Prime costs are all of the costs that are directly attributed to the production of each product. Prime costs are direct costs, meaning they include the costs of direct materials and direct labor involved in manufacturing an item. Companies use prime costs to price their products.
Formula for Calculating Prime Costs
Though the production of goods and services involves many different kinds of expenses, the prime cost formula only takes into account those variable expenses directly connected to the production of each item.
Examples of Prime Costs
Direct materials are one of the main components of prime costs and include raw materials and supplies that are consumed directly during the production of goods.
Raw materials are the physical components of the product. In manufacturing, raw materials might include metals, plastics, hardware, fabric, and paint. The types of raw materials vary greatly depending on the industry. For a furniture manufacturer, the raw materials might be lumber, hardware, paint, and varnish.
Businesses in the restaurant industry need to strike a balance between profitability and the need to create unique, mouth-watering meals with high-quality ingredients. In this industry, the various food and beverage items that a restaurant uses to build its menu are its raw materials.
Direct labor includes only wages paid to workers who directly contribute to the formation, assembly, or creation of the product. Direct labor would not include, for example, salaries for factory managers or fees paid to engineers or designers. These employees are involved in the creation of the product concept and the day-to-day operation of the business rather than the hands-on assembly of items for sale. However, commissions paid to salespeople who act as intermediaries between the manufacturer and the consumer are included in the prime cost equation.
The cost of labor and payroll taxes used directly in the production process are part of prime costs. Labor that is used to service and consult the production of goods is also included in prime costs. Direct labor examples might include assembly line workers, welders, carpenters, glass workers, painters, and cooks.
Labor is sometimes a little more complicated to define because, for many companies, the contributions of several different types of employees are crucial to the creation of the end product. However, the definition of a labor expense used in the prime cost formula includes wages paid only to those employees who directly participate in the building, formation, or assembly of an item for sale.
The definition of direct labor can depend on the product itself. A garment manufacturing company, for example, would include the wages paid to the workers who cut, stitch, and dye the clothing, but not to the employee who designs them. In a restaurant, the cooks, servers, busboys, and other staff are included in labor because the end product consists of the dining experience as well as the prepared meal.
Any materials or labor whose direct association in the production process cannot be established must be excluded from the prime costs. For example, factory overhead and administrative costs are not part of prime costs.
Cost Object and Prime Costs
Prime costs can vary depending on the cost subject under consideration. For instance, if a customer is the cost object, then any expenses associated with serving the customer are considered prime costs, including shipping, returns, and warranty. If the cost subject is a particular geographic area, then the costs associated with serving that area are part of prime costs, including wages of sales staff and maintenance of warehouses assigned for that area.
Numeric Example of Prime Costs
For example, assume a business manufactures 10 bed frames and incurs the following expenses:
- $5,000 for lumber
- $1,500 for hardware
- 50 hours of labor for product assembly at a rate of $15 per hour
Only the costs of raw materials and direct labor are used in the prime cost formula.
The raw materials include the lumber and hardware used for assembly:
- The total cost of raw materials = $6,500 ($5,000 + $1,500)
- The total cost of labor = $750 ($15 * 50 hours)
- The prime cost of a single bed frame = $72.50 ($6,500 + $750) / 10
The company must sell each bed frame for more than $72.50 to generate a profit.
Of course, the company likely incurred several other expenses that would not be included in the calculation of the prime cost such as manager salaries, or expenses for additional supplies needed to keep the factory running. These other expenses are considered manufacturing overhead expenses and are included in the calculation of the conversion cost. The conversion cost takes labor and overhead expenses into account, but not the cost of materials.
The Bottom Line
Calculating a product's prime cost is important because it can be used to determine a product's minimum sales price. If the sales price does not exceed the prime cost, the company will lose money on each unit produced.
There are numerous expenses associated with producing goods for sale. To calculate the prime cost of an item accurately, there must be a clear division between those expenses that can directly link to the production of each unit versus those that are required to run the overall business. The specific expenses included in the prime cost calculation vary depending on the item being produced.