What is Prime Cost? Formula, Definition, and More
There are many costs involved in bringing a product or service to the customer, from labor wages to inventory fees. If a business is not careful, these expenses can outweigh the profits, leading to a deficit.
Businesses should calculate their prime costs weekly, as well as their year-to-date, to see the overview of their financials. By taking account of evolving prime costs, companies can better compare their expenses and profits.
What are Prime Costs?
Prime cost, also known as a direct cost, is a vital key performance indicator (KPI) that totals the labor costs and cost of goods (CoGS). Direct costs are mandatory expenses required to offer goods and services.
Understanding prime costs enables businesses to manage their daily operations to generate enough sales and revenue to make a profit. It helps management determine the best pricing strategy and how much they can spend on labor before breaking even.
While businesses handle various expenses, the prime cost only includes-
- Food Inventory
- Beverage Inventory
- Raw Materials
- Labor Wages
- Payroll Taxes
- Workers' Compensation
- Employee Benefits
These fees are considered prime costs because they are either sold to the customer or facilitate the goods' delivery. The direct costs can look different depending on the good being reviewed. For example, if a business is determining the prime cost of a sales channel, they would consider the product, campaign fees, and commissions.
Prime costs do not include-
- Bathroom Supplies
- Office Supplies
How to Calculate Prime Cost
While the prime cost calculation simply totals the labor wages and total CoGS, there are separate steps necessary to configure these expenses-
1. Calculate the Total CoGS
CoGS is the cost of the raw materials of a product, dish, or beverage. This can be calculated using the CoGS formula-
CoGS = Beginning Inventory + Purchases Ending Inventory
The beginning inventory is the amount of stock a business begins an accounting period with. This is typically what is leftover from the previous cycle.
The purchases refer to any additional inventory bought during the cycle being measured.
The ending inventory is any stock left at the end of the accounting period.
For example, a bakery has a beginning inventory of $1,300 worth of pastries but makes an additional purchase of $500 within the accounting cycle. At the end of the period, the bakery had only $800 worth of inventory. To calculate their CoGS, they would set up their formula like-
$1,300 + $500 - $800 = $1,000
This makes their total CoGS $1,000.
2. Calculate the Labor Costs
To make it easier, start by dividing the labor costs into two categories-
Salaried Employees- Determine how much the company pays salaried workers within the given time frame, whether weekly, monthly, or quarterly.
Hourly Employee- The work hours of hourly employees need to be added and multiplied by the set wage.
Once the labor costs have been calculated, management should speak with their accountants to determine how much is allocated for employee taxes, benefits, insurance, and other applicable fees.
As for the previous example, the bakery spends $500 in labor wages during the same accounting period.
3. Calculate the Prime Cost
The prime cost formula takes these two values and adds them to find the total expense-
Prime Cost = CoGS + Total Labor Cost
Following the same example, if the bakery spends $1,000 in CoGS and $500 in labor wages, their direct cost formula would be set up like-
$1,000 + $500 = $1,500
This makes the bakery's prime cost $1,500. However, this number does not tell the relationship between direct cost and revenue. By using the direct cost ratio formula, management can determine how much capital these expenses take from the income-
Prime Cost Percentage = (Prime Cost / Total Sales) x 100
The bakery had sold $2,500 worth of goods, making the prime cost percentage-
$1,500 / $2,500 x 100 = 60%
With a 60% prime cost percentage, every dollar of revenue the bakery generates, 60 cents are already lost to the direct cost.
What is the Ideal Prime Cost for Restaurants?
The average prime cost for restaurants is approximately 60% for established businesses and around 75% for startups. This leaves just enough funds to cover overhead and conversion costs.
Ideally, restaurants should aim for 55%, as long as they are not sacrificing their service or quality of goods. This covers all financial obligations and generates profits. However, if the prime cost percentage dips below 50%, it could mean the restaurant is compromising on some aspect, such as customer experience or goods. Anything above 75% can prove difficult to cover expenses such as rent, utilities, and insurance. This also does not leave any safety funds for unexpected costs, such as repairs.
Businesses need to be careful that they are upholding the best service to keep customers returning. Once an establishment can secure a healthy prime cost percentage, it is essential to produce consistent ratios to ensure financial stability.
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