Explain and provide a real life business example for conversion costs. Explain the importance and main...

Companies that produce inventory rely heavily on certain metrics to track production as well as to evaluate the efficiency of how inventory is produced and sold. One of the metrics commonly used to do this is conversion costs. This metric refers to the expenses that go into turning raw materials into sellable inventory.

Conversion Cost

conversion cost is how much a company spends when turning raw material into finished product. Conversion costs typically include direct labor and overhead costs. Calculating and being aware of your business' conversion costs can provide you with a clearer picture of how much you spend on inventory production.

In the conversion cost calculation, direct labor refers to money spent on employees or other workers who directly work on production. For example, the salaries of the employees who are responsible for manufacturing goods, such as machinists or assembly-line workers, are considered direct labor costs. If you hire contract workers for a particular project, the wages you pay them would also be counted as direct labor expenses.

The overhead costs that are part of conversion costs are any expenses that aren't directly tied to the production of inventory but that are still necessary. For example, the cost to maintain the equipment that produces goods would be considered an overhead cost.

Conversion costs allow managers and other supervisors to accurately measure and keep track of the expenses of production. Conversion costs can also be used in the development of product-pricing models as well as when estimating the end value of finished products. Business owners or managers may also look at conversion costs to determine if there is waste that can be eliminated and to better understand the efficiency of their production process.

The manufacturing industry is typically the industry in which conversion costs are most frequently used, but any company that produces goods can use this metric when making business decisions related to their products. Additionally, a company may be required to calculate its conversion costs to determine its cost of sales to report on an income statement.making business decisions related to their products. Additionally, a company may be required to calculate its conversion costs to determine its cost of sales to report on an income statement.

Examples of common conversion costs in business

Conversion costs are considered any manufacturing cost that does not include the direct cost of raw materials. The following are a few of the most common conversion costs a company may incur:

Employee benefits

Salary

Wages

Payroll taxes

Production utility expenses

Equipment depreciation

Equipment maintenance costs

Factory or office rent

Insurance related to production, such as factory insurance

Supervision

Inspection expenses

Machining

Employee bonuses

Pension contributions

Smalls tools that are charged at expense