What are Conversion Costs?

Malcolm Tatum

Conversion cost is a term that is utilized in more than one financial application. The term can refer to total cost of production and labor costs associated with manufacturing a product. Conversion costs may also refer to the sum that is expended by rearranging equipment used in a manufacturing process, an effort that hopefully converts the older process into one that is more efficient. In investing situations, the term can refer to the expenses that are incurred when an investment is rolled over or converted into a different investment.

Conversion costs include expenses associated with rearranging or reconfiguring equipment to make a production change.
Conversion costs include expenses associated with rearranging or reconfiguring equipment to make a production change.

As related to the production of goods and services, conversion costs include all measurable types of expenses that make it possible to manufacture products suitable for sale to consumers. In this scenario, the costs would include the wages of those who are actively involved in the process, any type of direct production costs, and the manufacturing overhead cost that applies to the general operation of the facility. The concept of total factory cost is tied closely to conversion costs, and in some quarters the two terms are used interchangeably.

Manufacturing overhead costs must be considered when calculating conversion cost or total factory cost.
Manufacturing overhead costs must be considered when calculating conversion cost or total factory cost.

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When reworking a production floor by moving or equipment into a new sequence, any costs associated with the move are identified as conversion costs. For example, if the layout of a manufacturing plant is reworked to combine the activities of two formerly independent departments into a single working unit, the cost of disassembling old machinery, setting it up in a new configuration and reassigning responsibilities to workers in the revamped department would be charged back to the conversion process. In like manner, the loss incurred by the temporary shutdown of the two departments while the conversion was taking place may also be considered part of the overall conversion costs.

Businesses often watch conversion costs very closely. Since costs of this type have an impact on the amount of profit earned on each unit sold, there is the need to make sure the expenses are justified and reasonable. In the event that one of the costs is considered exorbitant, steps to minimize that cost will result in a greater potential earning profit, provided the change does not have a negative effect on the quality of the products produced.

Even with investing, there are conversion costs. This can include rolling one asset into some other form, such as moving the balance of a pension fund into a mutual fund, or converting one class of stock into another class. Any costs that are generated as a result of these actions may be classified as conversion costs, and in some cases utilized as a tax deduction, if the activity is recognized as an allowable deduction by the appropriate governmental revenue agency.

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