Prime Cost

Updated on April 12, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Prime Cost?

Prime cost is the direct cost incurred in manufacturing a product and typically includes the direct production cost of goods, including the raw material and direct labor costs. It is an essential part of total manufacturing expenses. Costing and effective pricing of the goods are primarily determined on their basis.

Prime Cost Formula

Prime Cost formula = Raw Material + Direct Labor

Prime Cost Formula explained

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Prime Cost Explained in Video

 

How to Calculate Prime Cost?

Example #1

A Hypothetical Car Manufacturing Company in India has incurred below expenditures in the year 2016-17 for manufacturing various cars-

Expenditures for Yr 2016-17Amt in Rs Cr
Raw Material Consumption7500
Direct Expenditures4250
Other Manufacturing Expenditure2400
Indirect Expenditures3500
Administrative Expenditures5250
Finance Cost1300
Depreciation1800

To calculate Prime Cost, we have to take figures of raw material consumption and direct cost paid to the workers. In the above example, suppose the company pays 3200 towards direct labor cost out of entire direct expenditures;

  • Formula = Raw Material + Direct Labour = 7500 + 3200 = 10700 Crore

Please note – 1 Crore (cr) = 10 million

Example #2

Let us take another example to calculate the Price Cost.

Calculate the Prime Cost of a hypothetical furniture manufacturing company that incurred the following manufacturing expenses for the completion of one of its assignments;

  • 5 Labour worked for 30 days
  • Labor charges are Rs 1000/- per labor per day
  • Wood – 100 sheets @ a cost of Rs 1500/- per sheet
  • Glue – 50 Kg @ a cost of Rs 250/- per Kg

Formula = Raw Material + Direct Labour

  • = (100*1500) + (50*250) + (1000*5*30)
  • = 150000 + 12500 + 150000
  • = Rs 312500/-

For an industry like furniture, wood and glue are basic raw materials, and skilled labor is required for making the customized furniture as per the customer’s need; without that, furniture could not be produced and turned into finished goods.

Here they use 100 sheets of wood @ a cost of Rs 1500/- per sheet and 50Kg Glue @ a cost of Rs 250/- per Kg. Then five workers work for 30 days at Rs 1000/- per worker per day. We multiply all of these to calculate the amount of direct labor cost. The summation of all the costs is nothing but the Prime Cost.

Important Points to Note

We have taken only direct labor cost out of the entire direct expenditure to calculate Prime Cost. Other costs may be involved in direct expenditure like carriage inwardCarriage InwardCarriage inwards, also known as freight inwards, is the cost of transporting goods from a warehouse to the buyer's business location, and it is treated as a direct expense. As a result, it is always reflected on the trading account's debit side.read more and freight. All other expenditures are part of the indirect expenditure and were neglected at the time of calculating Prime Cost.

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6 Reasons that will Influence the Prime Cost

Followings are a few reasons:

#1 – Inflation

Inflation increases the cost of raw materials, and direct labor is more costly during inflation. It is a macroeconomic factorA Macroeconomic FactorMacroeconomic factors are those that have a broad impact on the national economy, such as population, income, unemployment, investments, savings, and the rate of inflation, and are monitored by highly professional teams governed by the government or other economists.read more, and the entire economy would be affected by it, and a single manufacturer would not be able to control it. In the case of a recession, the scenario will reverse. Thus price escalation would be the main driving factor of this Cost.

#2 – Shortage of Supply

A short supply of raw material or unavailability of skilled labor may increase the cost of a specific product. It is an industry-specific measure, and manufacturers of other products may not face the same problem.

#3 – Regulatory Actions

Changes in regulatory requirements are uncontrollable, and the entire industry can be affected by them. For Example, the Government makes it mandatory for car manufacturing companies to add pollution control components to their cars. This Cost will increase by the amount of that specific pollution control component available in the market.

Let’s consider the above-stated example of a Car Manufacturing Company in India. Say the company requires to spend Rs 850 Crore on that pollution control component. In such a case, the Prime Cost for production of the car will increase to Rs 11550 Crores in 2016-17.

Prime Cost Formula = Raw Material + Pollution Control Equipment + Direct Labour

  • = 7500 + 850 + 3200
  • = 11,550 Crores

Please note – 1 Crore (cr) = 10 million

#4 – Taxes

Applicable taxes to purchase a raw material will directly impact the product’s Prime Cost. If the taxes and duties paid on the raw material rise, then the subsequent rise in the product cost will be reflected.

#5 – Technology

Technological changes directly affect the Prime Cost, and companies are ready to adopt such changes to compete with the rivalry. An increase in the utilization of high technology machines, instead of direct labor in the production process, improves the entire production cycle more efficiently and saves time and cost of production.

#6 – Exchange Rates

Multinational manufacturing companies operate their businesses in various locations across the globe, and they have to purchase raw materials from different destinations. In that case, foreign exchange rates of the importing countries could significantly impact the Prime Cost of the company.

  • For example, a Laptop Manufacturing company in the United States purchases spare parts for a laptop, i.e., raw materials from a Chinese company. If in case, the rate of the Chinese Yuan increases against the US Dollar by 3%, the imported raw material would be more expensive in the hands of a laptop manufacturing company in the United States, almost by 3%.
  • Hence the cost of manufacturing a laptop would rise, and the company’s laptop gets expensive in the market by 3% or more. In such scenarios, the company may purchase the raw material from countries like Japan, with which currency rates might be stable to maintain the price of laptops in the market.

Conclusion

Prime Cost is the core production cost, including direct raw material and labor costs. It is completely variable as it’s a major component of Cost of Goods SoldComponent Of Cost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more. Being a direct manufacturing expense, it is directly related to the number of sales. Unlike a fixed costA Fixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more, it may be changed according to the company’s production targets.

This article has been a guide to Prime Costs and its meaning. Here we discuss how to calculate Prime Costs, its formula, examples, and important features. We also explore six primary reasons that impact these costs. You may learn more about accounting from the following articles –

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