Question

What is meant by the term ‘conversion costs’?

Answer 1

Conversion costs are those production costs required to convert raw materials into completed products. The method is used in costing to infer the value of ending inventory, which is reported in the financial statements. It can be used to determine the incremental cost of creating a product, which is useful for price-setting purposes. The conversion activities involve labor and manufacturing overhead, the calculation of conversion costs is:

Conversion costs = Direct labor + Manufacturing overhead

Accounts managers and production managers of a company calculate these conversion costs to estimate the production expenses, the value of the finished and unfinished inventory and make product-pricing models.

Conversion costs are vital to be calculated by each company since they are fundamental for making important business decisions and carrying out basic accounting tasks.

Conversion costs are also used as a measure to gauge the efficiencies in production processes but take into account the overhead expenses left out of prime cost calculations. Operations managers also use conversion costs to determine where there may be waste within the manufacturing process.