Depreciation is part of COGS when the asset helps produce inventory, and it’s an operating expense when the asset supports the rest of the business. A factory press, the production building, and equipment on the assembly line depreciate into inventory cost and reach the income statement only as those goods are sold. Office computers, the sales fleet, and headquarters furniture depreciate straight to operating expenses in the current period. The classification turns on what the asset actually does, not on what kind of asset it is.
The Test: What Does the Asset Do?
The dividing line is function. If an asset physically helps make the goods a company sells, its depreciation belongs in manufacturing overhead and flows into inventory. If the asset supports general operations, its depreciation is a period cost that hits the income statement immediately.
The same piece of equipment can fall on either side depending on where it works. A forklift moving raw materials and finished units around a factory floor is a production asset; its depreciation enters COGS. An identical forklift at a corporate distribution center doing non-manufacturing work is a period expense. When one asset serves both purposes, the depreciation has to be allocated between production and administration based on actual usage.
How Production Depreciation Reaches COGS
Depreciation on a production asset doesn’t go straight to the income statement. It takes a longer route through the inventory accounts. Under GAAP absorption costing, all manufacturing costs must be absorbed into inventory, and that includes fixed overhead like depreciation on factory equipment and production facilities. ASC 330-10-30 requires companies to allocate both variable and fixed production overhead to each unit of inventory based on normal production capacity.
The path looks like this. Depreciation on a production asset is calculated for the period and classified as manufacturing overhead. That overhead is allocated to Work-in-Process inventory as goods move through production. When products finish, the costs move to Finished Goods inventory. The depreciation stays on the balance sheet, inside the inventory value, until the product actually sells. Only at the point of sale does it move to the income statement as part of COGS.
A concrete example: a $500,000 stamping machine depreciates $100,000 per year. If the company sells only half its production during the year, $50,000 of that depreciation sits in Finished Goods inventory at year-end and does not reduce net income until those remaining units sell. This is why overproducing can temporarily inflate reported profit. A portion of the year’s fixed costs stays parked on the balance sheet instead of running through COGS.
What Stays in Operating Expenses
Depreciation on assets that do not contribute to making inventory is a period cost. It hits the income statement in the period it’s incurred, no matter how many units the company sells or how much inventory is on hand. The depreciation on corporate headquarters, accounting department computers, and a regional sales manager’s company car all belong here.
These costs never enter the manufacturing overhead pool. They aren’t allocated to Work-in-Process or Finished Goods. They appear under operating expenses on the income statement, typically grouped with selling, general, and administrative costs. Because gross profit is calculated as sales minus COGS, this depreciation reduces operating income but leaves gross profit alone. That’s the point: keeping non-production depreciation out of COGS gives a cleaner picture of how efficiently the company actually manufactures its products.
The Tax Side: UNICAP
The IRS enforces a parallel requirement through the Uniform Capitalization rules under Section 263A. Taxpayers must capitalize both the direct costs and a proper share of indirect costs allocable to property they produce or acquire for resale. Depreciation on production equipment sits squarely within the indirect costs that must be capitalized into inventory rather than deducted as a current expense.1eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs
UNICAP reaches beyond manufacturers. Retailers, wholesalers, and other resellers also have to capitalize certain indirect costs into inventory. For resellers, the capitalizable costs include purchasing, handling, off-site storage and warehousing, and related mixed service costs. Depreciation on vehicles, equipment, and warehouse facilities used in those activities is part of the calculation.2Internal Revenue Service. Examining a Reseller’s IRC 263A Computation
This catches some owners off guard. A retailer who owns a warehouse might assume the depreciation is just overhead to deduct immediately. Under Section 263A, that depreciation has to be capitalized into inventory cost and deducted only as the inventory sells. The same logic applies to delivery trucks, storage equipment, and other assets tied to getting goods ready for sale.
