses incurred to change the form of raw materials into useful products that are consumed by you and me.
2. It can be defined as the cost of changing raw materials into finished goods. Or the difference between the cost of production and the cost of raw materials.

Key Explanations

Expenses. Manufacturing firms have certain types of expenses that are incurred in the production of goods. A brick-making firm will ensure wages are paid to laborers that make the bricks is an example. It will need electricity supply and equipment (depreciation) to process the raw materials required to make bricks. These expenses are what we refer to as conversion costs.

READ ON  Cost accounting functions you should know

Raw materials. The ingredients of materials needed by a producer to make a product. In our example of brick-making business, sand, certain types of stones, cement, and water as raw materials. It is from this material that the bricks are formed.

Useful Product. The result of the conversion is a product. The product is useful to consumers. Bricks are useful to those building houses. Cars are useful to individuals for mobility. Ice Creams are useful in hot weather.

Examples of Conversation Costs

  • Direct Labour/Wages
  • Depreciation of plant and machinery
  • Factory rent
  • Factory electricity
  • Repairs of plant and machinery
  • Repairs of factory building
  • Depreciation of factory Building and
  • Other indirect costs

The formula for Conversion Cost

The conversion cost formula is Production Costs minus Raw Materials Costs. Or Direct Labour Cost + Production Overheads

READ ON  Meaning of Pre Production Cost and Key Explanations

Production cost is called total product cost or manufacturing cost. It is the total costs incurred to make a product. In a bricks-making company, the manager has to know the total amount spent to make bricks.

Raw Materials Costs. This is the cost of purchasing materials required for production. The cost of sand, cement, water, and certain stones needed to make bricks forms the raw material expenses for the firm.

Direct Labour cost or direct wages is the amount paid to individuals who are involved in making the product. The person operating the machine used to make bricks is direct labor is an example. However, the supervisor is indirect labor. This cost cannot be included in the conversion cost.

Production/Factory Overheads are expenses necessary to make the product. These expenses occur in the factory used to make the product. In the list above, aside from direct labor/wages, all other examples provided are production overheads.

READ ON  Standard Cost Meaning and Key Explanations

Importance

1. It is used to set the price of a product. This includes setting up a profit margin.
2. It is used to calculate closing inventory cost which is listed as a line item in the statement of financial position.
3. It is used to plan, control, and monitor costs.

Conclusion

Conversion cost is the expenses incurred by an entity to change the form of raw materials into finished goods. The term is used mostly by manufacturing firms and in cost accounting. When calculating this cost, we examine the direct cost and factory overheads expenses. This is useful for determining the selling price of a product.

Shares