Yes, labor is included in Cost of Goods Sold when the worker’s effort directly produces the goods you sell or supports that production inside the factory. Wages for the welder assembling frames, the baker shaping dough, and the machine operator running a production line all belong in COGS. Wages for the corporate accountant, the salesperson, and the receptionist do not. Under federal tax law, businesses that manufacture products or acquire them for resale must capitalize both direct and indirect production costs, including wages, into inventory rather than deducting them immediately.1Office of the Law Revision Counsel. 26 USC 263A Capitalization and Inclusion in Inventory Costs of Certain Expenses The classification hinges on what the worker actually does, and getting it wrong distorts gross profit and can trigger IRS penalties.
Direct Production Labor
Direct labor is the clearest case. If a worker physically transforms raw materials into a product you sell, their compensation goes into inventory cost and eventually into COGS.
The IRS defines direct labor broadly. It includes not just base wages but also overtime pay, vacation and holiday pay, sick leave pay, shift differentials, payroll taxes, and payments to supplemental unemployment benefit plans.2IRS. Section 263A Costs for Self-Constructed Assets All of these elements get folded into the cost of the inventory that worker helped produce.
Classification depends on what someone does, not how they’re paid. A salaried supervisor who spends every hour on the factory floor operating equipment counts as direct labor. A contractor you hire to run a CNC machine for a production run counts too. The legal relationship between you and the worker doesn’t change whether the cost is direct; what matters is whether the labor physically produces the goods.
Indirect Factory Labor and Overhead
Factory workers whose efforts support production without directly transforming materials are still part of COGS, but they get there through a different route. Quality inspectors checking batches, maintenance crews servicing equipment, and production supervisors overseeing multiple lines all fall into indirect labor. Their wages can’t be traced to a specific unit of output, so they enter a pooled cost category called manufacturing overhead.
Manufacturing overhead gets assigned to products through a predetermined overhead rate. A company estimates total overhead costs for the year, picks an allocation base like direct labor hours or machine hours, and divides to get a rate. If estimated overhead is $500,000 and estimated direct labor hours are 50,000, the rate is $10 per direct labor hour. A product requiring five hours of direct labor absorbs $50 of overhead into its inventory value.
Employee benefits like health insurance contributions and retirement plan matches follow the same path. The IRS classifies these as indirect labor costs rather than direct labor, but they still must be capitalized as additional Section 263A costs.2IRS. Section 263A Costs for Self-Constructed Assets Benefits for production workers end up in inventory cost and eventually in COGS, just through the overhead allocation process rather than direct tracing.
Labor That Stays Out of COGS
The key boundary is between factory-related and non-factory labor. Corporate executives, salespeople, accountants, and HR staff have nothing to do with production. Their compensation is a selling, general, and administrative expense, deducted immediately on the income statement and never capitalized into inventory.
Misclassifying a factory supervisor’s wages as an administrative expense would understate inventory and overstate current expenses. The gross margin distortion misleads anyone analyzing operational efficiency, including lenders and investors relying on that metric.
The Tricky Middle: Overtime Premiums, Idle Time, and Split-Time Workers
Overtime premiums create a common point of confusion. The base-rate portion of overtime hours is direct labor, just like any other production hour. But the premium, the extra half-time or double-time amount above the normal rate, is generally treated as manufacturing overhead. If a production worker earns $30 per hour and works overtime at time-and-a-half, the first $30 of each overtime hour is direct labor, while the additional $15 premium goes into the overhead pool.
Idle time is also overhead rather than direct labor. Wages paid when production workers are waiting due to machine breakdowns, material shortages, or scheduled maintenance are a routine cost of running a factory and get allocated to products through the overhead rate.
Workers who split time between production and non-production tasks need their compensation allocated. If a machine operator spends 80% of a shift producing goods and 20% on paperwork, only 80% of their total compensation package gets capitalized as direct labor. The remaining 20% is expensed as an operating cost. This split-allocation is where most small manufacturers first run into trouble, because it requires genuine time-tracking rather than rough estimates.
