In cost classification, accountants identify costs as direct or indirect costs. The term "prime cost" represents the amalgam of direct costs associated with producing a product, service or unit. These direct costs are subdivided into:
♦ Direct materials
♦ Direct labour
♦ Direct expenses.
The concept of direct costs is critical when identifying the "prime costs." Direct costs are any costs that can be attributed directly to a product. For example, if you were producing a wooden chair, you would need wood, someone to make the chair and maintenance of tools for the production of the chair. The aforementioned costs represent direct materials (wood), direct labour (carpenter) and direct expenses (tool maintenance). Those are all part of the prime cost of producing a chair.
Prime costs and production overheads constitute the production or manufacturing cost—relating to a product or service. Production overheads are indirect costs (costs that are not directly traceable to a product, service or department). The context of the prime cost is that it is the result of other costs and provides data for production costs as well. Prime cost is calculated as follows:
♦ Prime cost = Direct materials + Direct wages/labour + Direct expenses
The prime cost is then used as data to calculate production costs using the following formula:
♦ Prime cost + Production overhead = Production cost
== Further examples of direct material costs include:
a) Parts of a product
b) A laptop needed for an insurance sales representative to conduct field visits
c) Packaging for the product itself (not boxes or containers that they are transported in)
== Further examples of direct labour include:
a) Wages and overtime spent on labour on the product itself or product line.
b) Quality control specialists
c) Supervisors and foremen
== Direct expenses include:
a) Rent of equipment or space to perform a particular job
b) Maintenance of fixtures and fittings or machinery that you can directly attribute to a product
It is important not to use Production Overhead and Production Costs interchangeably, since overheads form part of the total product/ service cost. Overheads are indirect costs associated with producing the goods or service. In calculating Total Costs, the formula — including prime costs — is:
♦ Prime cost + Production overheads + Total other costs = Total costs
Even though prime costs are directly traceable to a product, they might have to be imputed. For instance, you might have to pay for electricity for machinery in a factory; that is needed to produce the product. However, it is unlikely that this direct expense will be separate from other functions that exist. Accountants would have to estimate or impute it (for stepped costs) in order to determine the prime cost.