Work-in-progress (WIP) accounting is the set of rules that tracks the cost of goods or projects that have entered production but aren’t yet finished, holds those costs on the balance sheet as inventory, and then releases them to cost of goods sold as the work is completed or as revenue is recognized over time. It matters most in construction, custom manufacturing, aerospace, and any other business where production stretches across reporting periods, because the choices you make about cost accumulation, revenue timing, and tax method can shift income by millions between years.
Where WIP Sits in the Books
WIP is an inventory classification. Raw materials sit in their own account until production begins. The moment those materials are pulled into the production process and labor starts working on them, their cost moves into WIP. When the item is finished, WIP empties into Finished Goods inventory for manufactured products, or directly into Cost of Goods Sold for long-term contracts recognized over time.
On the balance sheet, WIP appears as a current asset under inventory, on the assumption that it will convert into a salable product within one operating cycle. The balance at any reporting date represents every dollar spent so far on items caught mid-production.
The Three Cost Components
Every dollar in WIP is either direct materials, direct labor, or manufacturing overhead. Companies track these using job order costing when projects are unique and identifiable, or process costing when production is continuous and high-volume. Either way, the goal is to capture the full cost of bringing the product to its current stage.
Direct Materials
Direct materials are the physical inputs you can trace to a specific product: lumber in a custom cabinet, steel in a bridge girder, specialized wiring in a data center build. When materials are issued to a job from storage, their cost transfers from Raw Materials into WIP.
Direct Labor
Direct labor is the wages, payroll taxes, and benefits of workers who physically convert materials into the finished product. Time is tracked against specific jobs so labor cost can be assigned precisely. Supervisory, maintenance, and administrative wages don’t qualify because they can’t be tied to a single unit; they fall into overhead instead.
Manufacturing Overhead
Manufacturing overhead covers every production cost that isn’t direct material or direct labor — factory utilities, equipment depreciation, property taxes on the production facility, indirect labor, and similar items. Because none of it can be traced to one unit, it’s allocated using a predetermined overhead rate.
The rate is estimated total annual overhead divided by an estimated activity base, typically direct labor hours or machine hours. A company expecting $500,000 in overhead spread across 10,000 direct labor hours applies overhead at $50 per labor hour, so a job consuming 500 hours picks up $25,000 in applied overhead. That’s how each job in WIP carries its share of total factory cost.
How WIP Is Valued
Under U.S. GAAP, inventory must be valued using full absorption costing, which means WIP carries not just direct costs but also its allocated share of manufacturing overhead. Variable costing, which leaves fixed overhead out of inventory, is acceptable for internal decision-making but not for external financial reporting.
Lower of Cost or Net Realizable Value
Inventory carried at FIFO or average cost must be measured at the lower of recorded cost or net realizable value. NRV is estimated selling price minus reasonably predictable costs to complete and sell. If NRV falls below cost, the inventory is written down and the loss hits the current period.1FASB. Accounting Standards Update 2015-11, Inventory (Topic 330)
The rule bites harder for WIP than most people expect. A half-built product can become impaired if the customer cancels, the market price of the finished good collapses, or production problems make completion far more expensive than planned. When any of those happen, the WIP balance has to be tested against NRV and written down as needed. Skip the test and assets are overstated.
Revenue Recognition on Long-Term Contracts
When WIP relates to a contract that spans reporting periods, the question shifts from valuing inventory to timing revenue. FASB Accounting Standards Codification Topic 606 replaced the old percentage-of-completion framework with a principles-based model built around the transfer of control to the customer.
When Revenue Is Recognized Over Time
ASC 606 requires revenue to be recognized over time, rather than at a single point, when at least one of three conditions is met:
- The customer simultaneously receives and consumes the benefit of the work as it’s performed, as with routine maintenance or cleaning.
- The work creates or enhances an asset the customer controls as production progresses, as in construction on the customer’s land.
- The work produces something with no alternative use to the seller, and the seller has an enforceable right to payment for work completed to date. This covers most custom manufacturing and specialized construction.
These criteria sit inside the standard’s five-step model for revenue recognition.2FASB. Accounting Standards Update 2014-09, Revenue From Contracts With Customers (Topic 606)
Measuring Progress
Once over-time recognition applies, you need a method to measure how far along the work is. ASC 606 offers two categories. Output methods look at value delivered to the customer, using milestones reached, units produced, or appraisals of results. Input methods look at effort expended relative to total expected effort, using costs incurred, labor hours, or machine hours.2FASB. Accounting Standards Update 2014-09, Revenue From Contracts With Customers (Topic 606)
The most common input method is cost-to-cost: total costs incurred to date divided by estimated total contract costs. Spend $1.5 million on a project estimated to cost $5 million total and you’re 30% complete. Apply 30% to total contract revenue to get cumulative revenue recognized. On a $7.5 million contract, that’s $2.25 million in cumulative revenue and $750,000 in gross profit. Those figures are updated each period as estimates change.
