Prime Cost: Definition
Prime cost is the aggregate of direct material cost, direct labor cost, and direct expenses. It is also known as ‘flat cost,’ ‘first cost,’ or ‘direct cost.’
Once the cost of raw materials has been ascertained, the cost of direct labor and direct expenses is known. The prime cost can be calculated by adding up the three figures.
Prime Cost: Explanation
Prime costs are the sum of direct costs incurred during the manufacture of a product. These costs comprise raw material and direct labor in the production process but do not include indirect expenses (e.g., factory rent or supervisor’s salary).
The method involves calculating the contribution margin of a product, and it shows the ability of a product to cover fixed expenses, as well as its profitability.
Prime costs play a vital role in cost and management accounting. These costs are the crucial ingredient required to calculate the contribution margin, determine prices, forecast sales and profits, and make decisions.
Prime costs constitute direct costs and refer to expenses directly associated with each unit of the manufactured product. These costs usually comprise the following:
- Direct material
- Direct labor
- Direct expenses
Tangible goods, materials, or supplies directly identified with a particular product. These are raw materials in the production process converted into finished goods.
For example, sugar and strawberry pulp are direct materials used for the manufacture of strawberry jam.
Workers or employees directly involved in the production of a particular product. Direct laborers apply their skills during the production process to produce the finished goods.
Hence, the direct labor cost includes wages paid to the direct laborers in an organization, such as salaries paid to the chefs in a restaurant.
Any direct expenses other than material and labor are included in the prime cost, irrespective of whether they are variable, semi-variable, or stepped fixed.
For example, a commission or bonus awarded to a salesperson who works as an intermediary between the producer and buyer on achieving a goal would also be included as indirect labor cost.
Compared to direct costs, indirect costs are not included in the calculation of prime costs.
Indirect expenses refer to the costs incurred in production that cannot be directly associated with a single output unit. Examples include factory rent, depreciation, salaries for supervisors and guards, utility bills, and more.
The prime cost per unit is often calculated to determine the production cost of each unit of output so that the organization could fix a minimum price.
However, indirect expenses are incurred and paid off aggregately, indicating why the total bill arrives annually or monthly.
Such a development makes the indirect expenses tricky to predict and spread and allocate these costs to the entire output of the firm.
This concept is supported by the marginal costing system of accounting, which only charges the prime costs to the cost of inventory, which is deducted from the amount of revenue to arrive at the contribution margin.
The contribution margin earned is then used to set off indirect expenses. After the deduction of indirect costs, the leftover contribution margin refers to the marginal profit earned by the company that year.
Prime cost = Direct materials cost + Direct labor cost
This formula shows that prime cost is the sum of all the production costs (those that are directly incurred) relative to the manufacture of goods.
In 2019, Elegance Limited, a sofa shop, manufactured 10 sets of sofas. They incurred the costs shown below.
In total, the laborers worked for 200 hours.
The total direct material of Elegance Limited amounts to timber + foam + cloth = $50,000 + $25,000 + $37,000 = $112,000.
The total direct labor cost of Elegance Limited amounts to 100 x 200 = $20,000.
Other direct expenses are $7,000 in total.
Hence, the prime cost of Elegance Limited for the year ended 2019 amounts to
$112,000 + $20,000 + $7,000 = $139,000.
Prime costs are a crucial metric to measure the profitability of a product and determine the selling price.
Reach out to a Financial Advisor
Basically, learning about prime cost is important so that you can properly determine a product’s minimum sales price. Learn more about it and other equally important topics by getting in touch with a financial advisor in Cincinnati, OH. Visit our financial advisor page if you live outside the locality.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.