Small Business Exemption
Not every business has to run UNICAP. The Tax Cuts and Jobs Act created an exemption for small business taxpayers whose average annual gross receipts over the preceding three tax years do not exceed $25 million, adjusted annually for inflation.3Internal Revenue Service. Section 263A Costs for Self-Constructed Assets The threshold rises each year, so check the current figure for your tax year.
If your business qualifies, you are not required to capitalize indirect costs like depreciation into inventory under Section 263A. You can use a simpler inventory method and deduct those costs sooner. The exemption applies only to the federal tax return. For financial reporting, absorption costing still applies. A small manufacturer might use absorption costing in its financial statements while taking a faster deduction for the same depreciation on its tax return, creating a book-tax difference that has to be tracked.
Book and Tax Depreciation Rarely Match
Even when depreciation is correctly capitalized into COGS on both sides, the dollar amounts almost always differ. For financial reporting, companies typically use straight-line depreciation over an estimated useful life with a salvage value. For tax, the IRS assigns mandatory recovery periods under the Modified Accelerated Cost Recovery System and generally uses an accelerated method with no salvage value.4Internal Revenue Service. Publication 946 – How to Depreciate Property
Most manufacturing equipment falls into the 5-year or 7-year MACRS class and uses the 200% declining balance method for tax. A machine written off over 10 years on the books might be recovered over 5 years on an accelerated basis for tax. MACRS front-loads deductions, producing larger tax depreciation early and smaller amounts later. The timing gap creates deferred tax liabilities that companies reconcile on Schedule M-1 and track in their financial statements.
Section 179 and Bonus Depreciation
Tax rules also allow immediate expensing that has no counterpart in GAAP. Section 179 lets businesses deduct the full purchase price of qualifying equipment in the year it is placed in service, up to $2,560,000 for tax years beginning in 2026, phasing out dollar-for-dollar once total equipment purchases exceed $4,090,000. 100% bonus depreciation is available for 2026 under reinstated provisions, covering eligible new and used equipment.
For manufacturers subject to UNICAP, claiming Section 179 or bonus depreciation on the tax return does not change the GAAP treatment. The financial statements still require absorption costing with depreciation allocated to inventory over the asset’s useful life. A $400,000 machine can be fully expensed on this year’s tax return while the income statement spreads that same cost across production for the next several years. Small businesses exempt from UNICAP have a simpler picture: they can take the immediate deduction on the tax return and use a simpler method for the books.
Why the Classification Matters
Gross profit is sales minus COGS, and it is the number lenders and investors use to judge production efficiency and pricing power. If manufacturing depreciation is wrongly excluded from COGS and buried in operating expenses, gross profit is overstated. Pricing decisions built on that inflated margin can leave a manufacturer selling products below their true cost without realizing it.
The balance sheet takes the same hit. Inventory that doesn’t include its share of manufacturing overhead, including production depreciation, is understated. For a company carrying significant unsold inventory, the understatement can be large enough to affect loan covenants tied to asset values or current ratios. Analysts comparing manufacturers within an industry rely on consistent absorption costing. When one company capitalizes production depreciation properly and another doesn’t, their gross margins aren’t comparable, and auditors zero in on this classification during inventory testing for exactly that reason.
Fixing a Prior Misclassification
If a business has been treating manufacturing depreciation as a period expense rather than capitalizing it into inventory, the fix isn’t just changing next year’s accounting. The IRS treats this as a change in accounting method, which requires filing Form 3115.5Internal Revenue Service. Instructions for Form 3115 – Application for Change in Accounting Method
The correction involves computing a Section 481(a) adjustment that captures the cumulative effect of the prior misclassification. A positive adjustment, which increases income and is common when moving to proper capitalization because previously deducted costs get added back, is spread over four tax years. A negative adjustment that reduces income is taken entirely in the year of change. Many UNICAP-related changes qualify for automatic consent procedures, but the filing itself is still required, and reconstructing prior-year inventory costs to get the 481(a) number right is complicated enough that most businesses bring in professional help.