Prime cost is the manufacturing cost, which consists of both direct material and direct labor. It is the main cost that contributes to the production process. Indirect overhead cost is excluded from prime cost. It is the major factor for calculating contribution margin which is present the product’s ability to cover the fixed cost. In some particular occasion, management may use the contribution margin to quickly calculate the minimum selling price.
Prime Cost excludes the other indirect material and labor, which will consider as the overhead. It refers to the main costs of production that have a huge impact on the final product.
In management accounting, it is very important to identify prime cost as it helps to determine the selling price, prepare sales budget and profit to support management decisions.
Prime Cost Formula
Prime cost is the expense which the company spends directly on the specific product.
Direct Material: is the physical material which is the main part of the product. It includes the raw material that the company put into production and it converts into physical goods. For example, steel is a direct material for engine production. However, the engine may become direct material for car production.
Direct Labor: is the workers who are physically working on the production process. Without them, we will not be able to get the finished product. They use their skill in order to convert the raw material into a product.
Prime Cost Example
Company A is producing electric cars. The production process is separated into main three such as electronic assembly, interior, battery, and windshield assembly.
Component of Prime cost include
|Cost of engine
|Workers, electric assembly
|Workers, battery installation assembly
|Workers, windshield assembly
Factor impact Prime Cost
|During inflation, the value of money will decrease and it will increase the cost of raw material and worker wage.
|The government can have an influence on our prime cost such as the increase of minimum wage, it will have a huge impact on our projected cost. The other example is the ban of some raw material which have a negative impact on health or environment, more than ten countries have banned the production of fusil fuel vehicle.
|The increase of import tax will have an impact on our raw material costing.
|The usage of a robot can be a replacement for direct labor in some parts. It will require a huge cash flow at the beginning but the expense will reduce over time.
|Decrease in supply
|The price of raw material may increase due to the supply cut in the market.
Prime Cost vs Conversion Vs Factory Cost
|Include direct material and direct labor
|It includes direct labor and manufacturing overhead.
|Include direct material, direct labor, and manufacturing overhead.
Prime Cost in Construction
Not different from other industries, construction also has prime cost as it requires to have direct material and direct labour in the process. However, in construction, the prime cost is the supply of labour, equipment and material which provide by the contractors and bare by the client. This cost will be excluded from the profit mark up by the supplier or contractor.
In some circumstances, both client and contractor use the Prime Cost Contract that the contractor pays for the prime cost plus overhead cost and percentage of profit. However, there is still room for adjustment if there are any fluctuate in price during the construction time.
This prime cost contract usually uses when the client requires a very urgent work done, and they are highly likely to pay the premium price. They will not consider an alternative cheap price, which needs to wait for the right time. Their times are more valuable than cost-saving.
The contractors will try to secure their profit by transfer all the material and labour premium costs to the client. They need to finish their work and bill the profit mark up, and the client will pay for all the prime cost.
Limitation of using Prime Cost
Prime cost calculation does not include the indirect cost, so it is incomplete. It will not provide a complete picture of the cost in the production process. Many overheads are excluded, such as electricity bill, manager salary, and other costs which keep the factory running.
It is hard to identify the direct and indirect costs. Not all production processes are the same, some of them are very hard to separate the direct and indirect cost, and it will incur more cost to get it done while benefits are not much.
It will be misleading if the indirect costs are significantly high compare to the total cost. Prime cost only takes into account the direct cost, which will show a high variance compared to the total cost. If management makes the decision base on this information, it will impact the overall business strategy, such as selling price and so on.