Conversion costs are costs that are incurred on raw materials to transform them into finished goods. It includes direct labor costs and manufacturing overheads.
The formula for conversion cost is:
Conversion costs = Direct Labor cost + Manufacturing overheads
Direct labor costs are direct costs that are traceable and are allocated on an hourly basis. For example, a factory worker casts raw iron and transforms it into one steel bar in 30 minutes and is paid at a rate of $50 per hour. This is traceable for each unit of the steel bar.
The worker works in a building that has a monthly rent of $5000. He also operates a press machine that consumes electricity of $6000 monthly and other maintenance costs of $1500. All these costs are not traceable and hence are allocated to each unit on a rate called FOH rate. Assume that per unit FOH cost is $35.00.
The total conversion cost for one steal bar will be:
Conversion costs = ($50 x 0.5 labor hours) + $35.00 = $60.00 per unit
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