Prime Costs

Prime costs are the costs of manufacturing that can be traced directly to individual units of product. They consist of two elements: direct materials, the raw materials and components that become part of the finished product, and direct labor, the wages and related costs of workers who physically make it. Prime costs leave out manufacturing overhead, such as factory rent, utilities, supervision and equipment depreciation, which cannot be traced to particular units.

The concept is used in cost accounting to measure the core variable cost of producing goods and to set prices. It sits alongside conversion costs, which are direct labor plus manufacturing overhead. Direct labor appears in both groupings, so prime costs and conversion costs should not be added together, or labor will be counted twice.

The formula is:

Here $\text{Direct materials}$ is the cost of materials used in production during the period, and $\text{Direct labor}$ is the cost of production workers' time spent making the product, including payroll taxes and benefits where these are charged as part of labor cost.

A furniture workshop makes 500 dining chairs in a month. It uses $18,000 of wood, fabric and fittings, all of which can be traced to the chairs. Carpenters spend 600 hours on the chairs at a fully loaded rate of $35 an hour, a total of $21,000. Factory rent, power, glue, sandpaper and the supervisor's salary total $11,000.

• Prime costs: $18,000 plus $21,000, or $39,000, which is $78 per chair.
• Conversion costs: $21,000 plus $11,000, or $32,000, which is $64 per chair.
• Total manufacturing cost: $18,000 plus $21,000 plus $11,000, or $50,000, which is $100 per chair.

Glue and sandpaper are indirect materials and the supervisor's salary is indirect labor, so they belong in overhead rather than prime costs. If a customer offers to buy an extra 50 chairs at $90 each, and the workshop has spare capacity so overhead will not rise, the order covers its prime costs of $78 per chair and adds $600 to profit, even though $90 is below the full $100 unit cost.

• Pricing: some businesses, especially small manufacturers and contractors, set prices by marking up prime costs to cover overhead and profit.
• Cost control: tracking prime costs per unit helps managers spot increases in material prices, waste or labor inefficiency.
• Overhead allocation: overhead is sometimes applied as a percentage of prime cost, though labor hours or machine hours are more common.
• Hospitality: restaurants use a related "prime cost" measure, food and beverage cost plus total labor cost, and often target it at around 60 to 65 percent of sales.

As automation has grown, direct labor has become a much smaller share of manufacturing cost in many industries, while overhead has grown, so prime costs can understate the true cost of production. Classification can also be difficult: some labor, such as machine setup or quality inspection, may be treated as direct in one company and indirect in another. For financial reporting, inventory must include overhead as well as prime costs under absorption costing, so prime costs alone are never used to value inventory in the balance sheet. They are most useful as an internal measure of direct cost, often derived from a bill of materials and labor time standards, and as one of the building blocks of job order costing and process costing.