Prime costs are the expenses that at business incurs as part of the manufacturing of a product. Costs of this type are usually considered to be direct costs, in that these expenses impact the look, feel, and quality of the actual product. Indirect costs such as administrative support for order processing and similar tasks are usually not included as prime costs.
A simple formula for determining the total amount of prime costs associated with the production of a good or service is to add the direct labor costs to the direct material costs. For example, a company that produces a line of canned soft drinks would include the cost of materials necessary to make the container for the product itself, the money spent to create the container, and the cost for the ingredients to make each type of soft drink manufactured by the company. In terms of direct labor costs, the prime costs would include wages and benefits paid to employees who are involved with the creation of the soft drinks and their packaging. In some calculations, even the freight charges associated with the transporting the raw materials to the plant site are considered to be prime expenses, and are included in the calculation.
Identifying prime costs is very important to a manufacturer. Doing so makes it possible to understand exactly how much money is invested in each unit of product that is manufactured. This in turn allows the business to identify the minimum purchase price per unit that must be earned in order to offset those costs. By also allowing for factors such as the pricing used by competitors, the business can identify a unit price that not only covers all prime costs but also generates at least some profit for the business.
By monitoring prime costs from one accounting period to the next, the company can determine if changes in the direct material or direct labor costs are having an adverse impact on the profit margin. If so, the company may begin to look at each of these direct costs and determine if there is some way to reduce expenses without lowering the quality of the product. This is sometimes managed by streamlining the production process to cut labor costs or by finding new vendors for one or more of the raw materials used in the process. These same approaches may also be used if shifts in the marketplace make it necessary to reduce the unit price in order to grow or at least maintain the company’s market share.
