The prime cost It is defined as all the direct costs of a product, that is, those costs that can be conveniently tracked for each unit produced. It then refers to the cost of direct materials and the cost of direct labor.
Therefore, they are all the costs of a company directly related to the manufacture of finished products. The higher the ratio of the prime cost to the total costs of a product, the more reliable the estimate of the cost of that product..
Firms use prime costs as a way to measure the total cost of the production inputs required to create a given product. By analyzing them, a company will be able to establish prices that generate the desired benefits. By reducing them, you can increase your profits or lower your competitors' prices..
Both prime costs and conversion costs have direct labor costs as a common built-in element..
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It refers to the costs of a manufactured product, which are calculated to guarantee the best profit margin for a company. The calculation of prime costs includes the total amount spent on direct materials, plus direct labor.
On the other hand, unlike the cost of conversion, the prime cost does not take into account indirect costs, such as utilities, advertising and administrative costs..
Direct materials refer to the cost of the items that are an integral part of the finished product. All tangible components are included, such as the raw materials needed to create the finished product.
Some examples are steel in cars, rubber in tires, fabric in clothing, etc..
Direct labor refers to wages, salaries and benefits that are paid only to workers who work in the transformation of raw materials into finished products.
The job is a bit more complicated to define because, for many companies, the contribution of several different types of employees is crucial to the manufacture of the final product..
Managers review prime costs to ensure the company has an efficient production process.
Calculating prime costs also helps companies set prices at a level that ensures they are generating an acceptable amount of profit. Based on costs, management can calculate the minimum equilibrium selling price.
Because the prime cost only takes into account direct costs, it does not include the total cost of production. Therefore, it can be misleading if the indirect costs are relatively large..
A second limitation is knowing exactly what production costs are really direct. There should be a clear division between expenses that can be directly linked to production, with respect to those required to run the business in general..
Although the production of goods and services involves many different types of expenses, the prime cost formula only takes into account the variable expenses directly related to the production of each item..
The prime cost is calculated by adding the cost of raw materials to the cost of labor directly associated with the production process. The formula is as follows:
Prime Cost = Direct Raw Materials + Direct Labor.
You can take the following example that shows how the calculation of the prime cost is performed.
You can calculate the prime cost of a furniture manufacturing company, which incurred the following manufacturing expenses to complete one of its products:
- 5 workers working for 30 days.
- Direct labor cost is $ 100 per worker per day.
- Wood: 100 sheets at a cost of $ 150 per sheet,
- Glue: 50 Kgs. At a cost of $ 25 per Kg.
Since the prime cost formula is equal to raw material cost + direct labor, we have:
Cost of raw material = (100 sheets of wood x $ 150) + (50 Kgs. Of glue x $ 25) = $ 15,000 + $ 1,250 = $ 16,250.
Direct labor cost = 5 workers x $ 100 x 30 days = $ 15,000.
The prime cost = $ 16,250 + $ 15,000 = $ 31,250.
For an industry like furniture, wood and glue are treated as basic raw material and skilled labor is required to make custom furniture, according to customers' needs..
Businesses in the restaurant industry must strike a balance between profitability and the need to create unique and delicious meals with high-quality ingredients..
In this industry, the various foods and beverages that a restaurant uses to make its menu are its raw materials..
Direct labor only includes wages paid to workers who contribute directly to the production, assembly, or creation of the product.
For example, direct labor would not include the salaries of factory managers or the fees paid to engineers or designers. These employees participate in the creation of the product concept and in the day-to-day operation of the business, not in the direct production of items for sale..
Examples of direct labor could include assembly line workers, welders, carpenters, glass workers, painters, and cooks.
In a restaurant, cooks, waiters, bartenders, and other related personnel are included in the direct workforce, because the end product consists not only of the prepared food, but also the culinary experience of service..
For example, suppose a business manufactures 10 bed frames and incurs the following expenses:
- $ 5,000 for wood.
- $ 1,500 for the iron frame.
- 50 man hours for product assembly at a rate of $ 15 per hour.
Only raw material and direct labor costs are used in the prime cost formula. The raw materials include the wood and iron used for assembly:
- Total cost of raw materials = $ 5,000 + $ 1,500 = $ 6,500.
- Total labor cost = $ 15 x 50 hours = $ 750.
- The prime cost of a single bed frame = $ 72.50 ($ 6,500 + $ 750) / 10.
Therefore, the company must sell each bed frame for more than $ 72.50 to generate a profit..
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