Older policies still often call this “percentage of completion.” The math is similar, but the framework that governs when and how you apply it changed with ASC 606. Accounting policies that still reference percentage of completion without mapping to the ASC 606 criteria draw auditor attention.
The Completed Contract Method
The completed contract method defers all revenue, costs, and profit until the contract is finished, with the entire profit landing in one lump at the end. Under current GAAP, this is limited to short-term contracts expected to wrap up within about a year, or to long-term contracts whose outcome genuinely can’t be estimated reliably because of significant uncertainties.
Tax Rules Under IRC Section 460
Tax accounting for long-term contracts follows its own rules and doesn’t always line up with financial reporting. The Internal Revenue Code requires the percentage-of-completion method for any long-term contract, defined as a manufacturing or building contract that won’t be completed in the same tax year it began.3Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts
The Small Contractor Exemption
Small construction contractors can use the completed contract method for tax purposes if two conditions are met: the contract is expected to be completed within two years, and average annual gross receipts for the three preceding tax years fall below the threshold set by IRC Section 448(c). That threshold is inflation-adjusted and has been around $30 million in recent years.3Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts
For qualifying contractors, deferring income until the completion year can meaningfully improve cash flow, especially on projects that are front-loaded with costs.
The Look-Back Rule
The PCM for tax relies on estimates of total contract cost, and estimates are always wrong to some degree. The IRS handles that with the look-back rule. When a contract finishes, you recompute each prior year’s tax using the actual final contract price and costs instead of the estimates that were used at the time. If the recalculation shows you underpaid earlier because estimates deferred income, you owe interest on the difference. If you overpaid, the IRS owes you interest.4Internal Revenue Service. Examination and Closing Procedures Form 8697, Look-Back Interest
The computation goes on IRS Form 8697, filed with the return for the year the contract is completed.5Internal Revenue Service. About Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts
A de minimis exception applies. The look-back rule doesn’t apply to contracts completed within two years that have a gross contract price of $1 million or less, or 1% of the average annual gross receipts for the prior three years, whichever is smaller.6eCFR. 26 CFR 1.460-6 – Look-Back Method
Software Development Costs
Software development creates its own WIP question: capitalize or expense. For tax purposes, the rules shifted starting in 2026. Under the One Big Beautiful Bill Act, new Section 174A allows businesses to immediately deduct domestic research and experimental expenditures, including software development costs, in the year they’re paid or incurred. That reverses the 2022 rule requiring five-year amortization of domestic R&E. Costs attributable to research conducted outside the United States still have to be capitalized and amortized over 15 years, so companies with both domestic and foreign development need to track where the work actually happens.
Financial reporting under GAAP runs on a separate track. Internal-use software development is governed by ASC 350-40, which generally requires expensing during the preliminary project stage, capitalization during the application development stage, and expensing again once the software is substantially complete and ready for use. The tax law changes did not touch these GAAP rules.
How WIP Shows Up on the Financial Statements
WIP appears on the balance sheet as a current asset under inventory. Long-term contracts add two more line items under ASC 606. A contract asset arises when revenue has been recognized for work performed but the customer hasn’t yet been billed; it’s earned but unbilled revenue. A contract liability, sometimes called deferred revenue, arises when the customer has paid or been billed before the work is done, reflecting an obligation to deliver future performance.2FASB. Accounting Standards Update 2014-09, Revenue From Contracts With Customers (Topic 606)
On the income statement, WIP flows through Cost of Goods Sold. For finished manufactured products, costs move from WIP to Finished Goods when production ends, then from Finished Goods to COGS when the product ships. For long-term contracts recognized over time, costs move from WIP straight into COGS in the same period the corresponding revenue is recognized, matching cost against revenue.
Where WIP Goes Wrong
WIP is one of the easier accounts to get wrong and one of the harder accounts to audit. The balance depends on cost allocations, percentage-complete estimates, and overhead rates that all involve judgment. Weak controls let errors compound quietly across reporting periods.
External auditors testing WIP focus on whether the costing method is applied consistently and whether costs assigned to specific jobs actually belong there. Under job costing, they trace material requisitions, labor time records, and overhead allocations back to individual jobs to confirm reported WIP matches the underlying activity. On long-term contracts, they test whether the over-time recognition model is being applied as the company’s stated accounting policies claim.
The area where WIP-heavy companies most often get into trouble is not fraud. It’s sloppy estimates. Understating the total cost to complete a project inflates the completion percentage, which pulls revenue and profit into the current period prematurely. Auditors know this, and testing the reasonableness of cost-to-complete estimates is usually the sharpest point of scrutiny in a WIP-heavy audit.