Conversion Cost in Accounting: Definition & Examples

Lesson Transcript
Instructor: Beth Loy

Dr. Loy has a Ph.D. in Resource Economics; master's degrees in economics, human resources, and safety; and has taught masters and doctorate level courses in statistics, research methods, economics, and management.

Conversion cost is included in the balance sheets of companies and is an important factor in calculating the total cost of a project. Learn about the conversion costs in accounting, direct labor and manufacturing costs, and how to determine the conversion costs. Updated: 12/15/2021

Conversion Costs in Accounting

If you cook, you already know all about conversion costs. When you make your favorite dessert, do you follow a recipe? Do you go to the store and purchase your ingredients? Do you need tools to make your dish? Imagine you are making a banana split. It takes labor, electricity, water, a refrigerator, equipment, and other supplies. Plus, we have those delicious ingredients. Let's come back to our banana split later and learn about what makes up conversion costs.

Conversion costs are direct labor costs combined with manufacturing overhead costs. Direct labor costs are just the costs to employ those who actually make a product. Manufacturing overhead costs are things like indirect labor, utilities, supplies, equipment, insurance, taxes, tools, and regulatory obligations. We will look at these costs in more detail later in the lesson.

So when we think of the costs that must be incurred to take raw materials and turn them into products, we are referring to conversion costs. The formula for conversion costs is:

Conversion Costs = Direct Labor Costs + Manufacturing Overhead Costs

Conversion costs may also be called production costs. We need to know these costs in order to determine:

  1. The cost of creating one unit of a product, which is used to set a price for a good
  2. The total costs of existing inventory, which is needed for balance sheets
  3. The costs of goods sold, which is required for income statements

Notice that the actual costs of the necessary raw materials are not included in conversion costs. But we want to focus on what is included in conversion costs, so let's look into what makes up direct labor costs and manufacturing overhead costs.

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  • 0:00 Conversion Costs in Accounting
  • 1:58 Direct Labor Costs
  • 2:39 Manufacturing Overhead Costs
  • 3:47 Finding Conversion Costs
  • 5:40 Lesson Summary
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Direct Labor Costs

Direct labor costs may seem to be pretty straightforward; however, these costs don't just include wages. You want to tally all of the costs that must be paid for the labor needed to actually manufacture a product. This means you have to add in insurance (including life, medical, short-term disability, long-term disability, workers' compensation, vision, hearing, and dental), payroll taxes, pension contributions, benefits costs, recruitment fees, and training costs. Direct labor costs should also include all of the expenses necessary to hire and retain an employee who physically works to turn the raw materials into a product.

Manufacturing Overhead Costs

Manufacturing overhead costs are those manufacturing costs necessary to produce a product, excluding the direct labor costs. This includes indirect labor costs, which are labor costs incurred by a company for those employees who are not directly involved in producing the actual good. Examples of employees in this category are managers, nurses, security guards, janitors, cooks, maintenance workers, accountants, executives, trainers, parking attendants, and secretaries.

Manufacturing overhead costs that don't include labor are pretty comprehensive. These include:

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