You can learn more about from the following articles —. Free Accounting Course. Login details for this Free course will be emailed to you. Conversion cost is used by the production management, budget controller, and other leadership teams of the company for the efficiency and effectiveness analysis of the labor and overhead costs purpose rather than valuing the inventories for financial reporting purposes.
Manufacturing overheads used in calculating conversion costs are the overheads that cannot be attributed to the production process or a single unit in production, for example, rent or electricity. Some other examples of manufacturing overheads are insurance, building maintenance, machine maintenance, taxes, equipment depreciation, machining, and inspection.
On the contrary, direct labor costs are the costs associated with the workers making the product. This may include wages, insurance costs for the workers, pension fund contributions, bonuses, and every other cost associated with the employed workers involved in the manufacturing process. These direct labor costs are the same ones used in calculating the prime cost in manufacturing.
As you have learned, equivalent units are the number of units that would have been produced if one unit was completed before starting a second unit. For example, four units that are one-fourth finished would equal one equivalent unit.
Each department tracks its conversion costs in order to determine the quantity and cost per unit see TBD; we discuss this concept in more detail later. Management often uses the cost information generated to set the sales price; to set standard usage data and price for material, labor, and overhead; and to allow management to evaluate the efficiency of production and plan for the future.
Conversion costs are the total of direct labor and factory overhead costs. They are combined because it is the labor and overhead together that convert the raw material into the finished product. Remember that factory, manufacturing, or organizational overhead you might see all three terms in practice is composed of three sources: indirect materials, indirect labor, and all other overhead costs that are not indirect materials or indirect labor.
Materials are often added in stages at discrete points of production, such as at the beginning, middle, or end of a process, but conversion is usually applied equally throughout the process.
For example, in the opening example, David and William do not add direct material ingredients evenly throughout the cookie-making process.
They are all added at the beginning of the production process, so they begin with the direct materials but add labor and overhead throughout the rest of the process. Just Born makes 5. In the Peep-making process, the direct materials of sugar, corn syrup, gelatin, color, and packaging materials are added at the beginning of steps 1, 2, and 5. While the fully automated production does not need direct labor, it does need indirect labor in each step to ensure the machines are operating properly and to perform inspections step 4.
Rock City Percussion has two departments critical to manufacturing drumsticks: the shaping and packaging departments. The shaping department uses only wood as its direct material and water as its indirect material. This includes the wages and salaries paid to assembly line workers, machinists, painters, and anyone who helps the manufacture products. The true cost a company uses in the process of turning raw materials into finished goods includes both overhead and direct labor.
Managerial accountants and production managers measure these conversion costs to estimate production expenses, develop product-pricing models, and estimate the value of finished inventory.
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