Prime costs are the sum of direct material and direct labor. Here’s how to calculate and interpret prime costs in your small business.


*

Prime costs sum direct material and direct labor, whereas conversion costs sum manufacturing overhead and direct labor.

You are watching: Prime costs consist of direct labor and factory overhead.


How to calculate prime costs

Before you calculate prime costs, determine all three product costs: direct material (DM), direct labor, and manufacturing overhead.

1. Calculate direct materials

The first element of the prime cost calculation is direct materials, which encompass the physical parts that make up your product.

A woodworker manufacturing a chair would count lumber and fabric as direct materials. Other materials used in production that don’t end up in the final product — such as the gloves, goggles, and masks for the woodworker — are considered indirect materials and are part of manufacturing overhead.

To calculate direct material used in production, use this formula:

Beginning DM Inventory + DM Purchases - Ending DM Inventory = Direct Material Used

2. Calculate direct labor

The next element to calculate is direct labor, or the compensation of factory workers.

There’s no labor cost formula per se, but follow this rule: Direct labor excludes pay for people who aren’t directly involved in work on the making or selling the product. Don’t count Supervisors, janitors, or other workers who weren’t putting your product together.

For example, a woodworker’s wages are considered direct labor, but a supervisor’s pay is indirect labor and would be part of manufacturing overhead.

Direct labor includes the following forms of compensation:

Hourly wagesSalaried wagesSales commissionsBenefitsBonusesEmployer payroll taxes

Time-tracking software can help you determine how much time employees spent manufacturing specific products. Sum the manufacturing workers’ earnings to determine direct labor.

3. Sum direct materials and direct labor

The prime costs formula sums direct labor and direct material.

Direct Labor + Direct Material = Prime Costs

Example of prime costs

James owns Snack Shack, a small beachfront restaurant in Miami. He’s looking for an investor who can provide some capital to turn the outdoor patio into the ideal lunch spot before next spring break.

A seasoned business owner, James knows investors will ask about prime costs, a metric restaurateurs often use as a proxy for financial health when compared to sales. Let’s calculate his business’s prime costs for the last calendar year.

1. Calculate direct materials

Start by adding up direct materials. For a restaurant, that’s ingredients, beverages, and other products that end up in front of the customer.

Reusable tableware isn’t considered direct material; as a general rule, direct material must be something the customer can (legally) leave with. However, the little paper umbrellas that adorn every cocktail are counted as direct material since they’re disposable garnishments.

The company"s accounting software shows the following inventory data.


Snack Shack used $400,000 in direct materials last year ($15,000 beginning inventory + $395,000 purchased inventory - $10,000 ending inventory).

2. Calculate direct labor

Servers, cooks, hosts, and bussers are the direct laborers at a restaurant. Add up their wages, bonuses, overtime pay, employer payroll taxes, and healthcare benefits.

The restaurant’s worker earnings data is below.


Name Job Restaurant compensation Tips
Rhonda Waiter $15,000 $22,000
Jose Waiter $15,000 $22,000
Amelia Cook $40,000 $0
James Owner $50,000 $0

Snack Shack’s direct labor cost is $70,000 ($15,000 Rhonda’s wages + $15,000 Jose’s wages + $40,000 Amelia’s wages). Since James doesn’t cook or serve, his earnings don’t count in the direct labor calculation.

Don’t include tips in the direct labor calculation since your employees earned them at no cost to the business.

3. Sum direct materials and direct labor

Snack Shack’s prime costs are $470,000 ($400,000 direct materials + $70,000 direct labor).

Now that James knows his prime costs, he can move on to calculating the restaurant’s profit margin, gross margin, and prime costs to sales ratio.

See more: Was 8 Mile A True Story ? Is 8 Mile Based On Eminem'S Real Life

You’ve been primed

Prime cost accounting can help you decide on a product’s selling price or whether to drop a product line in favor of a lower-cost alternative. However, looking at your prime costs is just one way to analyze your business’s financial performance. Check out a host of other financial accounting ratios you can use to take your financial analysis to the next level.