Definition of Prime Cost
Prime cost refers to the sum total of costs directly attributable to the manufacture of a product. The raw materials used to produce a finished good, and the cost of hiring workers involved directly in the manufacture of the finished good are the primary direct costs involved in the manufacturing process. Accordingly, prime cost can be said to be a sum of the cost of direct raw materials and direct labor.
Explanation
An entity incurs various direct and indirect costs to manufacture a product. Prime cost consists of the direct costs of production. It is a measure of the resources consumed solely for the production of the product being considered, or the core manufacturing costs.
The formula for Prime Cost
Example of Prime Cost
A single unit of the finished product – Product ‘A’ requires 500 units of raw material and 6 hours of labor to produce. The raw material costs $3 per unit. The company pays its factory workers at a rate of $20 per hour.
Prime Cost of producing 1 unit of ‘A’ can be calculated as follows:
Prime Cost = Cost of Direct Materials + Direct Labor
- Prime Cost = (500 units x $3 per unit) + (6 hours x $20 per hour)
- Prime Cost = $1,500 + $120
- Prime Cost = $1,620
What does Prime Cost include?
The costs that can be directly attributed to production are typically the cost of direct raw materials consumed, and direct labor.
- Direct Materials: refers to raw materials that are consumed in the production of the final product and are incorporated in the final product. Usually, the quantum of raw material used varies directly with the quantity of finished goods produced.
- Direct Labor: refers to the wages paid to factory workers who are directly involved in the manufacture of the product. For example, the salary paid to assembly line workers in charge of assembling the components that form the final product.
Since direct costs vary with the level of production, Prime cost consists of variable costs and not fixed costs. Prime cost does not include indirect manufacturing costs (overheads) that cannot be precisely mapped on a one-on-one basis to the product, like factory rent, factory electricity charges, etc.
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Factors Affecting Prime Cost
Factors that influence an entity’s cost of raw material and factory wages would affect the entity’s Prime cost. For example –
- Shortage of supply of the particular raw material that would push up the prices for the material.
- Shortage of labor or shortage of labor force skilled in the manufacture of the particular product.
- A hike in taxes levied on raw material would also increase the cost of raw materials.
- In case the entity imports its raw materials, an increase in exchange rates could also increase the raw material costs.
- Regulations requiring an increase in the minimum wage rate paid to the factory workers.
- The inflationary trend in the economy which would increase both raw material and labor costs for the entity.
- An effect of any new regulation introduced. For example, the government might require the product to be fitted with a particular safety component as a measure towards consumer safety. The cost of the additional safety component would increase the cost of materials required to manufacture the product.
Importance of Prime Cost
Importance of prime cost are given below:
- Aids in the determination of Selling Price: Prime cost can be an important measure to aid the entity in fixing prices for its products. Any company would typically not want to price its products at less than the costs to produce it. Hence, a profit margin would be added to the cost of production. The company may add a particular profit margin to the Prime cost of producing a product to arrive at a possible selling price.
- Can be used for cost control and cost reduction: Since Prime cost consists of direct costs incurred in manufacturing a product, it aids in calculation of product-wise profitability and hence canbe a good measure of cost control and cost reduction.
- Basis for allocation of Overheads: Overheads can be allocated to different products on the basis of their relative Prime costs.
Advantages of Prime Cost
Some of the advantages are given below:
- Easy-to-calculate and objective measure since the calculation of the cost of direct materials and direct labor does not involve the use of any complex formulae or estimates.
- A measure of direct costs related to production hence can serve as an important area to focus on for cost control and cost reduction.
- Helps serve as a base to determine the selling price of a product.
Disadvantages of Prime Cost
Some of the disadvantages are given below:
- Prime cost does not consider overheads and other indirect costs that are also incurred in connection with the manufacture of the product. Hence any price determined solely based on Prime cost would not cover all the costs of manufacturing a product.
- All direct costs of manufacturing a product need to be included for the purpose of calculating Prime cost. In case an entity’s information systems do not accurately identify all direct costs, the calculation of Prime cost would then not be accurate. As a result, even the overhead costs which may be allocated based on Prime cost may be inaccurately allocated.
Conclusion
Prime cost is the sum total of all direct costs of manufacturing a product and typically includes cost of direct raw materials and direct labor. It serves as a basic measure of the costs of manufacturing a product. However, since Prime cost does not include indirect costs of manufacture, it does not depict the total costs of manufacturing a product.
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