How to Calculate Conversion Cost | Formula | Example
Conversion Cost is the cost that company spends to convert the raw material to the finished goods. It only happens in the company that manufactures the goods. They spend a huge cost to produce the finished goods from the raw material.
The cost of a product is determined by the amount of labor and overhead needed to convert raw materials into finished goods.
The conversion of materials into a finished product is what we call “conversion.” It’s an important process that happens at every stage in the manufacturing cycle. The more complex and sophisticated the products become, though the higher this cost can potentially go up. The use of this ratio in process costing is to calculate the cost for both direct labor and manufacturing overheads. It’s important because it will become the cost of the inventory which will impact the selling price.
By using conversion costs, we can calculate an efficient way of determining equivalent units and unit costs.
The conversion cost is a key metric for managers to use when analyzing their company’s efficiency and effectiveness. This number represents the total amount that needs to be spent on materials, wages, or other costs during production processes. These costs will incur in order to satisfy demand at an affordable price while still maintaining profitability without over-spending.
Without proper control, it can lead businesses into financial ruin if not managed properly by management teams who know what’s best about how much each item should retail for.
Conversion Cost Formula
Conversion cost = Manufacturing Cost + Direct Labor
Manufacturing cost is the cost that company spends to support the production process but they cannot allocate to each product. They are the indirect cost that incurs to support the manufacturing, but it is very challenging to apply the cost to each production unit. It is very hard to calculate the manufacturing cost per unit.
The cost of manufacturing a product cannot be traced to just one unit in the process. Some common examples are insurance, building maintenance, machine breakup, and taxes on equipment or machining.
Direct labor is the cost that company spends on the workers for manufacturing directly. It refers to the workers who work to convert the raw material to the finished product.
They refer to the worker wage, bonus, workers’ salary, pension fund, and insurance for these workers.
It excludes the salary of management, office staff, and other people who are not working directly with the products.
Example of Conversion Cost
ABC is a manufacturing company that produces electronic devices for the market. During the month, they have spent the following costs:
- Purchase raw materials $ 100,000
- Pay for workers wage $ 50,000
- Pay for factory electricity $ 10,000
- Depreciation for the machinery $ 30,000
- Repair and Maintenence expense for machinery $ 10,000
- Salary for marketing department $ 50,000
- Pay for workers overtime $ 10,000
Please calculate the conversion during the month.
These are the expenses that incurs during the month, some of them related to conversion cost and other may not. We will separate the calucation as following:
Manufacturing cost: Factory electricity + Machinery depreciation + Repair & Maintenance
= $ 10,000 + $ 30,000 + $ 10,000 = $ 50,000
Direct Labor = Worker wage + OT for worker = $ 50,000 + $ 10,000 = $ 60,000
Conversion Cost = $ 50,000 + $ 60,000 = $ 110,000
Important of Conversion Cost
As we know, the conversion cost is the cost that we spend to convert the raw material to the finished product. There are several important of the conversion cost calculation as follows:
- Help to calculate the equivalent unit: At the end of the accounting period, management needs to calculate the ending inventory. Some of the products are still not yet finished but workers have worked on them. They are a work in progress, and they have to convert using the equivalent unit. Management needs to use the conversion cost to estimate the percentage of completion.
- Identify waste: the conversion cost will identify the costs that spend on manufacturing. It will allow the management to see all processing costs which help to identify the waste that is not intended to spend during the process. It helps them to reduce the unnecessary cost that is not adding value to the products. They can reengineer the production process if necessary.
- Help to calculate the cost of finished goods: conversion cost is a part of the finished goods. When we calculate the conversion cost, it will help us to calculate the cost of the finished goods at the end of the accounting period.
- Time-Saving: The calculation of conversion cost will save time from the calculation of equivalent units and the cost of finished goods.
- Calculate selling price: The product selling price arrive from the total cost and profit margin. When a company can calculate proper costing, it will help them to calculate the competitive price for the market.