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21.2 Explain and Identify Conversion Costs

Product Costs in Process Costing​

In process costing, product costs are often separated into:

  1. Direct Materials
  2. Conversion Costs (Direct Labor + Manufacturing Overhead)

Conversion Costs​

Conversion costs are the costs of converting raw materials into finished products. They include direct labor and manufacturing overhead.

Formula: Conversion Costs = Direct Labor + Manufacturing Overhead

Why Called "Conversion":

  • These costs "convert" materials into finished products
  • They represent the processing/manufacturing effort
  • Materials are "converted" through labor and overhead

Direct Labor​

Direct labor is the cost of employees who work directly on converting materials into finished products.

Examples:

  • Machine operators
  • Assembly line workers
  • Production workers
  • Quality control inspectors (if direct)

Manufacturing Overhead​

Manufacturing overhead includes all manufacturing costs except direct materials and direct labor.

Examples:

  • Indirect labor (supervisors, maintenance)
  • Factory rent
  • Factory utilities
  • Equipment depreciation
  • Factory insurance
  • Indirect materials

Why Separate Conversion Costs?​

Reasons:

  1. Timing: Materials may be added at different stages than conversion
  2. Completion: Materials and conversion may be at different completion levels
  3. Cost Control: Separate tracking helps identify issues
  4. Analysis: Understand material vs. conversion cost behavior

Example: Bread Production​

Direct Materials:

  • Flour: €0.50 per loaf
  • Yeast: €0.05 per loaf
  • Water: €0.02 per loaf
  • Other ingredients: €0.08 per loaf
  • Total Materials: €0.65 per loaf

Conversion Costs:

  • Direct labor: €0.20 per loaf
  • Manufacturing overhead: €0.15 per loaf
  • Total Conversion: €0.35 per loaf

Total Cost per Loaf:

  • Materials: €0.65
  • Conversion: €0.35
  • Total: €1.00 per loaf

Conversion Cost per Unit​

Formula: Conversion Cost per Unit = Total Conversion Costs ÷ Equivalent Units

Equivalent units account for partially completed units (discussed in next section).

Luxembourg Compliance Note​

In Luxembourg:

  • Conversion costs must be properly classified
  • Direct labor includes social charges
  • Overhead includes all indirect manufacturing costs
  • PCN accounts support cost classification
  • Cost records should separate materials and conversion

Think It Through​

Why are conversion costs separated from direct materials in process costing? How does this separation help with cost analysis?