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Conversion costs
March 11, 2019

Conversion costs are those production costs required

to convert raw materials into completed products. The
concept is used in cost accounting to derive the value
of ending inventory, which is then reported in the
financial statements. It can also be used to determine
the incremental cost of creating a product, which
could be useful for price setting purposes. Since
conversion activities involve labor and manufacturing
overhead, the calculation of conversion costs is:

Conversion costs = Direct labor + Manufacturing

overhead

Thus, conversion costs are all manufacturing costs

except for the cost of raw materials. Examples of costs
that may be considered conversion costs are:

• Direct labor and related benefits and payroll

taxes

• Equipment depreciation

• Equipment maintenance

• Factory rent

• Factory supplies

• Factory insurance

• Machining

• Inspection

• Production utilities

• Production supervision

• Small tools charged to expense

As can be seen from the list, the bulk of all conversion

costs are likely to be in the manufacturing overhead
classification.

If a business incurs unusual conversion costs for a

specific production run (such as reworking parts due
to incorrect tolerances on the first pass), it may make
sense to exclude these extra costs from the
conversion cost calculation, on the grounds that the
cost is not representative of day-to-day cost levels.

Example of Conversion Costs

ABC International incurs a total of $50,000 during

March in direct labor and related costs, as well as
$86,000 in factory overhead costs. ABC produced
20,000 units during March. Therefore, the conversion
cost per unit for the month was $6.80 per unit
(calculated as $136,000 of total conversion costs
divided by the 20,000 units produced).

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