Conversion Cost in Accounting: Definition & Examples

In accounting, conversion costs are important for balance sheets and income statements. And if you cook, you are actually already familiar with
these things. In this lesson, we will learn about conversion costs and practice calculating them.

Conversion Costs in Accounting

If you cook, you already know all about conversion costs. When you make your favorite dessert, do you follow a recipe? Do you go to the store
and purchase your ingredients? Do you need tools to make your dish? Imagine you are making a banana split. It takes labor, electricity, water, a
refrigerator, equipment, and other supplies. Plus, we have those delicious ingredients. Let's come back to our banana split later and learn about
what makes up conversion costs.

Conversion costs are direct labor costs combined with manufacturing overhead costs. Direct labor costs are just the costs to employ those who
actually make a product. Manufacturing overhead costs are things like indirect labor, utilities, supplies, equipment, insurance, taxes, tools, and
regulatory obligations. We will look at these costs in more detail later in the lesson.

So when we think of the costs that must be incurred to take raw materials and turn them into products, we are referring to conversion costs. The
formula for conversion costs is:

Conversion Costs = Direct Labor Costs + Manufacturing Overhead Costs

Conversion costs may also be called production costs. We need to know these costs in order to determine:

1. The cost of creating one unit of a product, which is used to set a price for a good
2. The total costs of existing inventory, which is needed for balance sheets
3. The costs of goods sold, which is required for income statements

Notice that the actual costs of the necessary raw materials are not included in conversion costs. But we want to focus on what is included in
conversion costs, so let's look into what makes up direct labor costs and manufacturing overhead costs.

Direct Labor Costs

Direct labor costs may seem to be pretty straightforward; however, these costs don't just include wages. You want to tally all of the costs that
must be paid for the labor needed to actually manufacture a product. This means you have to add in insurance (including life, medical, short-term
disability, long-term disability, workers' compensation, vision, hearing, and dental), payroll taxes, pension contributions, benefits costs,
recruitment fees, and training costs. Direct labor costs should also include all of the expenses necessary to hire and retain an employee who
physically works to turn the raw materials into a product.

Manufacturing Overhead Costs

Manufacturing overhead costs are those manufacturing costs necessary to produce a product, excluding the direct labor costs. This includes
indirect labor costs, which are labor costs incurred by a company for those employees who are not directly involved in producing the actual
good. Examples of employees in this category are managers, nurses, security guards, janitors, cooks, maintenance workers, accountants,
executives, trainers, parking attendants, and secretaries.

Manufacturing overhead costs that don't include labor are pretty comprehensive. These include:

 Utilities necessary for production, such as fuel, natural gas, oil, water, Internet, telephone, and sewer
 Equipment costs, which also includes repairs, depreciation, replacement, and disposal
 Factory costs, including taxes, rent, insurance, and maintenance
 Tools and machinery, like hand and pneumatic tools; lifting, pushing, and pulling devices
 Supplies: paper towels, cleaning materials, soap

Finding Conversion Costs

Let's go back and look at making our banana split. Let's say it takes us two hours to get everything together and thirty minutes to make the banana
split. At $10 an hour, what are the direct and indirect labor costs?
Direct labor costs would be 0.50 x 10 = $5

Indirect labor costs would be 2 x 10 = $20

So we have one part of our formula for conversion costs and one part for our manufacturing overhead costs. Let's look at the rest of our
manufacturing overhead costs. Do we include the costs of our bananas, whipped cream, nuts, cherries, and hot fudge? We don't include raw
materials, so we don't include these. But we have to include the costs of the utilities, equipment, tools, and supplies needed to keep all of our raw
materials fresh and put them together. If we say these costs come out to $15, then we have everything we need for our conversion cost: 5+35 =
$40. The $35 comes from our indirect labor costs ($20) combined with our other manufacturing overhead costs ($15).

Let's look at a business example. Say we are looking to find Lotsa Fabrication's conversion costs for a widget. Lotsa Fabrication incurred $30,000
during November in direct labor and related costs. The company also incurred $55,000 in factory overhead costs. Lotsa made 30,000 widgets
during November. This made the conversion cost $85,000. If we want to know conversion costs per widget for the month, we divide $85,000 by
30,000 and get $2.83 per unit.

Lesson Summary
To summarize our lesson on conversion costs in accounting, we learned about direct and indirect labor costs. We used a formula for
conversion costs where direct labor is added to manufacturing overhead costs. Indirect labor costs are included in manufacturing overhead costs
along with other things such as utilities, equipment and factory costs, tools and machinery, and supplies. The formula is:

Conversion Costs = Direct Labor Costs + Manufacturing Overhead Costs

We used this formula to calculate conversion costs, but it can also be used to find one of the missing variables, such as direct labor costs or
manufacturing overhead costs. From this, we can set our price, fill in our balance sheet, and complete our income statements.