What is a 'Prime Cost'
Prime cost refers to a manufactured product's costs, which are calculated to ensure the best profit margin for a company. The prime cost calculates the use of raw materials and direct labor, but does not factor in indirect manufacturing expenses such as the cost for a company logo or gas used to deliver the product.
BREAKING DOWN 'Prime Cost'Prime cost is the direct cost of manufacturing an item for sale. Businesses use prime cost as a way of measuring the total cost of the production inputs needed to create a given output. By analyzing its prime costs, a company can determine how much it must charge for its finished product in order to make a profit. By lowering its prime costs, a company can increase its profit and/or undercut its competitors' prices.
How to Calculate the Prime Cost
The formula to discover the prime cost is as follows:
Raw Materials + Direct Labor = Prime Cost
For example, the prime costs for creating a table would include raw materials such as the lumber, hardware and paint. For all of the materials, it would cost $200. In this example, it would take three hours to finish the product for sale, and would cost $50 per hour. To find the prime cost of the table, it would then look like this:
$200 (Raw Material) + $150 (Direct Labor) = $350 (Prime Cost)
Knowing that the prime cost is $350 means that the business cannot sell the table for under $350 unless they wish to incur a loss.
When calculating the prime cost, a company does not factor in indirect costs, such as advertising costs, manager salaries, or delivery costs. While it is good for a business to know its indirect costs for budgeting purposes, it is not essential to individual product costs.
Who Needs to Know Prime Cost?
Businesses need to calculate the prime cost of each product manufactured to ensure they are turning a profit. Individuals who work for themselves, such as artisans who sell custom-made furniture, must use the prime cost to ensure they are making the hourly wage they desire while also profiting on each product made.
For example, if it took an individual three hours and $200 to make a table, and they sold it for $250, they would technically make a profit but would only make about $16 an hour. If the individual knows that he wants to make at least $30 an hour, then he would calculate the prime cost like this:
$200 (Raw Material) + $90 (desired hourly wage * hours worked)= $290