Prime Cost – Meaning, Formula, Importance And More

Prime Cost (or Flat Cost or First Cost) is the direct cost that the company incurs in manufacturing a product. Such costs usually include direct production costs, like the cost of raw materials and direct labor costs.

In other words, we can say prime costs are the core production costs, which may serve as the basis of allocating overheads to different products.

Formula

One can calculate prime costs using any of the following formulas depending on the type of information available.

Prime Costs = Direct Materials Cost +  Direct Labor Cost

Prime Costs = Total Manufacturing Costs – Total Manufacturing Overheads

For example, a furniture maker makes a custom sofa set for a customer. The cost of material that the furniture maker uses (wood, paint, hardware are more) equals \$300, while the labor charges are \$100. In this case, the total prime cost to produce the sofa is \$400.

Importance

A company, primarily, uses the prime costs to improve the production process and make cost objects more efficient. For example, if the company plans to determine prime costs for a paint department, then paints, supplies, chemical and other material that this department uses will constitute prime cost. In this way, the management can analyze the cost process and come up with ways to minimize it.

Prime Cost also serves as a base for determining the effective pricing of the product and also defines the profit margin of the company. A company can use these costs to determine the minimum break-even selling price. However, since it does not include the overhead costs, they are not viable to define the long-term profitability of the company.

Along with companies, the concept of prime costs is important for self-employed individuals as well. For instance, those selling custom-made furniture would calculate such a cost to ensure their hourly wage is as per the expectations and they are making a profit on the product made.

What does it Include?

Direct materials

These are the raw materials that a company uses to manufacture a product. Such costs may also include the supplies that the company consumes for producing individual units.

Piece Rate Pay

It includes the cost of labor and the payroll taxes directly attributable to the production of an additional unit. Such costs do not include labor costs that an accounts manager can’t associate with the production of individual units. For example, labor costs for manning an assembly line.

Service Labor

Such costs include the cost directly attributable to a client or project. For example, the cost of consulting labor billed to a client.

Commission

Prime costs will include the commission to a salesperson if it is attributable to a specific sale.

Apart from these, more items can come under prime costs depending on the purpose of review. For instance, if the purpose is to trace the cost of a distribution channel, then the prime costs would also include the cost of maintaining the distribution channel, like marketing expenses.

On the contrary, if the purpose is to find the costs attributable to a client, then it will also include the cost of field servicing, warranty claims, returns processing and more. Separately, if the purpose is to determine the cost for a region, then it would include warehousing expenses for the region as well.

Indirect costs, like allocated factory overhead and administrative costs, do not usually come under the prime cost. A company excludes such a cost because it is difficult to quantify and allocate them.

Limitations

• Since it only includes direct costs, it does not tell the total cost of production. Overhead expenses, such as electricity and others to keep the factory running form a significant portion of the manufacturing expenses. Thus, the prime cost may give an incomplete picture of the manufacturing process.
• Sometimes it gets difficult to know exactly what costs are direct. Many expenses form part of the manufacturing process, but not all go into calculating prime costs. So, there must be a clear distinction between the expenses that can be directly attributable to each unit versus those that the company spends on the whole business.
• Another limitation is, the specific expenses that go into the calculation of prime cost vary depending on the purpose and the product in question.

Prime Cost vs. Conversion Cost

Conversion Costs also helps in calculating the profits on the basis of the cost of production. However, along with the direct materials and labor, it also includes overhead expenses. The conversion cost calculation includes overhead expenses, such as electricity or other utilities because they are necessary for converting raw materials into finished goods.

Prime costs, on the other hand, do not take into account overhead expenses. Management also uses conversion costs to plug the loopholes in the manufacturing process.

Factors Affecting Prime Costs

• A rise or fall in inflation directly affects the cost of raw material and labor costs.
• Shortage of raw material or skilled labor may raise the cost of a product. What’s of concern is that this is an industry-specific issue. Other industries may not face the same issue.
• A change in regulation could also increase the cost for the entire industry or all industries. For example, an increase in any sales tax could raise the cost for all companies. On the other hand, the government introducing a new requirement for pollution control equipment would raise the cost for auto companies.
• A change in the technology to better compete with the rivals or to get at par with others will also raise the cost.
• If a company exports its products, then an adverse movement in the exchange rate will also raise the cost of the product.

Final Words

A company must always strive to minimize the prime cost per unit. Doing this will maximize profit. One can use target costing for cost reduction process, but the company must ensure that it does not compromise on the quality of the product.1–3

1.
Prime costs definition —  AccountingTools. AccountingTools. June 2019. [Source]
2.
Prime Cost. XPLAINDCOM. August 2019. [Source]
3.
Kenton W. Prime Cost. Investopedia. April 2019. [Source]
Last updated on : October 2nd, 2019