Conversion cost is a term used in cost accounting to refer to the expenses incurred in converting raw materials into finished products. It is the cost incurred by any manufacturing entity in converting its raw material into finished goods capable of being sold in the market. Conversion costs include direct labor and overhead expenses, which are necessary for operations, such as the electricity required to keep a manufacturing plant functioning throughout the day. Direct labor refers to the wages and benefits paid to employees who work directly on the production line, while overhead costs are expenses that cannot be directly attributed to the production process.

The formula for calculating conversion costs is the sum of all direct labor and manufacturing overhead costs. Thus, conversion costs are all manufacturing costs except for the cost of raw materials. If a business incurs unusual conversion costs for a specific production run, it may make sense to exclude these extra costs from the conversion cost calculation, on the grounds that the cost is not representative of day-to-day cost levels.

Conversion costs can be used to determine the incremental cost of creating a product, which could be useful for price setting purposes. The component costs and conversion costs of a product, when combined, represent the lower threshold price at which a product should be sold, so that the producer at least earns back the costs associated with the product. Management often uses the cost information generated to set the sales price, to set standard usage data and price for material, labor, and overhead, and to evaluate the efficiency of production and plan for the future.