The prime cost is the total direct material and labor costs of producing a product or delivering a service. It helps you analyze how much these costs reduce your gross profit, making it easier to determine whether your expenses are within a healthy range.
The formula for computing prime costs is as follows:
Prime cost = Direct materials + Direct labor
Industry-specific prime costs
The prime cost formula is straightforward — just adding direct materials and direct labor. Simple, right? The challenge lies in knowing which numbers to add.
- Direct materials (DM) are the raw materials and components that are physically part of the product being made or are directly used in providing a service. They must be easily traceable to a specific product or service.
- Direct labor (DL) refers to the wages and benefits paid to employees who are directly involved in creating a product or delivering a service. These workers’ efforts can be specifically linked to each unit of output.
Understanding what goes into your prime costs is key to getting an accurate picture of your cost structure. The matrix below outlines common direct material and labor costs by industry. While the list is not exhaustive, it provides a solid starting point. Be sure to review your financial records for any additional costs specific or unique to your business.
Industry | Direct materials | Direct labor |
|---|---|---|
Retail | Products for resale, packaging, shopping bags, labels, tags, hangers, shelves, display racks, signage, security tags, wrapping materials, promotional materials | Sales associates, cashiers, stockroom staff, warehouse pickers, inventory clerks, visual merchandisers, delivery staff, customer service representatives |
Food & beverage | Meat, seafood, vegetables, fruits, dairy, beverages, spices, condiments, cooking oil, flour, sugar, coffee, tea, alcohol, napkins, plates, utensils, takeaway containers, straws, stirrers, food packaging, cleaning supplies (direct to food prep) | Chefs, sous chefs, cooks, line cooks, prep cooks, dishwashers, servers, bartenders, baristas, bussers, food runners, host/hostess, delivery drivers |
Manufacturing | Raw materials (metal, plastic, wood, fabric, glass), components, fasteners (screws, bolts, nails), adhesives, lubricants, packaging materials, containers, pallets, labels, tools, spare parts for machinery | Assembly line workers, machine operators, welders, fabricators, quality control inspectors, production supervisors, maintenance workers, packaging staff, material handlers |
Construction | Lumber, concrete, steel, bricks, drywall, roofing materials, insulation, nails, screws, electrical wiring, plumbing pipes, fixtures, paint, adhesives, flooring materials, tools, safety gear, scaffolding, equipment rental, fuel for machinery | Carpenters, electricians, plumbers, masons, construction laborers, machine operators, roofers, HVAC technicians, project supervisors, welders, landscapers, site managers |
Wholesale & distributio | Products for resale, packaging (boxes, crates, bubble wrap, plastic wrap), shipping labels, pallets, containers, barcode labels, tape, packing peanuts, stretch film | Warehouse workers, packers, forklift operators, delivery drivers, loaders, inventory managers, order pickers, shipping and receiving clerks |
Healthcare | Medical supplies (gloves, syringes, bandages, gauze, surgical tools), pharmaceuticals, diagnostic equipment, cleaning and sanitizing supplies, PPE (masks, gowns, face shields), medical instruments, lab supplies, IV fluids | Doctors, nurses, medical assistants, lab technicians, radiology technicians, physical therapists, pharmacists, dental hygienists, surgical assistants, patient care aides |
Personal care | Beauty products (shampoos, conditioners, skincare products, hair dyes, makeup), grooming tools (scissors, razors, clippers, brushes), towels, capes, disposable gloves, spa products (massage oils, lotions), cleaning supplies | Hair stylists, barbers, estheticians, massage therapists, nail technicians, spa therapists, cosmetologists, assistants, receptionists (if directly involved in service) |
Professional services | Minimal materials, office supplies (paper, pens, printing costs), legal forms, software subscriptions, presentation materials, technology (laptops, monitors) | Consultants, lawyers, accountants, financial advisors, administrative staff, paralegals, legal assistants, customer-facing staff (billable hours) |
Education | Textbooks, teaching aids, classroom supplies (paper, markers, whiteboards), digital learning platforms, laboratory equipment, sports equipment, computers, furniture (desks, chairs) | Teachers, instructors, tutors, teaching assistants, lab technicians, coaches, daycare workers, classroom aides, librarians (instructional roles) |
Creative services | Design software (Adobe Creative Cloud, CAD tools), art supplies (paints, canvases, brushes), photography equipment (cameras, lenses, lighting), video production equipment, printing costs, props, costumes, staging materials | Graphic designers, photographers, videographers, writers, editors, illustrators, actors, models, animators, production assistants, set designers |
Transportation | Fuel, vehicle parts, tires, maintenance tools, lubricants, cleaning supplies, GPS systems, uniforms, safety gear, tolls, parking fees | Drivers, mechanics, logistics coordinators, vehicle inspectors, dispatchers, delivery personnel, loaders, route planners |
Home services | Repair materials (pipes, wiring, wood, paint, HVAC components, roofing materials), tools, spare parts, cleaning supplies, safety equipment, fuel for vehicles, uniforms | Plumbers, electricians, HVAC technicians, landscapers, carpenters, painters, pest control technicians, cleaners, handymen, apprentices, assistants |
Information technology | Computers, servers, networking equipment, cables, software licenses, cybersecurity tools, cloud storage, backup devices, peripherals (monitors, keyboards, mice), replacement parts | IT technicians, developers, system administrators, cybersecurity specialists, help desk staff, network engineers, database administrators, software testers |
Ecommerce | Inventory (products for resale), shipping supplies (boxes, bubble wrap, tape, labels), packaging materials, warehouse equipment (shelving, carts, pallets), barcode scanners, storage containers | Warehouse pickers, packers, order processors, shipping and receiving clerks, customer service representatives, inventory managers, fulfillment specialists |
Digital services | Software subscriptions (design, analytics, SEO tools), web hosting, cloud services, digital assets (fonts, templates, stock photos), hardware (laptops, monitors), content creation tools | Developers, designers, content creators, project managers, social media managers, copywriters, video editors, SEO specialists, customer support teams |
Prime cost industry benchmarks
Now that I’ve introduced you to the DM and DL costs and how to compute prime costs, you should also know how to compare your prime cost with industry benchmarks. But first, you need to compute the prime cost ratio to standardize the comparison.
