In a processing environment, there are two concepts important to determining the cost of products produced. These are the concepts of equivalent units and conversion costs. 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. Conversion costs are the labor and overhead expenses that “convert” raw materials into a completed 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.
Definition of Conversion Costs
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.
Conversion costs can be explained through the process of making Just Born’s Peeps. Just Born makes 5.5 million Peeps per day using three ingredients and the following process:1
- Use machines to add and mix the sugar, corn syrup, and gelatin into a mixture called a slurry. Send slurry through a whipper to give the marshmallow its fluffy texture.
- Color the sugar.
- Deposit marshmallows on sugar-coated belts in the Peep shape. Send Peeps on belts through a wind tunnel that stirs up the sugar to coat the entire shape.
- Add eyes, and inspect.
- Move the Peeps via belt into their appropriate tray, and wrap with cellophane.
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).
Mechanics of Applying Conversion Costs
Let’s return to our drumstick example to learn how to work with conversion costs. 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. In the shaping department, the material is added first. Then, machines cut the wood underwater into dowels, separate them, and move them to machines that shape the dowels into drumsticks. These machines need electricity to operate and personnel to monitor and adjust the processes and to maintain the equipment. When the shaping is finished, a conveyer belt transfers the sticks to the finishing department.
Since the drumsticks are made by performing one process on one batch at a time, instead of producing one stick at a time from start to finish, it is difficult to determine the exact materials, labor, and overhead for a single pair of drumsticks. It is easier to track the materials and conversion costs for one batch and have those costs follow the batch to the next process.
Therefore, once the batch of sticks gets to the second process—the packaging department—it already has costs attached to it. In other words, the packaging department receives both the drumsticks and their related costs from the shaping department. For the basic size 5A stick, the packaging department adds material at the beginning of the process. The 5A uses only packaging sleeves as its direct material, while other types may also include nylon, felt, and/or the ingredients for the proprietary handgrip. Direct labor and manufacturing overhead are used to test, weigh, and sound-match the drumsticks into pairs.
Thus, at the end of the accounting period, there are two work in process inventories: one in the shaping department and one in the packaging department.
Direct materials are added at the beginning of shaping and packaging departments, so the work in process inventory for those departments is 100% complete with regard to materials, but it is not complete with regard to conversion costs. If they were 100% complete with regard to conversion costs, then they would have been transferred to the next department.
Key Concepts and Summary
- Conversion costs are the costs of direct labor and manufacturing overhead used to convert raw materials into a finished product.
- Materials are added during various stages of the manufacturing process, such as the beginning or end, while conversion of the product from raw material into finished goods is considered to occur uniformly through the process. Thus, it is possible for a product to have all of its materials and not be complete.
- Equivalent units for direct materials can be different than the equivalent units for conversion costs because materials are added in steps through the manufacturing process, while conversion costs are incurred evenly throughout the process.
(Figure)Which is not needed to compute equivalent units of production?
- the percentage of completion for inventory still in process
- the number of units transferred out
- the number of units started and completed
- the material cost per unit
(Figure)What is the cost of direct labor if the conversion costs are $330,000 and manufacturing overhead is $275,000?
(Figure)What is the conversion cost to manufacture insulated travel cups if the costs are: direct materials, $17,000; direct labor, $33,000; and manufacturing overhead, $70,000?
(Figure)Which of the following lists contains only conversion costs for an inflatable raft manufacturing corporation?
- vinyl for raft, machine operator, electricity, insurance
- machine operator, electricity, depreciation, plastic for air valves
- machine operator, electricity, depreciation, insurance
- vinyl for raft, electricity, insurance, plastic for air valves
(Figure)What is the difference between prime costs and conversion costs?
Prime costs and conversion costs both include labor. Prime costs are the direct costs, other than equipment, used in manufacturing and therefore are direct material and direct labor. Conversion costs are the costs involved in converting the direct material into the product and therefore are direct labor and manufacturing overhead.
(Figure)Explain conversion costs using an example.
(Figure)Why are there conversion costs in both job order costing and process costing?
Job order costing and process costing are the accounting systems used to record the costs expended to produce a product. Conversion costs are the direct labor and manufacturing overhead involved in the production process and exist regardless of the accounting system used.
(Figure)What are equivalent units of production, and how are they used in process costing?
(Figure)How can there be a different number of equivalent units for materials as compared to conversion costs?
While conversion typically occurs evenly throughout the process, materials are not typically added evenly, so the ending work in process can be different. For example, when materials are added at the beginning of the process, materials can be 100% complete and conversion can be 50% complete. Different completion percentages result in different equivalent units.
(Figure)Why is the number of equivalent units for materials only sometimes equal to the equivalent units for conversion?
- 1 Just Born. “Marshmallow Peeps Factory Tour.” n.d. http://www.justborn.com/resource/corporate/popups/virtualTour.cfm