Depreciation shows up in cost of goods sold only when the depreciated asset helps make the product, and only once that product is actually sold. Depreciation on factory machinery, the production building, and quality-testing equipment eventually flows through COGS. Depreciation on office furniture, sales vehicles, and the headquarters building never does. Between those two facts sits a timing rule that can hold manufacturing depreciation on the balance sheet for months before it ever touches the income statement.
Which Depreciation Belongs in COGS
Every depreciation dollar is either a product cost or a period cost, and the label decides everything that follows.
Product costs are tied to manufacturing: depreciation on factory machinery, the production facility itself, quality-testing equipment, and anything else that directly or indirectly supports turning raw materials into finished goods. Product costs get folded into the value of inventory on the balance sheet. They become an expense only when the inventory they’re attached to is sold.
Period costs are tied to running the rest of the business — selling, administrative work, corporate management. Depreciation on the sales team’s laptops, the corporate office building, or delivery trucks lives here. Period costs hit the income statement immediately as selling, general, and administrative expenses. They skip inventory entirely and never become part of COGS.
The classification sometimes takes judgment. A server running the factory’s production scheduling software is a product cost. The same model of server running the company’s email and HR systems is a period cost. Getting this wrong inflates or deflates inventory values and misstates gross profit, which is exactly the kind of error auditors look for.
How Factory Depreciation Gets Into Inventory
Depreciation on production assets is an indirect overhead cost. You can’t point to a single unit and say a specific machine’s wear-and-tear belongs to that unit. Instead, companies use a predetermined overhead rate to distribute the cost across production.
Total budgeted manufacturing overhead, depreciation included, is divided by a budgeted activity measure — usually machine hours or direct labor hours. Every unit produced absorbs overhead based on how much of that activity it consumed. The rate is set at the start of the year from estimates, so actual production and actual depreciation rarely match the budget perfectly.
The gap is called underapplied or overapplied overhead. For small variances, companies typically close the entire difference into COGS at year-end, on the reasoning that most of the year’s production has already sold. Larger variances get split proportionally among work-in-process inventory, finished goods inventory, and COGS based on ending balances. Either way, the depreciation embedded in overhead eventually reaches the income statement.
When It Actually Hits the Income Statement
Manufacturing depreciation behaves differently from almost every other expense on the books. Most expenses are recognized when incurred. Manufacturing depreciation can sit on the balance sheet for months, sometimes years, before it affects profitability.
The sequence runs in stages. Depreciation is first recorded into a manufacturing overhead account and applied to work-in-process inventory. As products are completed, their accumulated costs, including that embedded depreciation, transfer to finished goods. The cost stays parked in finished goods until someone buys the product.
Only the sale moves the cost from balance sheet to income statement. A company that manufactures 1,000 units but sells 600 recognizes 60% of the allocated depreciation as COGS that period. The other 40% remains in inventory.
This is the matching principle at work: depreciation expense is recognized in the same period as the revenue from the product it helped create. It also means that building up inventory delays recognition of manufacturing depreciation and temporarily lifts reported profits. That isn’t manipulation when done correctly; it’s how absorption costing works. But it matters when comparing companies with very different inventory turnover rates.
Factory Depreciation That Never Reaches COGS
Not all factory depreciation qualifies for inventory capitalization. GAAP requires that abnormal amounts of idle facility expense be recognized as a current-period charge rather than included in inventory cost. If a factory normally operates at 80% capacity but drops to 30% because of a supply-chain disruption or demand collapse, the depreciation attributable to that abnormal idle capacity gets expensed immediately. It never enters inventory and never flows through COGS.
Fixed overhead allocated to each unit should be based on normal production capacity. When production drops well below normal, the per-unit allocation stays the same and the unabsorbed portion is written off as a period expense. There’s no bright-line test for what counts as abnormal, so companies need to document their reasoning. A seasonal slowdown the factory experiences every year isn’t abnormal. A six-month shutdown from a one-time event probably is.
How the Tax Rules Differ
Tax accounting and financial accounting don’t always agree on which depreciation costs belong in inventory. The Uniform Capitalization Rules under Internal Revenue Code Section 263A cast a wider net than GAAP. Section 263A requires taxpayers who produce tangible personal property or acquire property for resale to capitalize all direct costs and a proper share of indirect costs allocable to that property.
Under GAAP, only costs tied to the manufacturing function get capitalized into inventory. Under Section 263A, certain costs GAAP treats as immediate period expenses must also be capitalized. Depreciation on a warehouse used to store raw materials, or a portion of the depreciation on a shared administrative building that partly supports production, may need to be included in inventory costs for tax purposes even though financial reporting expenses them immediately. Treasury regulations also treat depreciation on temporarily idle equipment and facilities as an indirect cost that still gets capitalized into inventory for tax purposes, even when the equipment isn’t running.
The practical result: companies subject to UNICAP carry higher inventory values and report lower COGS on their tax returns than in their financial statements. That delays depreciation-related deductions and raises current taxable income. Companies keep two sets of inventory cost records, one following GAAP and one following Section 263A.
The Small Business Exemption
Not every business has to deal with UNICAP. Section 263A exempts taxpayers who meet the gross receipts test under Section 448(c), originally set at $25 million in average annual gross receipts over the preceding three tax years and indexed for inflation. For the 2025 tax year, the threshold stood at $31 million. Tax shelters are excluded from the exemption regardless of gross receipts.
Qualifying businesses can skip UNICAP entirely and use simpler inventory costing for tax purposes. If a company grows past the threshold, moving into full UNICAP compliance requires an accounting method change filed with the IRS, which can trigger adjustments to prior-year inventory balances.
What to Look For in Public Company Disclosures
The SEC watches how depreciation is reported within cost of sales. SEC staff reviews have questioned companies that fail to allocate non-cash items like depreciation to cost of sales, because excluding these amounts distorts gross margin. An unusually high gross margin is one of the first things regulators check for misclassified manufacturing depreciation sitting in operating expenses instead of COGS.
For investors, the useful disclosure lives in the footnotes. Companies typically disclose total depreciation expense, but the split between the portion in COGS and the portion in operating expenses isn’t always broken out clearly. When it is, the ratio signals how capital-intensive the production process is relative to the rest of the business.