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 are:
- 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. This 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.
Prime costs do not include indirect costs, such as allocated factory overhead. Administrative costs are generally not included in the prime cost category.
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.
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.
Prime costs are the same as direct costs.