Prime costs definition
/What are Prime Costs?
Prime costs are the costs directly incurred to create a product or service. These costs are useful for determining the contribution margin of a product or service, as well as for calculating the absolute minimum price at which a product should be sold. However, since prime costs do not include overhead costs, they are not good for calculating prices that will ensure long-term profitability.
Examples of Prime Costs
Examples of prime costs are as follows:
Direct materials. This is the raw materials used to construct a product. This may also include supplies consumed during the production of individual units, if such an association can be established.
Piece rate pay. This is the cost of labor and related payroll taxes directly associated with the production of one additional unit. It does not include other types of labor, such as manning an assembly line, if such labor cannot be clearly associated with the production of individual units.
Service labor. Service labor is the cost of billed labor, such as the cost of consulting labor billed to a client.
Commission. If there is a salesperson commission associated with a specific sale, then that is a prime cost.
What is the Prime Cost Formula?
The prime costs incurred will vary somewhat by business, but are generally considered to include the costs of direct materials, piece rate pay, service labor, and commissions. Therefore, the prime cost formula is as follows:
Direct materials + Piece rate pay + Service labor + Commissions = Prime costs
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Costs Not Considered Prime Costs
Costs that are not considered to be prime costs are generally referred to as indirect costs or overhead costs. These costs cannot be directly traced to the production of a specific product or service. One major category is manufacturing overhead, which includes expenses like factory rent, utilities, depreciation of equipment, maintenance, and salaries of supervisory and support staff who are not directly involved in production. Additionally, indirect materials (such as lubricants and cleaning supplies) and indirect labor (such as quality control inspectors and warehouse staff) fall into this category.
Another set of costs excluded from prime costs are selling, general, and administrative expenses. These are non-manufacturing costs that cover marketing, advertising, salaries of corporate management, office supplies, and legal and accounting fees. Also, costs like research and development and distribution expenses do not count as prime costs. Unlike direct materials and direct labor, these indirect costs support overall business operations and are allocated across all products rather than being directly attributable to a specific product’s production.
In many businesses, this means that the majority of all costs incurred are not prime costs.
Variability of Prime Costs
Prime costs can vary depending upon the cost object being reviewed. For example, if the cost object is a distribution channel, then the prime costs associated with it will include not only the items just specified, 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 also include the cost of warranty claims, returns processing, field servicing, and any staff who are assigned full time to servicing that customer. As another example, if the cost object is a sales region, prime costs may also include the cost of maintaining distribution warehouses in that region.
Use of Prime Costs in Product Design
A key focus of a company's product design staff is to reduce the prime cost per unit sold, so that the business can realize a larger profit. This cost reduction process is best achieved through the analyses used in target costing.
Terms Similar to Prime Costs
Prime costs are the same as direct costs.