The prime cost ratio is computed as follows:
Prime cost ratio = Prime cost ÷ Total sales
Below are the average prime cost ratio benchmarks for each industry, which are the same benchmarks I used in the calculator above. While these figures may not perfectly reflect your specific cost structure, they provide a general reference point for assessing your prime cost levels. You can also apply a tolerance level between 5% and 10% to account for errors and fluctuations.
Industry | Range |
|---|---|
Retail | 50%-65% |
Food and beverage | 55%-60% |
Manufacturing | 70%-80% |
Construction | 80%-90% |
Wholesale and distribution | 75%-85% |
Healthcare | 50%-60% |
Personal care | 45%-55% |
Professional services | 40%-50% |
Education | 65%-80% |
Creative services | 40%-50% |
Transportation | 60%-70% |
Home services | 50%-60% |
Information technology | 40%-50% |
Ecommerce | 50%-70% |
Digital services | 35%-50% |
How to interpret
- Within range: Your prime cost levels are within the expected range, indicating that your direct material and labor costs are aligned with industry benchmarks. This suggests a healthy balance between expenses and sales.
- Outside of range: If your prime cost ratio falls outside the range, start by reviewing your data to rule out mathematical errors. Ensure that all direct material and labor costs are accurately accounted for and that no overhead expenses are mistakenly included. Conversely, verify that no direct costs were overlooked. If everything checks out, you can confidently conclude that your prime cost ratio is genuinely out of range and should investigate the underlying causes.
- Above the upper limit: This suggests that your direct material and labor costs are consuming too much of your revenue, indicating that sales aren’t keeping pace with expenses. Possible reasons include slow sales, a shrinking customer base, or pricing that’s too low to cover costs. It may also point to inefficiencies in labor management or excessive spending on materials.
- Below the lower limit: This can be a sign of strong profitability, as you’re generating higher sales without significantly increasing direct costs. However, it could also indicate issues like understaffing, which can lead to burnout and lower productivity, or cost-cutting measures that compromise product or service quality. Reviewing both labor capacity and material quality helps ensure that the low ratio is due to efficiency, not shortcomings.
Why track prime costs
Tracking prime costs isn’t something you can easily pull from your records. Since it’s primarily used in managerial accounting, your accounting software may not have a built-in feature that instantly displays all prime costs. But why should you care? Here’s why:
- Aids in cost control: Let’s say material costs quietly creep up, but you don’t notice until profits take a hit. Tracking prime costs helps you catch these changes early, whether it’s rising supplier prices, labor inefficiencies, or excessive waste. By identifying these cost drivers, you can negotiate better deals, reduce waste, or optimize production to keep expenses in check.
- Supports competitive pricing: Let’s say you set prices based on what competitors charge, only to realize your costs are higher. Without knowing your prime costs, you risk pricing too low and barely breaking even or too high and losing customers. Tracking prime costs ensures your pricing covers direct expenses while leaving room for profit, helping you stay competitive without sacrificing your bottom line.
- Reveals operational efficiency: Imagine your labor costs are climbing, but sales haven’t budged. Without tracking prime costs, you might miss the fact that you’re scheduling too many employees during slow periods or paying too much overtime. By monitoring prime costs, you can spot these inefficiencies early and adjust staffing or processes before they drain your profits.
Common problems in prime cost computations
Prime cost is easy to compute, but the data can sometimes be the problem.
- Cost misclassification: This happens when you mix up which costs should be included in your prime cost calculation. For example, adding indirect costs like rent, office supplies, or manager salaries makes your prime cost seem higher than it really is. On the other hand, forgetting to include materials like packaging or missing labor costs like overtime makes your prime cost look lower than it should be.
- Inconsistent labor allocation: Only direct labor should be included in prime costs. Adding indirect labor can inflate prime costs and skew your analysis. For example, including supervisors’ salaries (which are indirect costs) as direct labor overstates expenses while excluding overtime or temporary workers directly involved in production understates them.
- Lack of waste control: This occurs when materials are wasted due to spoilage, overuse, errors, or inefficient processes, increasing direct material costs and inflating prime costs. For example, excessive food waste in a restaurant or defective components in manufacturing raises expenses without generating additional sales.
Frequently asked questions (FAQs)
It is the total cost of direct material and direct labor. Businesses track prime costs to assess how much they spend on essential production elements and ensure profitability.
In restaurants, prime cost is the sum of food and beverage costs (direct materials) and labor costs (direct labor). It measures how much a restaurant spends on ingredients and staffing to generate revenue.
The formula for calculating prime cost is Direct Materials + Direct Labor.
Bottom line
Tracking prime costs helps you spot inefficiencies and cost leaks in your operations. Differences between standard and actual direct material and labor costs may signal underlying issues that need investigation. Regular monitoring helps you catch rising costs or process inefficiencies early, ensuring your business stays competitive and profitable.
