Conversion costs

Conversion costs consist of those costs that arise from the activity of transforming a raw material with an original or virgin state to an already manufactured product.

Conversion costs

These costs are mainly made up of two costs, on the one hand that of labor and on the other hand that related to the transformation or manufacturing process.

It should be noted that we refer to the workforce that is directly involved in the transformation or manufacturing process, so it must be detailed which employees have a leading role in the process or not.

In turn, the conversion costs belong to the prime costs. That is, if the prime costs are the set of expenses that are directly related to the manufacture of a product or the provision of a service, in this case the conversion costs are part of the manufacturing costs. This means that in a company that dedicates its main activity to the provision of services with few exceptions, you will not have expenses to classify as ‘conversion costs’.

Objectives of calculating the conversion cost

The calculation or determination of the conversion cost tries to find out which sources of expenses are directly related to the transformation or conversion of the products in the company. With this, it is intended in the matter of internal accounting to analyze the following data:

  • Identification and origin of each conversion cost.
  • Number of costs that intervene or make up the conversion costs.
  • Weight of each conversion cost.
  • Detect inefficient or unnecessary costs.

With the data set obtained, it will be possible, among other things, after analyzing the situation, to make a decision at the cost accounting level to determine if any cost has been found that is not efficient or some type of improvement in the conversion process that is may apply.

Conversion cost formula

In this case, although the formula may seem simple compared to others that we can know in the economic field, determining costs that have some relation to the conversion process is a task that needs a good analysis.

In addition, mislabeling a cost not only can affect us in the current formula, but it triggers a small domino effect by not including this cost in another possible formula or ratio in which it may belong.

Then the formula would be the following:

1

As can be seen, labor is the cost that mainly determines the transformation or conversion process, then from here on there must be costs of a similar nature or of a similar impact.

Examples are electricity or water supplies that are used proportionally, that is, the more transformation, the greater the labor, but also the greater the consumption of supplies (if applicable).

Example of conversion costs

Given a company that is dedicated as an ordinary activity to transform fruits into juice-based drinks or concentrated juice of these, what expenses of those exposed below are part of the conversion costs?

  1. Raw Materials
  2. Direct labor involved in the manufacturing process
  3. Direct labor involved in ordinary activity in general
  4. Supplies they consume in the manufacturing process (water and electricity)
  5. Punctual repair of machinery involved in the manufacturing process
  6. Miscellaneous costs directly involved in the transformation process

In this case, the costs that would be part of the conversion process are numbers 2, 4 and 6, since they are those that participate directly during the transformation of raw materials into a final product.