Table of Contents Hide
- What is Prime Cost?
- How to Calculate the Prime Cost with the Formula
- How Does Prime Costs Work?
- Labor Definition
- Example of Using Prime Cost
- Prime Cost Variability
- Factors Influencing the Prime Cost
- The Benefits of Prime Costs
- The Drawbacks of Using Prime Costs
- Conversion Cost vs. Prime Cost
- Prime Cost FAQs
- What is the difference between provisional sum and prime cost?
- What is a contingency sum?
To manufacture a product, an entity incurs a variety of direct and indirect costs. The direct costs of production are included in the prime cost. It is a measurement of the resources used solely for the production of the product under consideration, also known as the core manufacturing costs. In this article, we are going to look at the different components of prime cost and how to use it in your business accounting. We’ll also see how to calculate the prime cost using the formula.
What is Prime Cost?
The direct cost incurred in the process of manufacturing a product is known as the prime cost, and it typically includes the direct production cost of goods, including raw material and direct labor costs. It is an important component of total manufacturing costs. The basis determines the costing and effective pricing of the goods.
The cost of direct labor and direct expenses is known once the cost of raw materials is determined. The total of the three figures equals the prime cost.
How to Calculate the Prime Cost with the Formula
Though the production of goods and services involves a wide range of expenses, the prime cost formula only considers those variable expenses that are directly related to the production of each item.
The cost of raw materials is added to the cost of labor directly associated with the manufacturing process to calculate the prime cost. The prime cost formula is as follows:
How Does Prime Costs Work?
The sum of direct costs incurred during the manufacture of a product is referred to as prime costs. These costs include raw materials and direct labor in the manufacturing process but do not include indirect costs (for example, factory rent or supervisor’s salary).
The method involves calculating a product’s contribution margin, which demonstrates a product’s ability to cover fixed expenses as well as its profitability.
Prime costs are critical in cost and management accounting. These expenses are necessary to calculate the contribution margin, set prices, forecast sales and profits, and make decisions.
Prime costs are direct costs that are directly associated with each unit of manufactured product. These expenses typically include the following:
- Direct material
- Direct labor
- The direct expenditures
#1. Direct Substance
Tangible goods, materials, or supplies that are directly associated with a specific product. These are raw materials that are converted into finished goods during the manufacturing process.
Sugar and strawberry pulp, for example, are direct materials used in the production of strawberry jam.
#2. Direct Labor
Workers or employees who are directly involved in the manufacture of a specific product. Direct laborers use their skills to produce finished goods during the manufacturing process.
As a result, the direct labor cost includes wages paid to direct laborers in an organization, such as chef salaries in a restaurant.
#3. Direct Expenditure
Other than material and labor, all direct expenses are included in the prime costs, whether variable, semi-variable, or stepped fixed.
A commission or bonus paid to a salesperson who acts as an intermediary between the producer and the buyer in order to achieve a goal, for example, would be considered an indirect labor cost.
Labor is sometimes more difficult to define because, for many businesses, the contributions of various types of employees are critical to the creation of the end product. However, the prime cost formula’s definition of a labor expense includes only wages paid to employees who directly participate in the construction, formation, or assembly of an item for sale.
The definition of direct labor can vary depending on the product. A clothing manufacturing company, for example, would include the wages paid to workers who cut, stitch, and dye the clothing but not the employee who designs them. Cooks, servers, busboys, and other restaurant staff are included in labor because the end product includes both the dining experience and the prepared meal.
Any materials or labor that cannot be directly associated with the production process must be excluded from the prime costs. Factory overhead and administrative costs, for example, are not included in prime costs.
Example of Using Prime Cost
Assume, for example, that a professional woodworker is hired to build a dining room table for a customer. The table’s prime costs include direct labor and raw materials such as lumber, hardware, and paint. The materials directly contributing to the production of the table cost $200. This project takes three hours to complete and the woodworker charges $50 per hour for labor. The prime cost of making the table is $350 ($200 for raw materials + $150 for direct labor). To make a profit, the table’s price should be set higher than its prime cost.
Consider the same woodworker who built and sold a $250 handcrafted table. The raw materials cost $200, and it took him three hours to build. The woodworker made a $50 profit after deducting labor costs. If his direct labor costs were $15 per hour, he made a $5 profit. As a result, it is especially critical for self-employed individuals to use the prime cost method when determining what price to set for their goods and services.
If the same artisan desired a $20 per hour labor wage and a $100 profit, the prime cost and price would be $260 ($200 for materials and $60 for labor) and $360 (prime cost + desired profit), respectively.
Prime Cost Variability
Prime costs can vary depending on the cost object under consideration. If the cost object is a distribution channel, for example, the prime costs associated with it will include not only the items just mentioned, but also the direct cost of maintaining the distribution channel, such as marketing expenses.
