What is Prime Cost? – Definition
Prime Cost is the aggregate of direct material cost, direct labor cost and direct expenses. Prime Cost is also known as ‘Flat Cost’, ‘First Cost’ or ‘Direct Cost’.
The total of a product’s direct costs is called the prime cost. Once the cost of raw materials used in a particular period has been ascertained and the cost of direct labor and direct expenses is known. The prime cost can be calculated by simply adding up the three figures.
Prime costs can be defined as the sum of direct costs incurred during the manufacture of a product. It only includes the cost of material and labor directly consumed in the course of production of total output, such as raw material and direct labor, but excludes indirect expenses like factory rent and supervisor’s salary.
This is used to calculate the contribution margin of a product, which represents the ability of a product to cover fixed expenses and its profitability.
Prime costs play a vital role in cost and management accounting. Prime cost is the essential ingredient required in costing for the calculation of contribution margin, determination of prices, forecasting of sales and profits as well as decision making.
As discussed above, prime cost constitutes direct costs. In other words, it refers to expenses that can be directly associated with each unit of product manufactured. Prime costs usually comprise of direct material, direct labor, and direct expenses.
- Direct material: These are tangible goods, materials, or supplies that are directly identified with a particular product. These are raw materials put into the production process that are converted into finished goods. For example, sugar and strawberry pulp are direct materials used for the manufacture of strawberry jam.
- Direct labor: These are workers or employees that are directly involved in the production of a particular product. Direct labors apply their skills, during the production process, on to the goods being converted into finished goods. Hence, direct labor cost includes wages paid to the direct labors in an organization, for example, salaries paid to the chefs in a restaurant.
- Direct expenses: Any direct expenses other than direct material and direct labor are also 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 indirect labor cost.
As compared to the direct costs, indirect costs are not included in the calculation of prime costs. Indirect expenses can be defined as costs incurred in the course of production that can’t be directly associated with a single unit of output. Examples include factory rent expense, depreciation expense, supervisor’s salary, guard’s salary, utility bills, and more.
Prime cost per unit is often calculated to determine the cost of production of each unit of output so that the organization could fix a minimum price. However, indirect expenses are incurred and paid off aggregately, which is why the total bill arrives annually or monthly. This causes the indirect expenses to be quite difficult to predict beforehand and to spread and allocate these costs to the entire output of the firm.
This concept is also supported by the Marginal Costing system of accounting. Marginal costing is a system where only the prime costs are charged 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 of contribution margin is referred to as the marginal profit earned by the company that year.
Prime cost calculation formula:
Prime cost = direct materials cost + direct labor cost
The formula of prime cost is just a sum of all the cost of production incurred directly in regards to the manufacture of goods.
Example of Prime Cost
Elegance Limited is a sofa shop that has manufactured ten sets of sofas in the year ending 2019 and incurred the following costs:
The total hours worked by the labor are 200.
The total direct material of Elegance Limited shall be = timber + foam +cloth = $50,000 +$25,000 + $37,000 = $112,000
Total direct labor cost of Elegance Limited shall be = 100 200 = $20,000
Other direct expenses = $7,000
Hence, the PRIME COST of Elegance Limited for the year ended 2019 shall be
$112,000 + $20,000 + $7,000 = $139,000.
Prime costs are an important metric to measure the profitability of a product and to determine the selling price. A negative contribution margin implies that sales and production of the product would result in losses, whereas a positive contribution margin implies that sales and production of the product would result in profits.