In managerial accounting, separating direct and indirect costs is highly crucial. Managerial accounting refers to the branch of accounting which covers the internal accounting process. This branch covers the information flow within a company, particularly to managers. Based on this information, managers can make well-informed and better decisions. One of the fundamental areas included within managerial accounting includes cost accounting.
Cost accounting involves the accounting for costs incurred during the production process. For service firms, these costs concerns expenses to render the underlying service. Essentially, cost accounting helps companies establish the total costs of an underlying item. This process may involve using various tools and methods to derive those costs. It also includes dividing costs based on several features. One of these divisions may consist of direct costs.
A direct cost is an expense that directly relates to a product or service. This cost is crucial in converting the underlying item into its finished form. For most companies, direct costs include material, labor, and other expenses. One of the distinguishing features of these costs consists of their traceability to a particular cost object. Usually, these costs are variable and depend on a company’s activity levels. They also help in calculating prime costs.
What are Prime Costs in Managerial Accounting?
The term prime costs refer to expenses directly related to the materials and labor used in manufacturing. It helps companies understand the value of a product or service. Based on that information, they can calculate the product’s price. On top of that, it allows companies to choose the best profit margins for their products or services. Prime costs also become a part of product costs.
Prime costs are not a part of financial accounting. These costs are relevant in managerial accounting, where costing techniques are prevalent. Usually, prime costs are a part of almost every costing technique. These costs are crucial for both absorption and marginal costing, which are prevalent. Prime costs are also critical in calculating the contribution margin for a product or service.
Prime costs include any expenses directly incurred to create a product or service. These costs include direct materials and direct labor. Essentially, prime costs represent the sum of these costs. Companies may calculate direct material and labor on their own. However, they combine them to calculate prime costs, which is more meaningful. Prime costs differ from several other cost sums in various regards.
The primary difference between prime costs and others is the exclusion of overheads. These costs neglect any indirect costs and overheads. Although factory overheads are a part of product costs, prime costs do not consider them relevant. On top of that, indirect costs do not contribute to a product directly. Therefore, prime costs also ignore these as a part of the calculation.
Overall, prime costs represent the sum of direct material and direct labor costs for a product or service. These costs are crucial in decision-making. However, they cannot help companies establish the final price for the given products. Therefore, they cannot help in establishing prices to ensure long-term profitability. Prime costs are an essential part of various costing techniques in managerial accounting.
What Are the Components of Prime Costs in Managerial Accounting?
Prime costs include two components direct materials and direct labor. Each is a standalone component that helps calculate a product’s prime costs. Usually, companies calculate them as their own. Once they do so, companies can sum them as a part of the final calculation. An explanation of each of these components is as follows.
Direct material
Direct material includes materials and supplies consumed during the manufacturing process of a product. It covers any items that are a part of the finished product produced through this process. Usually, direct materials are raw goods that go into a production process. Companies can obtain a list of those goods in the bill of materials file for a product. However, direct materials exclude materials that are a part of the general overheads of a company.
Direct materials are the essential component to produce a product. Without these materials, companies cannot manufacture the underlying item. Direct materials also include any scrap or spoilage incurred during the production process. However, there is no guidance on determining direct materials. Instead, it depends on their manufacturing process. Direct materials for one company may classify as indirect for others.
Some examples of direct materials include the following.
- Wood, fabric and foam for a furniture company.
- Flour, eggs and yeast for a baking company.
- Computer components for a PC manufacturer.
Direct labour
Direct labor is similar to direct material. It includes costs incurred for employees who contribute to the production process directly. Usually, these costs consist of salaries, wages, taxes, and benefits paid to those employees. For service-based firms, direct labor is the only component of prime costs. Usually, these firms do not have any direct material expenses. However, they don’t calculate prime costs either.
Direct labor is as essential to producing a product as direct material. Companies cannot convert those materials without paying employees to do so. However, direct labor is more diverse compared to direct materials. On top of that, it excludes any compensation paid to employees outside the production process. An example of direct labor includes the salaries and wages paid to workers operating machines during production.
What is the Formula for Prime Costs?
The formula for prime costs is straightforward. It calculates the sum of the two essential components for those costs. As mentioned above, it includes direct material and direct labor. Therefore, the prime cost formula will be as follows.
Prime costs = Direct material + Direct labor
For example, a company manufactures laptops. For that company, the direct material costs include the various components obtained from several suppliers. The company combines those components into a single laptop product. Consequently, it pays workers to gather and put those components together. On top of that, the company also pays another worker to install software on the laptop.
The company includes various components into a single laptop. The combined cost of these components is $400. On the other hand, it pays one employee $100 to combine those components. In contrast, the salary for the installation worker is $50. Overall, the prime costs for the company will be as below.
Prime costs= Direct material + Direct labor
Prime costs = $400 + ($100 + $50)
Prime costs = $550
What is the Importance of Prime Costs?
Prime costs in managerial accounting are critical for several reasons. Primarily, these costs allow companies to establish the direct costs incurred on a product. However, they exclude factory overheads and other fixed expenses. On top of that, prime costs also improve the production process and focus on that area specifically. This way, it can make cost objects more efficient.
Prime costs also help companies determine the cost of a product or service. Usually, it is an essential part of various costing techniques. Through these techniques, companies can also establish profit margins. This way, it also helps determine the final price for the underlying product or service. Prime costs are also crucial in calculating a break-even point.
More importantly, prime costs are essential in allowing companies to control and reduce their costs. Since these costs primarily focus on production aspects, they are crucial in establishing the total expenses. Once companies determine those expenses, they can control and reduce them. Prime costs also aid in calculating product-wise profitability.
Prime costs also serve as a base for allocating overheads to various components. This basis can be essential in several costing techniques. On top of that, prime costs are easy to calculate compared to other expenses. They present a measure of direct costs related to production. Similarly, they help determine the selling price of products.
Conclusion
Prime costs include the direct material and direct labor costs for a product. These costs are essential in various regards. Primarily, prime costs include two components, including direct material and direct labor. These costs do not consider factory overheads or other indirect expenses. Prime costs are vital for several reasons, as mentioned above.