Similarly, if the cost object is a customer, prime costs may include the cost of warranty claims, returns processing, field servicing, and any full-time staff assigned to servicing that customer. If the cost object is a sales region, prime costs may also include the cost of maintaining distribution warehouses in that region.
Product Design Using Prime Costs
The primary goal of a company’s product design team is to reduce the prime cost per unit sold so that the company can make a larger profit. This process of cost reduction is best accomplished through the analyses used in target costing.
Factors Influencing the Prime Cost
The following are a few of the factors:
Inflation raises the cost of raw materials, and director labor becomes more expensive during an inflationary period. It is a macroeconomic factor that would affect the entire economy, and it would be impossible for a single manufacturer to control. In the event of a recession, the situation will be reversed. As a result, price escalation would be the primary driver of this Cost.
#2. Lack of Supply
A scarcity of raw materials or a scarcity of skilled labor may raise the cost of a specific product. It is an industry-specific measure, and other product manufacturers may not face the same issue.
#3. Regulatory Actions
Changes in regulatory requirements are uncontrollable, and they can have an impact on the entire industry. For example, the government requires car manufacturers to include pollution-control components in their vehicles. This cost will rise in proportion to the amount of that specific pollution control component on the market.
Consider the preceding example of a car manufacturing company. Assume the company needs to spend $850 on pollution control. In such a case, the prime cost for car production will rise to $11550 in 2016-17.
Using the prime cost formula
Taxes levied on raw materials have a direct impact on the prime cost of the product. If the taxes and duties paid on raw materials increase, the cost of the product will increase as well.
#5. Technological advancements
Technological changes have a direct impact on prime costs, and businesses are willing to make such changes in order to compete. An increase in the use of high-tech machines instead of direct labor in the manufacturing process improves the entire production cycle while saving time and cost.
#6. Currency Exchange Rates
Multinational manufacturing companies conduct business in various locations around the world, and they must source raw materials from various locations. In that case, the foreign exchange rates of the importing countries could have a significant impact on the company’s prime costs.
The Benefits of Prime Costs
Some of the benefits are as follows:
- Because the cost of direct materials and direct labor is calculated without the use of complex formulae or estimates, it is a simple and objective measure.
- A measure of direct production costs can thus be an important area to focus on for cost control and cost reduction.
- Serves as a starting point for determining a product’s selling price.
The Drawbacks of Using Prime Costs
Because prime cost only considers direct costs, it does not capture the total cost of production. As a result, if indirect costs are relatively high, the prime cost calculation can be misleading. A company’s other expenses, such as manager salaries or additional supplies needed to keep the factory running, are almost certainly not included in the calculation of the prime cost. These additional costs are classified as manufacturing overhead and are factored into the conversion cost calculation. The conversion cost includes labor and overhead expenses but not material costs.
A second limitation of prime cost is the difficulty in determining which production costs are indeed direct. There are numerous costs associated with manufacturing goods for sale. To accurately calculate the prime cost of an item, a clear distinction must be made between expenses that can be directly linked to the production of each unit and those that are required to run the overall business. The specific expenses included in the prime cost calculation may differ depending on the item being manufactured.
Conversion Cost vs. Prime Cost
According to the preceding discussion, prime costs are the direct core costs. It includes all direct costs that can be easily identified and tracked with each unit of production. Conversion costs, on the other hand, are the costs associated with converting direct raw materials into finished goods.
As we all know, the three major components of manufacturing costs are:
- The direct cost of raw materials
- Direct labor expenses
Manufacturing overheads can include indirect material, indirect labor, other common manufacturing expenses, cost costs, and other similar costs. All of these are overheads because direct identification of each unit of production is difficult. As a result, these costs are spread across all units manufactured.
As a result, the first two items – direct material and direct labor costs – are included in the prime cost. Whereas conversion cost includes all direct labor costs as well as all other indirect costs and manufacturing overheads. In other words, the conversion cost includes all other costs incurred during the process of transforming basic raw materials and inputs into ‘finished goods.’
The core production cost is the prime cost, which includes direct raw material and direct labor costs. This is completely variable because it is a significant component of the Cost of Goods Sold. It is directly related to the number of sales because it is a direct manufacturing expense. Unlike a fixed cost, it can be adjusted to meet the company’s production goals.
Prime Cost FAQs
What is the difference between provisional sum and prime cost?
A prime cost is traditionally confined to the cost of supplying the relevant item and does not include the cost of any labor associated with it (such as its installation). Provisional sums, on the other hand, comprise allowances for both the supply item and all related work to be undertaken by the contractor.
What is a contingency sum?
A contingency sum is a line item in a bill of quantities. The item refers to unforeseeable costs that are likely to arise during the cost of the contract.