Yes, cost of goods sold includes labor, but only the labor connected to making or acquiring the products you sell. Wages paid to a factory worker assembling your product belong in COGS. Wages paid to your office manager, salesperson, or CEO do not. The dividing line is production: if someone’s work is tied to producing or acquiring inventory, their compensation flows through COGS, and if it isn’t, it’s an operating expense deducted in the current period.1Internal Revenue Service. Publication 334 – Tax Guide for Small Business
Direct Production Labor Belongs in COGS
The clearest case is direct labor: wages paid to employees who physically work on the product. The welder joining steel beams, the baker shaping loaves, the technician assembling circuit boards. If you can trace someone’s work to a specific unit or batch, their compensation is direct labor and belongs in COGS.2eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs
The IRS reads direct labor broadly. It’s not just base wages. Overtime pay, vacation and holiday pay, sick leave pay, and shift differentials all count. Contract workers and independent contractors are treated the same as regular employees for this purpose. Hire a freelance machinist for a production run and that payment is direct labor, not an immediate expense.2eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs
Direct labor is variable. Double your production and direct labor hours roughly double with it, which is what makes the cost relatively easy to assign to specific units or runs.
Indirect Production Labor Belongs in COGS Too
Plenty of people keep a factory running without ever touching the product. A quality control inspector, a maintenance worker fixing equipment, a plant supervisor overseeing the line. Their wages are indirect labor, and they still belong in COGS.1Internal Revenue Service. Publication 334 – Tax Guide for Small Business
Indirect labor gets pooled with other factory costs like equipment depreciation, utilities, and facility insurance to form manufacturing overhead. That pool is spread across the units you produce, typically based on direct labor hours, machine hours, or material usage. Each finished unit absorbs a share, which is how a portion of the plant supervisor’s salary ends up embedded in the cost of every unit.
The reach extends further than many owners expect. Service department costs that directly benefit production, such as in-house accounting for the plant, on-site security, and HR staff servicing production workers, may also need to be capitalized.2eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs These employees never set foot near the production line, but their work supports it, and a share of their cost follows the inventory.
Payroll Taxes and Benefits Ride Along
Wages alone don’t capture the true labor cost that belongs in COGS. Payroll taxes and certain benefits tied to production employees get capitalized right alongside the wages, and the load is significant.
For 2026, the employer’s share of Social Security tax is 6.2% on wages up to $184,500, and Medicare tax is 1.45% with no wage cap.3Social Security Administration. Contribution and Benefit Base Federal unemployment tax, state unemployment premiums, workers’ compensation insurance, health insurance contributions, and retirement plan contributions for production workers all fold in as well. The regulations specifically list payroll taxes and payments to supplemental unemployment benefit plans as elements of direct labor cost that must be capitalized.2eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs
A production worker earning $25 an hour can easily cost $33 or more once burden is included. That full loaded amount is what goes into inventory.
Labor That Stays Out of COGS
A large share of most payrolls never touches COGS. Salespeople, marketing staff, human resources, the CEO, corporate accountants, and office administrators earn wages that are operating expenses. Those costs are deducted in the period you pay them, regardless of when any inventory sells.1Internal Revenue Service. Publication 334 – Tax Guide for Small Business
The IRS draws the line cleanly: only direct and indirect production labor, plus overhead tied to manufacturing, belongs in COGS. Everything else is a period expense.1Internal Revenue Service. Publication 334 – Tax Guide for Small Business That’s why gross profit and operating profit tell different stories. Gross profit isolates production efficiency. Operating profit reflects the full cost of running the company.
Retailers and wholesalers are a special case. If you buy finished goods and resell them without altering them, you typically have no production labor to capitalize. Your COGS is the purchase price of the merchandise plus freight and similar acquisition costs. Wages paid to stock shelves, run the register, or manage the store are operating expenses.
Service businesses sit outside the framework in a different way. Firms delivering services rather than goods often report a “cost of revenue” or “cost of services” line that includes the labor of the people delivering the service, but they generally don’t capitalize that labor into a balance-sheet inventory the way a manufacturer does. If you’re a pure service provider without physical inventory, the COGS question mostly doesn’t apply to you in the same form.
Why Timing Matters: The UNICAP Rules
The legal backbone for capitalizing production labor into inventory is Section 263A of the Internal Revenue Code, known as the Uniform Capitalization rules, or UNICAP. Any business that produces or resells tangible property has to capitalize the direct costs of that property along with a proper share of allocable indirect costs. “Produce” is defined broadly enough to cover constructing, manufacturing, developing, or improving property.4Office of the Law Revision Counsel. 26 USC 263A – Certain Costs Must Be Capitalized
The practical effect is a timing shift. You don’t get to deduct production labor when you pay it. The cost sits in inventory on the balance sheet until the goods sell, and only then does it flow to COGS on the income statement. Manufacture goods in December, sell them in March, and the December labor doesn’t reduce your taxable income until the following year’s return.
The Small Business Exemption
Not every business has to work through UNICAP. Section 263A(i) exempts businesses meeting the gross receipts test in Section 448(c).4Office of the Law Revision Counsel. 26 USC 263A – Certain Costs Must Be Capitalized For tax years beginning in 2026, you qualify if your average annual gross receipts over the prior three tax years do not exceed $32 million.5Internal Revenue Service. Revenue Procedure 2025-32 Tax shelters are excluded regardless of size. The threshold is inflation-adjusted each year, so check the current revenue procedure before filing.
A related provision, Section 471(c), lets qualifying small businesses use simplified inventory methods. You can treat inventory as non-incidental materials and supplies, or follow the method you use in your financial statements, rather than maintaining detailed inventory cost accounting.6Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories You still need a method that clearly reflects income, but the granular allocation requirements go away.
The three-year averaging matters. A single strong year won’t push you out, and a single weak year won’t automatically pull you in. Run the calculation each year.7Internal Revenue Service. Instructions for Schedule C (Form 1040)
What Happens If You Get the Classification Wrong
Booking production labor as an operating expense, whether on purpose or through loose bookkeeping, accelerates deductions the tax code doesn’t allow you to take yet. The IRS treats that as an underpayment.
The accuracy-related penalty under Section 6662 adds 20% on top of the underpaid tax when the underpayment results from negligence or a substantial understatement. For individuals, a substantial understatement means the underpayment exceeds the greater of 10% of the tax that should have been reported or $5,000.8Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
The common mistake is indirect production labor. A growing manufacturer hires a plant supervisor, books the salary as an administrative expense, and quietly runs afoul of UNICAP. The fix on its face is simple, reclassify and capitalize into inventory, but finding it years later means amended returns, interest, and possibly that 20% penalty.
How to Classify a Given Employee
Ask one question: does this person’s work relate to producing or acquiring the goods you sell? If yes, their wages, payroll taxes, and benefits belong in COGS through inventory. If no, they’re an operating expense in the current period.
Split-time employees are handled by allocation. If someone spends part of their week on the production floor and part on non-production work, you can allocate wages between COGS and operating expenses based on the hours or percentage spent on each.1Internal Revenue Service. Publication 334 – Tax Guide for Small Business Keep time records that back up the split. On audit, the burden of showing the allocation is reasonable falls on you.