What is Prime Cost?
Prime cost is defined as the accumulation of all costs directly incurred during the manufacture of a product. Prime cost is also known as a direct cost, flat cost, or first cost.
Prime cost includes all costs directly attributed to the production of output, and consists of expenses like direct material, direct labor, and other direct expenses.
On the other hand, indirect costs like factory rent and supervisors’ salaries are not directly attributable to the production of finished goods and hence are not a part of prime cost.
The Formula of Prime Cost:
Prime cost = Direct Materials + Direct Labor
The major two components of prime cost are direct materials and direct labor; totaling the two figures results in the calculation of prime cost.
Components of Prime Cost:
1) Direct Material:
Direct materials are referred to as the raw materials or supplies upon which the production process happens. Raw materials are the physical components that are converted into finished goods.
For example, a manufacturing company may require plastic, lumber, chemicals, paint, or clothe as raw materials.
The type of raw materials required varies from industry to industry. A cloth manufacturing company’s major raw material would be yarn, thread, and viscose whereas a furniture manufacturer would require lumber, varnish, and fixtures.
2) Direct Labor:
Direct labor includes hourly wages and salaries paid to the employees who are directly involved in the production process and also their payroll taxes.
These are workers who apply their skills, during the manufacturing process, to the raw materials to convert it into finished goods. It consists of the staff that is part of the daily operations during the production of the goods.
Direct labor does not constitute wages paid to administration, factory supervisors, or guards as they are indirect labor who can not be directly attributed to the production of goods.
Other than this, direct labor also includes any commission paid to the salesperson who acts as the middle-man between the producer and customer.
Examples of direct labor include assembly line workers, welders, production supervisors, quality control inspectors, mechanists, painters, chefs, etc.
Uses of Prime Cost:
Prime cost is a significant part of management costing and allows the management to make decisions regarding the production of goods.
Prime cost identifies the total cost that shall be incurred to produce a given output and hence plays a major role in price making decisions.
It allows the management to decide on the desired profit margin. A good analysis of prime cost can lead to the elimination of several inefficiencies by switching to a cheaper supplier or varying the labor wages as per the requirements of the situation.
Numeric Example:
A car manufacturing company has an annual output of 10 and incurs the following expenses:
- Direct materials: $30,000
- 500 hours of direct labor at a rate of $100 per hour.
Cost of labor: 500 $100 = $50,000
Total Prime Cost = $50,000 + $30,000 = $80,000
Prime Cost of a Single Car = $80,000/10 =$8,000
