A prime cost refers to an entity’s expense directly related to the materials and labor used in production. Prime costs are those costs that are directly incurred to create a product or a service and are particularly useful in determining the contribution margin of a product or a service and calculating the minimum price at which a product should be sold.
However, prime costs do not include overhead costs, so they are not good at calculating prices that ensure long-term profitability. It excludes all indirect expenses such as advertising and administrative costs.
More indirect costs such as utilities, manager salaries, and delivery costs are also excluded from prime costs. The production of goods and services involves many different kinds of expenses.
Still, the prime cost formula only considers the variable expenses, which are directly connected to the production of each item.
The formula used to calculate the prime cost is:
Prime Cost = Direct material + Direct labour
See the explanation below for the breakdown of this formula,
Direct material is the main component of prime cost and includes raw materials and supplies consumed directly during the production of goods.
Raw materials are the physical components, and during manufacturing, they might include metals, plastics, hardware, fabric, and paint.
The types of raw materials vary depending on the nature of the business. For example, the raw materials might be lumber, hardware, and paint for a furniture manufacturer.
On the other hand, the other component of prime costs is direct labor, which includes wages paid to workers who directly contribute to forming, assembling, or creating a product.
It does not include salaries paid to factory managers or fees paid to engineers and designers. It only includes the wages that are directly related to the manufacturing of the product.
These employees are involved in the creation of the product and the day-to-day operation of the business. Moreover, commissions paid to salespeople who work as intermediaries between the manufacturer and the consumer also come under direct labor. Direct labor includes assembly line workers, welders, carpenters, glass workers, painters, and cooks.
Basically, the prime cost is the total sum of direct costs, which may be fixed or variable. Businesses use prime cost to measure the total cost of production inputs needed to create a given output.
By analyzing the prime costs, a company can set a price that will bring maximum profits. If a company cuts down its prime costs, it can increase its profits or undercut its competitor’s prices.
They need to calculate the prime cost of every product they have manufactured to generate a profit. Self-employed individuals often use prime costs to ensure that they are making their desired hourly wage while also profiting from every product they have made.
Businesses exclude indirect costs from the prime cost calculation because they can be tough to quantify and allocate. Prime costs also vary depending on the cost object being reviewed.
If the cost object is a distribution channel, the prime cost will include the items specified and the direct costs of maintaining the distribution channel, such as marketing expenses.
However, if the cost object is a customer, prime costs can also include the cost of warranty claims, return processing, field servicing, and any staff assigned full time to service that customer.
For example, if a business manufactures 10 frames and incurs expenses such as $5,000 for lumber, $1500 for hardware, and 50 hours of labor for product assembly at a rate of $15 per hour, then only the costs of raw materials and direct labor are used in the prime cost formula.
The raw materials include $5,000 in lumber and $1,500 in hardware, so the total cost of raw materials is $6,500.
The total labor cost is $750, which is calculated as 50 hours multiplied by $15 per hour. The prime cost of 10 frames is $7,250, and one frame is $725.
List 10 Examples of Prime Costs:
Prime costs refer to the direct costs that are directly associated with the production of goods or services. Here are ten examples of prime costs with explanations:
- Raw materials: Raw materials are the basic materials used to produce goods. They are a prime cost because they are directly used in the production process.
- Direct labor: Direct labor costs refer to the wages paid to employees who are directly involved in producing goods or services. These wages are a prime cost because they are directly used in the production process.
- Manufacturing supplies: Manufacturing supplies are the tools and equipment used in the production process. These are prime costs because they are directly used in producing goods.
- Packaging materials: Packaging materials are used for packaging finished goods. These are prime costs because they are directly related to producing goods.
- Freight costs are the cost of shipping finished goods from the manufacturing facility to the customer. These costs are prime cost because they are directly related to the sale of goods.
- Commissions: Commissions are payments made to salespeople or agents who sell goods. Since commissions are directly related to the sale of goods, they are a prime cost.
- Royalties: Royalties are payments made to the intellectual property owner (such as patents or trademarks) for the use of that property in producing goods. The cost of royalties is a prime cost because it is directly related to the production of goods.
- Equipment depreciation: Equipment depreciation refers to the reduction in the value of manufacturing equipment over time. Since the equipment is used specifically for the production of goods, the cost of depreciation is a prime cost.
- Direct overhead: Direct overhead costs are costs that are directly associated with the production process but are not included in the cost of raw materials or direct labor. Examples may include rent, utilities, and maintenance costs of manufacturing equipment.
- Direct R&D expenses: Direct R&D expenses are costs associated with developing or improving new products. Since R&D expenses are directly related to producing goods, they are a prime cost.
Frequently Ask Questions Relate to Prime Cost
What is included in prime costs?
Prime costs are the direct costs of producing a product or service, which normally include direct material and direct labor that is identifiable and directly contributes to the products or services. Indirect materials or labor that are not directly attributed to the products are not included.
How do you calculate the prime cost?
To calculate the prime cost of the product, you will know the total direct material that directly contributes to the products.
Then, you will also need to know the total direct labor incurred and directly contributing to the products. With the combination of these two costs, then you will get prime cost.
Is rent a prime cost?
To make the products, the company might need to rent the warehouse and office. The rental expenses are normally considered as the period cost or overhead cost. It is also considered a fixed cost. However, the rental expenses that the company spends on the warehouse and office could not be considered prime costs.
Is overhead a prime cost?
Overhead cost is the cost that does not directly contribute to the production. Those costs include rent, utilities, depreciation, and others.
Prime costs include only direct material and direct labor costs of products. Therefore, the overhead cost is not considered or included as a prime cost.
Is Depreciation a prime cost?
The company is allowed to allocate the cost of building, machines, computers, innovations, and other assets that qualify as capital assets over a period of time through the systematic way called depreciation.
The depreciation expenses that will be considered are normally categorized under the general administrative expenses for financial reporting purposes and considered as fixed overhead for managerial accounting purposes. It is not considered as the material cost of production. Therefore, it is not the prime cost.
What is the purpose of prime cost?
The purpose of prime cost is to accurately calculate the cost of goods sold (COGS) for a business. COGS is an important figure for businesses, directly affecting their profitability.
By accurately calculating the prime costs associated with producing goods or services, businesses can determine the true cost of production.
The prime cost includes direct costs such as raw materials, direct labor, and manufacturing supplies directly associated with producing goods or services.
It excludes indirect costs such as rent, utilities, and administrative expenses. By excluding indirect costs, prime cost provides a more accurate picture of the direct costs of producing goods.
By calculating the prime cost, businesses can accurately determine the cost of each production unit, which can then be used to set prices for their products or services. Additionally, knowing the prime cost can help businesses identify areas where they can reduce costs to increase profitability.
In summary, the purpose of prime cost is to accurately calculate the cost of goods sold and provide businesses with a better understanding of the direct costs associated with producing goods or services.
This information can be used to set prices, identify cost-saving opportunities, and ultimately increase profitability.