Updated on 9 November 2026 by Nicolas Finet, CEO of Sortlist. This guide has been rewritten with a UK perspective: it explains conversion costs in accounting (direct labour plus manufacturing overhead), how they are calculated and treated under accounting standards, a worked UK example using the 2026 National Living Wage, and a short section on the different meaning of cost per conversion in marketing.
The phrase "conversion cost" has two meanings. In cost accounting it is the cost of turning raw materials into finished goods. In marketing it is the cost of getting a visitor to take an action. This guide covers the accounting meaning in depth, because that is what manufacturers, food producers and makers need, and then points you to the marketing meaning.
Key takeaways
- Conversion cost = direct labour + manufacturing overhead. It is the cost of transforming raw materials into finished products, and excludes the cost of the materials themselves.
- Under accounting standards such as IAS 2, costs of conversion include costs directly related to production (such as direct labour) and a systematic allocation of fixed and variable production overheads.
- Prime cost = direct materials + direct labour. The two measures overlap on direct labour.
What are conversion costs?
Conversion costs are the costs a manufacturer incurs to convert raw materials into finished goods. They have two components:
- Direct labour: wages and related costs of people who work directly on the product, such as machine operators and assemblers.
- Manufacturing overhead: all other production costs that cannot be traced to a single unit, such as factory rent, energy, machine depreciation, indirect labour (supervisors, maintenance) and consumables.
Conversion costs do not include the cost of raw materials, or selling and administration costs.
“The cost of inventories includes all costs of purchase, costs of conversion (direct labour and production overhead) and other costs incurred in bringing the inventories to their present location and condition.”
IFRS Foundation, IAS 2 Inventories
UK companies preparing accounts under IFRS apply IAS 2, and those using UK GAAP follow equivalent rules in FRS 102. Rules on how to allocate fixed overheads, for instance based on normal capacity, are technical: ask your accountant to confirm the treatment for your business.
How to calculate conversion cost
Conversion cost = direct labour + manufacturing overhead
Direct labour
Include wages, employer National Insurance, pension contributions and other employment costs for the staff working directly on production, for the hours worked on the product. The National Living Wage rose to £12.71 an hour for workers aged 21 and over from April 2026, which sets a floor on labour costs in many UK production businesses, though actual pay is often higher.
Manufacturing overhead costs
- Variable overheads: change with output, such as energy used by machines, packaging consumables and small tools.
- Fixed overheads: stay broadly the same in the short term, such as factory rent and business rates, depreciation on equipment and salaried supervisors.
- Allocation: overheads are allocated to products using a measure such as machine hours or labour hours, giving an overhead absorption rate.
Example of how conversion costs work
A UK bakery makes 10,000 loaves in a month. All figures are hypothetical.
| Item | Amount |
|---|---|
| Direct materials (flour, yeast, packaging inputs) | £6,000 |
| Direct labour (bakers on the production line) | £8,000 |
| Manufacturing overhead (rent, energy, depreciation, supervisor) | £5,000 |
| Conversion cost (£8,000 + £5,000) | £13,000 |
| Conversion cost per loaf | £1.30 |
| Prime cost (£6,000 + £8,000) | £14,000 |
| Total production cost | £19,000, or £1.90 per loaf |
The bakery now knows that converting ingredients into bread costs £1.30 a loaf, regardless of what the flour costs. If flour prices fall, total cost drops but conversion cost does not, so the manager can see where efficiency gains must come from.
Prime cost vs conversion cost
| Measure | Includes | Excludes | Use |
|---|---|---|---|
| Prime cost | Direct materials, direct labour | Manufacturing overhead | Direct, traceable cost of a unit |
| Conversion cost | Direct labour, manufacturing overhead | Direct materials | Cost of production efficiency |
Direct labour appears in both, which is why you should not add prime and conversion costs together to get total cost. Total manufacturing cost = direct materials + direct labour + manufacturing overhead.
Why conversion costs matter
- Efficiency: they show how well a business turns materials into products, which is vital when wages and energy costs rise.
- Pricing: a clear per-unit conversion cost helps set prices and minimum acceptable margins.
- Cost control: splitting labour from overhead shows where savings are possible: automation, scheduling, energy efficiency or better use of capacity.
- Inventory valuation: conversion costs are included in the cost of finished goods and work in progress on the balance sheet.
- Make-or-buy decisions: compare your conversion cost with an outsourcing quote.
- Benchmarking: compare periods, lines and sites.
Limits and common mistakes
- Allocating overhead on an arbitrary basis, which distorts product costs.
- Treating abnormal waste or idle capacity costs as normal conversion costs. Accounting standards say that abnormal amounts are expensed rather than added to inventory.
- Forgetting indirect labour, or double counting labour as overhead.
- Using outdated overhead rates when energy or rent costs change quickly.
- Ignoring volume effects: fixed overheads per unit fall as output rises.
Conversion cost in marketing: cost per conversion
In digital marketing, "conversion cost" usually means cost per conversion (or cost per acquisition): total spend divided by the number of conversions, such as sales or leads. For example, £2,000 of advertising that produces 50 sales has a conversion cost of £40. This is a different concept from the accounting measure above. To learn about improving it, see conversion rate optimisation, search engine advertising and landing page price.
Summing up
Conversion cost is direct labour plus manufacturing overhead: the cost of making something out of raw materials. Calculate it per unit, track it over time and use it for pricing and efficiency decisions. For accounting treatment under IFRS or UK GAAP, rely on your accountant.
Frequently asked questions about conversion cost
What is the formula for conversion cost?
Conversion cost = direct labour + manufacturing overhead.
Do conversion costs include raw materials?
No. Raw materials are direct materials, which are part of prime cost but not conversion cost.
What is the difference between prime cost and conversion cost?
Prime cost is direct materials plus direct labour; conversion cost is direct labour plus manufacturing overhead.
How do accounting standards treat conversion costs?
Under IAS 2, the cost of inventories includes costs of conversion, which are direct labour and a systematic allocation of production overheads.
Is cost per conversion in marketing the same thing?
No. In marketing, cost per conversion is advertising spend divided by the number of sales or leads.
How can I reduce conversion costs?
Improve productivity, reduce waste and downtime, manage energy use, optimise scheduling and consider automation.
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Sources: IFRS Foundation, IAS 2 Inventories, IFRS Community, cost of inventories, UKCalc, National Living Wage. The bakery example is hypothetical. This is general information, not accounting advice.
