Employee salaries are operating expenses when the worker supports the business rather than directly producing what the business sells. Wages paid to factory workers, field technicians, and other employees whose labor creates a product or delivers a billable service belong in cost of goods sold (COGS) instead. The line between the two categories shapes your gross margin, moves income between tax years, and determines whether the IRS treats your return as accurately filed.
Which Salaries Belong in Operating Expenses
Compensation for employees who keep the business running, but who don’t build inventory or perform billable client work, is an operating expense (OPEX). Executives, office managers, human resources staff, accountants, and IT support all sit here. So do marketing and sales teams, because their work drives demand rather than producing a unit of anything. Commissions paid to salespeople are operating expenses too, even though they move with performance, because the sales function supports the business rather than producing inventory.
Federal tax law lets you deduct these payments as ordinary and necessary expenses of the trade, provided the compensation is reasonable for the services actually performed.1Office of the Law Revision Counsel. 26 U.S. Code 162 – Trade or Business Expenses
The defining trait of an operating-expense salary is that it stays relatively flat regardless of production volume. If your factory doubles output next month, your HR director’s paycheck doesn’t change. That stability is what makes these “period costs” under accrual accounting: you recognize them on the income statement in the period they’re incurred, not when a product eventually sells.
Which Salaries Belong in Cost of Goods Sold
Wages tied directly to creating a product or delivering a specific service belong in COGS. Assembly line workers, machine operators, welders, and packaging staff fall here. So does the hourly pay for a plumber on a job site or a consultant billing time to a client project. These costs scale with output. If the factory shuts down for a week, this portion of your payroll drops with it.
Section 263A of the Internal Revenue Code requires businesses that produce property or acquire it for resale to capitalize both direct labor costs and a share of indirect costs into inventory.2Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses A production supervisor’s salary doesn’t hit your income statement the moment you cut the check. It gets folded into the value of your inventory and expensed only when you sell the finished goods. That matching of expense to revenue is what gives your gross margin its accuracy.
Small Business Exemption From Capitalization
Not every business has to track labor through inventory. If your average annual gross receipts over the prior three years fall at or below the inflation-adjusted threshold (set at $25 million and adjusted annually), you’re exempt from Section 263A’s uniform capitalization rules entirely.3Federal Register. Small Business Taxpayer Exceptions Under Sections 263A, 448, 460, and 471 Smaller manufacturers and resellers can deduct production wages more simply without pushing them through inventory first.
Employees Who Split Time Between Roles
Real businesses don’t sort neatly into categories. A shop foreman who spends mornings on the production floor and afternoons handling scheduling and vendor calls straddles the line. So does a small-business owner who installs flooring half the day and manages billing the other half.
The standard approach is to allocate wages based on time spent on each function. If a worker logs 60% of hours on production tasks and 40% on administrative duties, split the salary the same way. Keep timesheets or other records that support the split, because the IRS can challenge an allocation that looks like guesswork. Pick a reasonable method and apply it consistently period after period.
The Full Employer Cost Follows the Classification
The salary on an offer letter understates what the position actually costs the business. Mandatory and voluntary expenses stack on top of base pay, and each one follows the underlying wage into either OPEX or COGS.
Payroll Taxes
Employers pay 6.2% of each employee’s wages toward Social Security and 1.45% toward Medicare under the Federal Insurance Contributions Act.4Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates The combined 7.65% applies only up to the Social Security wage base, which is $184,500 for 2026.5Social Security Administration. 2026 Cost-of-Living Adjustment (COLA) Fact Sheet Above that threshold, the employer still owes the 1.45% Medicare portion on every dollar with no cap. The additional 0.9% Medicare surtax on wages over $200,000 is the employee’s burden alone and doesn’t add to the employer’s cost.6Internal Revenue Service. Publication 926 (2026), Household Employer’s Tax Guide
Federal unemployment tax adds another layer. After the standard credit for paying state unemployment taxes, most employers owe 0.6% on the first $7,000 of each employee’s annual wages.7Employment and Training Administration. FUTA Credit Reductions State unemployment rates vary by state, industry, and layoff history, generally running from under 1% to over 10% of taxable wages.
Benefits and Other Add-Ons
Employer-sponsored health insurance premiums, 401(k) matching contributions, and workers’ compensation insurance all raise the true cost per employee. Discretionary perks like professional development budgets and wellness stipends count too. Every one of these costs travels with the employee into either OPEX or COGS depending on the role.
Where Each Type Shows Up on the Income Statement
Production labor appears in the COGS line at the top of the income statement. Revenue minus COGS gives you gross profit, which tells you how efficiently you turn labor and materials into sales before overhead enters the picture.
Administrative, management, and sales salaries appear further down in the Selling, General, and Administrative (SG&A) section. Gross profit minus SG&A and other operating costs produces operating income, sometimes called earnings before interest and taxes. The layered format lets investors and lenders see separately how much production labor costs and how much the corporate infrastructure consumes.
Public companies must follow SEC Regulation S-X Rule 5-03, which requires income statements to separate cost of revenue from SG&A expenses by function.8GovInfo. Securities and Exchange Commission Regulation S-X 210.5-03 Income Statements Private companies have more flexibility, but following the same structure makes financial statements easier to compare and more credible to a bank reviewing a loan application.
What Happens if You Classify Wrong
Misclassifying salary expenses between COGS and OPEX shifts income between tax years. If production wages are wrongly expensed as operating costs instead of capitalized into inventory, the business deducts them too early and understates taxable income in the current year. The IRS treats this as a potential accuracy-related penalty situation and can impose a 20% penalty on the portion of tax underpaid because of negligence or a substantial understatement of income.9Internal Revenue Service. Accuracy-Related Penalty Interest runs on top of the penalty from the original due date of the return.
A separate problem, and often a more expensive one, is misclassifying employees as independent contractors. That is a different question from OPEX versus COGS: it changes whether the person belongs on payroll at all. When a worker who should be on payroll is instead paid as a contractor, the business avoids withholding income tax and paying its share of FICA and FUTA. Under 26 U.S.C. ยง 3509, the IRS can assess a combined employment tax penalty on the misclassified wages, and the Department of Labor can pursue the issue independently for violations of wage and hour protections.10U.S. Department of Labor. Final Rule: Employee or Independent Contractor Classification Under the Fair Labor Standards Act Getting worker status right at the outset avoids both the tax penalties and the back-pay exposure.