What is Prime Cost
Prime costs are a firm's expenses for the direct materials and labor used in production. It 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 expenses, such as advertising and administrative costs.
BREAKING DOWN Prime Cost
A prime cost is the direct cost of manufacturing an item for sale. Businesses use prime costs 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 set prices that yield desired profits. 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 Direct Raw Materials + Direct Labor = Prime Cost. For example, a professional woodworker is hired to construct a dining room table for a customer. The prime costs for creating the table include direct labor and raw materials, such as lumber, hardware, and paint. The materials directly contributing to the table's production cost $200. The woodworker charges $50/hour for labor, and this project takes three hours to complete. The prime cost to produce the table is $350 ($200 for the raw materials + $150 in direct labor). To generate a profit, the table's price should be set above its prime cost.
Indirect costs, such as utilities, manager salaries, and delivery costs are not included in prime costs. One reason why indirect costs are excluded from the prime cost calculation is that they can be difficult to quantify and allocate.
Who Needs to Know Prime Cost?
Businesses need to calculate the prime cost of each product manufactured to ensure they are generating a profit. Self-employed individuals, such as artisans who create and sell custom-made furniture, often use the prime cost calculation to ensure they are making the hourly wage they desire while also profiting from each product made.
Consider the same woodworker creates and sells a new hand-crafted table for $250. The cost of the raw materials was $200, and it took him three hours to construct. Without regard to labor costs, the woodworker realized a gain of $50. If his direct labor costs were $15/hour, he realized a modest gain of $5. Therefore, it is especially important for self-employed persons to employ the prime cost method when determining what price to set for their goods and services. If the same artisan desired a labor wage of $20 and a profit of $100, the prime cost and price would be $260 ($200 for materials and $60 for labor) and $360 (prime cost + desired profit), respectively.