How to Calculate Prime Costs

Prime costs are all the costs directly involved in creating a product or service. They are therefore highly important and have a direct impact on profit.

With that in mind, let’s define prime costs in more detail and explore their significance when it comes to profitability.

What are prime costs?

As mentioned above, prime costs are all the costs incurred when creating a product or service. They are useful for deciding on the minimum price for a product or service, as well as determining the contribution margin of each product and service a business offers.

However, prime costs should not be the only factor considered when deciding on prices as they do not include overhead costs.

Prime cost formula

Prime costs can be calculated using the following formula:

• Prime cost = direct materials cost + direct labor cost

As the formula reveals, prime costs are the sum of all costs directly tied to production.

Prime cost examples

Examples of prime costs include the following:

• Direct materials - These are the raw materials used to manufacture a product.

• Pay per production unit - This is the cost of labor directly linked to the manufacturing of one production unit. It only includes costs which can be directly associated with unit productions. It doesn’t therefore include the pay of supervisors, for example, if their impact on the production of one unit cannot be accurately evaluated.

• Service labor - This refers to the cost of billed labor. For example, a consultant who bills their client by the hour.

• Commission - If salespersons are paid commission, then commission linked to a specific sale will be included in prime costs.

Which costs are not considered prime costs?

Sometimes it can be tricky to accurately determine what are prime costs in accounting and what aren’t. However, it’s vital that you can differentiate them.

An easy way to think of it is that prime costs are all costs that can be directly linked to the creation of a product or service. If a cost is linked to the general running of a business and not specifically production - even if it benefits or has an impact on production - it is probably not a prime cost.

Prime costs do not include, for example indirect costs, such as warehouse rent, utilities and office supplies. Administrative costs are also not usually considered prime costs. For most businesses, this entails that the majority of all costs incurred are not, in fact, prime costs.

Prime cost vs variable cost?

Prime costs and variable costs are different things. Prime costs include all of a company’s fixed expenses pertaining to production, while variable costs only refer to costs that fluctuate in line with production. Consequently, prime cost is usually higher than variable cost, and is also more stable and easy to predict.

What happens if prime costs are too high?

If your prime costs are too high, your production costs are also too high. This can result in an adverse effect on competitiveness in the marketplace as well as overall profitability.

Indeed, your profit margin will be reduced if you attempt to keep prices in line with the market while prime costs are high. Likewise sales will decline if you increase your markup to try and maintain your profit margin.

The best solution if you find yourself in this predicament is to find a way to bring costs down. Some of the ways you can do this include:

• Negotiating with suppliers to see if you can get a better deal

• Streamlining your operations for greater efficiency

• Investing in software and technology that can reduce labor costs and increase efficiency

How can calculating prime costs be useful?

Being aware of prime costs helps you to recognize which products are most cost-efficient and bring in the most profit. You can use this information to raise or lower your prices accordingly.

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