Definition: A prime cost is an expenditure that directly relates to the production of finished goods. In other words, these expenses are directly incurred to create finished goods.
What Does Prime Cost Mean?
Prime costs consist of direct materials and direct labor. Direct materials include all tangible components of a product. For example, direct materials include raw materials, supplies, and any other component that becomes part of the finished product. A rim would be considered a direct material in a bicycle.
Direct labor includes the wages paid to employees who produce finished products. These employees can be welders, machinists, painters, or any other person who directly contributes to the production of a product.
Prime costs do not, however, include any indirect costs like factory overhead or administrative expenses. These costs are considered conversion costs because they are required to covert raw materials into finished goods. You might be thinking that direct labor also helps convert materials into salable products. You are right. Direct labor can be classified as both a prime and conversion cost.
Management tends to use prime costs to focus on improving the overall production process and making cost objects more efficient. Assume the paint department is the cost object for example. Chemicals, paints, supplies, and other materials used by this department all go into its prime costs. Management can analyze the amount of direct costs stemming from this department and target ways to improve processes to decrease consumption. Each cost object has different costs that management can use to analyze processes.
Management can also use these costs to establish selling prices for their products. Based on the costs, management can calculate the minimum break even selling price. Then they can use market analysis to see what consumers are willing to pay for products and price their finished goods accordingly.
Internal accountants also use these costs to calculate the contribution margin of specific products.