# Understanding Prime Cost: Definition, Formula, and Calculation Explained

> **Definition**
>
> Prime costs are the direct expenses associated with a business’s production, and include materials and labor.

## What Is a Prime Cost?

Prime costs are the [direct costs](https://www.investopedia.com/terms/d/directcost.asp) associated with production, specifically raw materials and labor. Businesses calculate their prime costs to determine [profitability](https://www.investopedia.com/terms/p/profitmargin.asp) and to set competitive pricing. Prime costs don't include indirect costs and overhead. It's important to understand that prime costs aren't the total costs of production; they can be misleading if there are high indirect costs.  

### Key Takeaways

*   Prime costs include only direct costs like raw materials and labor, not indirect expenses.
*   Calculating prime costs helps businesses determine pricing for desired profit margins.
*   Prime costs are crucial for understanding the production expenses directly linked to goods or services.
*   Prime costs exclude indirect expenses, which can lead to misleading assessments if those are high.
*   Knowing prime costs supports pricing strategies and efficiency improvements in production processes.

![Prime Cost: A firm’s expenses directly related to the materials and labor used in production.](https://www.investopedia.com/thmb/93VbonuBJKRF9rsBtP9jebJ5a2A=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/prime-cost-FINAL-8f9a2da7d5b149d092acf430205d0fd2.png)

*To calculate prime cost, add direct raw materials and direct labor. — Jiaqi Zhou / Investopedia*

## How to Calculate Prime Costs: Formula and Steps

The formula and calculation of prime cost are as follows:

$\text{Prime cost} = \text{Direct raw materials} + \text{Direct labor}$

1\. Identify Direct Raw Materials Costs: Start by finding the total cost of direct [raw materials](https://www.investopedia.com/terms/r/rawmaterials.asp) on your company's balance sheet.  
   
2\. Identify Direct Labor Costs: Next, locate the total direct labor cost appearing on the [balance sheet](https://www.investopedia.com/terms/b/balancesheet.asp).  
  
3\. Calculate Prime Cost: Add the two derived figures for direct raw materials and direct labor together to get the prime cost.

## Understanding the Purpose and Benefits of Prime Costs

Prime cost is the total of the direct costs, both fixed and variable, for making an item. Businesses use it to measure total production input costs needed to create a product. Analyzing prime costs helps a company set profitable prices. Lowering prime costs can boost profits or allow for competitive pricing.

Companies need to calculate the prime cost of each product manufactured to ensure they are generating a [profit](https://www.investopedia.com/terms/p/profit.asp). Self-employed individuals, such as artisans who create and sell custom-made furniture, often use the prime cost calculation to ensure they are making the hourly wage they desire while also profiting from each product made.

Indirect costs like utilities and salaries aren't included in prime costs because they're hard to quantify and allocate.

## Practical Examples of Prime Costs in Action

Let’s say, as an example, a professional woodworker is hired to construct a dining room table for a customer. The prime costs for creating the table include direct labor and raw materials, such as lumber, hardware, and paint. The materials directly contributing to the table’s production cost $200.

The woodworker charges $50 per hour for labor, and this project takes three hours to complete. The prime cost to produce the table is $350 ($200 for the raw materials + $150 in direct labor). To generate a profit, the table’s price should be set above its prime cost.

Consider the same woodworker who constructed and sold a new handcrafted table for $250. The cost of the raw materials was $200, and it took them three hours to construct. Without regard to labor costs, the woodworker realized a gain of $50. If their direct labor costs were $15 per hour, they realized a modest gain of $5.

Therefore, it is especially important for self-employed people to employ the prime cost method when determining what price to set for their goods and services.

If the same artisan desired a labor wage of $20 per hour and a profit of $100, the prime cost and price would be $260 ($200 for materials and $60 for labor) and $360 (prime cost + desired profit), respectively.

## Comparing Prime Costs and Conversion Costs: Key Differences

Conversion costs, which include direct labor and [overhead](https://www.investopedia.com/terms/o/overhead.asp), help to calculate profitability based on production costs.

Overhead costs are expenses necessary for operations, like utilities, but are not directly tied to production. Direct labor costs are the same for both prime and conversion cost calculations.

Conversion costs are also used as a measure to gauge the [efficiencies](https://www.investopedia.com/terms/e/efficiency.asp) in production processes but take into account the overhead expenses left out of prime cost calculations. Operations managers also use conversion costs to determine where there may be waste within the manufacturing process.

Conversion costs and prime costs can be used together to help calculate the minimum profit needed when determining prices to charge customers.

## Limitations and Challenges of Prime Costs

Because prime cost only considers direct costs, it does not capture the total cost of production. As a result, the prime cost calculation can be misleading if indirect costs are relatively large. A company likely incurs several other expenses that would not be included in the calculation of the prime cost, such as manager salaries or expenses for additional supplies needed to keep the factory running.

These other expenses are considered manufacturing overhead expenses and are included in the calculation of the conversion cost. The conversion cost takes [labor](https://www.investopedia.com/terms/l/labor-market.asp) and overhead expenses into account, but not the cost of materials.

A second limitation of prime cost involves the challenges associated with identifying which production costs are indeed direct. There are numerous expenses associated with producing goods for sale.

To calculate the prime cost of an item accurately, there must be a clear division between those expenses that can be directly linked to the production of each unit vs. those that are required to run the overall business. The specific expenses included in the prime cost calculation can vary depending on the item being produced.

## What Is the Prime Cost Formula?

To calculate the prime cost formula, take the direct raw materials costs and add them to a business’s direct labor costs, both found on the balance sheet.

## What Is the Difference Between Prime Cost and Overhead Cost?

Prime costs are the direct costs involved in production, including raw materials and labor. By contrast, overhead costs refer to costs that are indirectly related to production, which include electricity, rent, or salaries, among others.

## Is Depreciation a Prime Cost?

[Depreciation](https://www.investopedia.com/terms/d/depreciation.asp) is considered an indirect cost and is typically included in a company’s overhead. For instance, manufacturing overhead may include utility costs or the depreciation expense of factory equipment.

## Is Salary a Direct Expense?

[Salary](https://www.investopedia.com/articles/personal-finance/031115/salary-vs-hourly-how-benefits-laws-differ.asp) is considered an indirect expense, as it is not directly involved in a manufacturer’s production.

## Why Is It Called Prime Cost?

The word “prime” stems from the Latin word “prôtos,” which means first in existence, or the first in order. Just as prime numbers are indivisible, prime costs refer to the direct costs of raw materials and labor that are essential to manufacturing a product.

## The Bottom Line

The prime cost is the total of the direct raw material costs and direct labor costs involved in production. It doesn't account for indirect costs like utilities and administrative expenses. Businesses should calculate their prime costs to ensure appropriate profit margins and to determine the lowest selling price that allows them to remain profitable. Prime costs are different from conversion costs, which include both direct labor and the overhead expenses necessary to transform raw materials into finished products. Prime costs are a crucial metric for businesses, including self-employed individuals, when they assess their cost structures and price strategies.