Service Businesses
Service companies don’t manufacture physical products, but they still have a version of COGS called Cost of Services (sometimes Cost of Sales). Labor is usually the single largest component. A consulting firm’s billable staff, a trucking company’s drivers, a law firm’s associates deliver the service the company sells, so their compensation belongs in Cost of Services rather than operating expenses.
The dividing line follows the same logic as manufacturing: if the worker’s effort is directly tied to delivering revenue-generating services, the cost goes above the gross profit line. A delivery company includes driver wages in Cost of Services. The receptionist’s salary goes under operating expenses because it supports the business generally rather than delivering the service a customer pays for.
Service businesses have more discretion here than manufacturers do, because no federal statute equivalent to Section 263A forces capitalization of service labor. The accounting department makes judgment calls about what counts as directly related to delivering the service, and reasonable people can disagree. Consistency matters more than perfection: once you establish a classification approach, apply it the same way every period.
Software Developers
Software companies face a specialized version of this question. Under current GAAP, developer wages for internal-use software must be capitalized once management has committed to funding the project and it’s probable the software will be completed and used as intended.3Financial Accounting Standards Board (FASB). FASB Issues Standard That Makes Targeted Improvements to Internal-Use Software Guidance Before that point, you expense the wages.
R&D Labor Follows Different Rules
Research and development wages are a boundary case worth flagging. They aren’t part of ordinary COGS, and the treatment changed dramatically starting in 2022. Wages paid to researchers and their direct supervisors must now be capitalized and amortized over five years for domestic research, or fifteen years for research conducted outside the United States, under IRC Section 174.4Office of the Law Revision Counsel. 26 USC 174 Amortization of Research and Experimental Expenditures Before this change, companies could deduct R&D costs immediately.
The scope of Section 174 is broader than many businesses expect. It covers wages for anyone developing a new or improved product, process, or software, and it includes not just base salary but also nontaxable benefits and retirement contributions. A manufacturer improving an existing product line may have workers whose wages partially fall under Section 174 rather than the regular COGS capitalization rules.
The distinction matters because deduction timing is completely different. Production labor hits COGS when inventory sells, which could be weeks or months. R&D labor gets spread across five years regardless of when anything sells. If a worker splits time between production and development, you need to allocate their wages between both regimes.
The Small Business Exemption
Not every business has to follow the full capitalization requirements. Small businesses that meet a gross receipts test are exempt from the uniform capitalization rules entirely, which changes how they can handle production labor.5Internal Revenue Service. Accounting Periods and Methods
To qualify, your average annual gross receipts over the prior three tax years must not exceed the inflation-adjusted threshold, which for 2026 tax years is $32 million (per Rev. Proc. 2025-32). You also cannot be a tax shelter. If you meet both conditions, Section 263A’s detailed allocation requirements don’t apply to you.
Exempt businesses still need to account for inventory in a way that clearly reflects income, but they have more flexibility. The two main options are treating inventory as non-incidental materials and supplies, or matching the treatment used in your audited financial statements.5Internal Revenue Service. Accounting Periods and Methods If you don’t have audited financials, you can use whatever method your books and records follow. Small manufacturers can avoid the overhead allocation gymnastics that Section 263A otherwise demands.
The exemption is worth monitoring annually because it depends on a rolling three-year average. A business that qualifies one year might lose the exemption the next if revenue spikes. Crossing the threshold means adopting the full capitalization rules, which requires changing your accounting method through IRS Form 3115.
What Misclassification Costs You
If you discover production labor has been incorrectly expensed instead of capitalized, or the reverse, you can’t simply adjust going forward. Changing how you treat these costs is a change in accounting method, which requires filing IRS Form 3115 and IRS consent before the change takes effect.6Internal Revenue Service. Instructions for Form 3115 Most corrections to labor capitalization qualify for automatic change procedures, which means no user fee and a streamlined process.
The stakes are real. If the IRS determines that misclassification caused a tax underpayment, you face a 20% accuracy-related penalty on top of the tax owed, plus interest. The penalty applies when the underpayment results from negligence or a substantial understatement of income tax, defined for individuals as the greater of 10% of the tax due or $5,000.7Office of the Law Revision Counsel. 26 US Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments Immediately expensing labor that should have been capitalized inflates deductions in the current year, which is exactly the kind of understatement that triggers this penalty.