Conversion cost

Conversion Costs - this term is connected with generation of costs during manufacturing process. Conversion costs consist of elements, which transform raw materials to completed goods. When manufacturers produce goods should take into account three key cost ingredients because it is essential to produce finished products, that are : direct materials, direct labour and manufacturing over head (Walther, Skousen 2009, pp. 26-27). Conversion costs for prepared products should contain all cost directly connected with the units produced, such as labor cost and overhead costs. Cost other than this and material cost are capitalized just to the range they are essential to redound products to their actually position and location (Wiley et al. 2015, p.142).

Cost Components

All companies know the three ingdredients of manufacturing costs and it consists of prime costs and conversion costs (Hart, Wilson, Fergus 2012,p.19):

• Prime costs = direct material + direct labour:

Factory outlay are classified in the regular way as indirect costs or overheads.

• Conversion costs = direct labour + overhead costs:

This type of outlay can be used where there are superior levels of automation in the manufacture cycle what result less direct labour costs and comparatively higher overheads. Service organizations have not materials costs but they have direct labor costs and overheads costs, which are suchlike to production organizations (Needles et al. 2010, p.864).

Elements of conversion costs

Conversion costs consist of direct labour and manufacturing overhead (Walther, Skousen 2009, pp. 26-27):

• Director labour - this item includes gross wages paid to those who work on the product being fabricated.
• Manufacturing overhead - this item includes cost of production but other than direct materials and direct labour, it indirect materials, indirect labor, factory connected deprecation, insurance, repair, conservation, property taxes, utilities etc.

Subdiviosion of the conversion cost - example

For example, in economics of staple yarn production conversion costs refer how the fibres affect to the mechanism and moreover it has commercial importance of its quality and costs, then primary divisions of conversion cost are (Lord 2003, p.301):

• direct labor costs
• overhead costs
• capital costs of machines
• space costs
• power costs

Cash conversion cykle

The cash onversion cycle of a firm is the term used to describe length of time among payment and receipt cash inflows. Cash conversion cykle includes activities such as (Whittington 2015, p.242):

• repay providers
• completed products and sell tchem
• assemble receivable

Advantages of Conversion cost

Conversion costs have several advantages. Firstly,* they provide information about the cost of goods produced and the cost of sales. This allows companies to better manage their budget and optimize profitability. Secondly,* conversion costs can be used to compare different production methods and processes, helping to identify areas of improvement. Thirdly,* conversion costs provide a better understanding of the true cost of producing a product and can be used to identify areas of cost savings. Lastly,* conversion costs can be used to help identify areas of inefficiency and areas where production can be improved.

Limitations of Conversion cost

The limitations of Conversion Costs include:

• Difficulty in accurately attributing costs to specific products: Conversion costs can be difficult to accurately attribute to specific products, as the cost of labour and overhead may be spread across multiple products.
• Allocation of fixed costs: It is difficult to accurately apportion the fixed costs of production, as the cost of production is determined by the number of products produced, not the cost of production.
• Overhead costs: Overhead costs such as rent, utilities, and insurance, can be difficult to include in conversion costs as they are often difficult to attribute to specific products.
• Unpredictability of production and costs: It is difficult to predict the cost of production when the number of products produced is uncertain.
• Inflation: Inflation can cause the cost of production to rise, making it difficult to accurately budget for conversion costs.

Other approaches related to Conversion cost

In addition to direct materials, direct labour and manufacturing overhead, conversion costs also include the following elements:

• Process cost - this includes costs related to the transformation of inputs into outputs, such as labour and overhead costs.
• Changeover cost - this refers to the cost associated with switching from one production process to another. This includes costs related to the setup of new equipment and the retooling of existing machines.
• Quality cost - this includes costs associated with ensuring the quality of the product, such as testing and inspection costs.
• Scrap cost - this includes costs related to the disposal of scrap materials or products that do not meet quality standards.

In summary, conversion costs are a broad category of costs associated with the production of goods and services that include direct materials, direct labour, manufacturing overhead, process cost, changeover cost, quality cost, and scrap cost.

Conversion cost — recommended articles

Direct expense — Absorbed costs — Manufacturing cost — Cost element — Indirect material — Non recurring cost — Scrap rate — Direct labor cost — Segment margin

References

• Ajanović A. (2011). Biofuels versus food production:Does biofuels production increase food prices?, "Energy", Issue 4, pp. 1-7.
• DeBald P.S., Dale M.E. (1991). Tree Value Conversion Standards Revisited, "Northeastern Research Station", 645, pp.1-29.
• Hart J., Wilson C., Fergus Ch. (2012)., Management Accounting :Principles & Applications.
• Lord P.R. (2003)., Handbook of Yarn Production:Technology, Science and Economics.
• Miao R., Feng H., Hennessy D.A. (2014). Sodbusting, Crop Insurance, and Sunk Conversion Costs. "Land Economics", 601-622.
• Needles B.E., Powers M., Crosson S.V. (2010)., Principles of Accounting.
• Walther L.M., Skousen C.J. (2009)., Managerial and Cost Accounting.
• Whittington O.R. (2015)., Wiley CPAexel Exam Review 2015 Study Guide:Business Environment and Concepts.
• Wiley J., Chaudhry A.,Coetsee D., Bakker E., Varughese S.,Mcllwaine S.,Fuller C.,Rands E.,Vos N., Longmore S., Balasubramanian (2015)., Wiley Interpretation and Application of International Financial Reporting Standards.

Author: Marta Bartula