Direct labor refers to the time spent by individuals who work specifically on manufacturing a product or performing a service. Any factory or production cost that is indirect to the product or service and, accordingly, does not include direct material and direct labor is overhead. This cost element includes factory supervisors’ salaries, depreciation on the machines producing plastic food storage bags, and insurance on the production facilities. The sum of direct labor and overhead costs is referred to as conversion cost. In an equation form it is represented as
Conversion Cost = Direct Labor Cost + Manufacturing Overhead Cost
The conversion cost includes both the direct and indirect expenditure incurred in converting a currency, material, or security from one form or type into another. The conversion cost also includes the cost of moving from one kind of equipment or production process to another. These costs are high when converting from a manual system to a computerized system. For example it includes the cost of new equipment plus training.
When overhead is applied on a direct labor basis, or when direct labor and overhead are added to the product at the same rate, a single percentage of completion estimates can be made and used for both conversion cost components. Let us take an example. Company XYZ had the following costs related to producing 20,000 units of its product.
Direct materials $90,000
Direct labor 40,000
Conversion cost per unit = direct labor + rent + depreciation / no. of units produced
conversion per unit = $ 40,000 + 8,000 + 6,000 / 20,000
= $ 2.70
The direct materials and direct labor maybe combined into another classification called prime cost. Direct labor and factory overhead (which includes rent and depreciation) may be combined into a classification called conversion cost, which represents the cost of converting direct materials into finished products.