Yes, cost of goods sold includes labor, but only the labor that goes into making, assembling, or acquiring the goods you sell. The wages of a welder on your production floor belong in COGS; the salary of your office manager does not. Federal tax law requires production-related labor to be capitalized into inventory and deducted only when the inventory is sold, while administrative and sales wages are deducted as operating expenses in the period you pay them.1Internal Revenue Service. Publication 334 – Tax Guide for Small Business
Direct Labor That Clearly Counts
Direct labor is the easiest piece. It covers wages paid to employees whose work can be traced to a specific unit or batch of product. The baker shaping loaves, the technician assembling circuit boards, the welder joining steel beams — if you can tie the work to the goods, the compensation is direct labor.2eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs
The IRS reads direct labor broadly. It includes base wages, overtime, vacation pay, holiday pay, sick leave, and shift differentials.2eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs If an employee splits time between the production floor and other work, allocate the production portion into COGS as long as you can identify it.1Internal Revenue Service. Publication 334 – Tax Guide for Small Business Keep time records that back up the split; in an audit, the burden sits with you to show the allocation is reasonable.
Contract labor counts too. The UNICAP regulations treat independent contractors the same as employees for classifying direct and indirect labor.2eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs A freelance machinist hired for a production run is a direct labor cost that goes into inventory, not an immediate deduction.
Indirect Labor That Reaches COGS Through Overhead
Plenty of people keep a factory running without touching the product. A quality control inspector, a maintenance worker, a plant supervisor. Their wages are indirect labor.1Internal Revenue Service. Publication 334 – Tax Guide for Small Business
Indirect labor is pooled with other factory costs — equipment depreciation, utilities, facility insurance — into manufacturing overhead, and that pool is spread across the units produced. Common allocation bases include direct labor hours, machine hours, or material usage. Each finished unit absorbs a share, which is how a slice of the plant supervisor’s salary ends up embedded in the cost of every widget that leaves the line.
Federal tax rules require capitalizing both direct costs and a proper share of indirect costs into inventory.3Office of the Law Revision Counsel. 26 USC 263A – Certain Costs Must Be Capitalized Indirect labor does not hit your income statement the moment you pay it. It sits on the balance sheet as part of inventory value until the goods are sold, and then flows into COGS with the rest of the loaded cost.
The capitalization requirement reaches further than many owners expect. Service department costs that benefit production — in-house accounting staff at the plant, plant security, HR servicing production workers — may also need to be capitalized under Section 263A.2eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs These employees never set foot near the line, but their costs still get caught.
Payroll Taxes And Benefits Ride Along With The Wages
Wages alone understate what belongs in COGS. Payroll taxes and certain benefit costs for production employees are also capitalized into inventory. Accountants call this “labor burden,” and it can add a meaningful percentage on top of base pay.
For 2026, the employer’s share of Social Security tax is 6.2% on wages up to $184,500, and Medicare tax is 1.45% with no wage cap.4Social Security Administration. Contribution and Benefit Base Federal unemployment tax adds another layer, most states charge their own unemployment insurance premiums, and workers’ compensation, health insurance contributions, and retirement plan contributions for production employees fold in as well.
The IRS regulations specifically list payroll taxes and payments to supplemental unemployment benefit plans as elements of direct labor cost that must be capitalized.2eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs A production worker earning $25 per hour can actually cost $33 or more once burden is included, and that full amount belongs in inventory.
Labor That Stays Out Of COGS
A large portion of most payrolls never touches COGS. Salespeople, marketing staff, HR for the corporate office, the CEO, corporate accountants, and office administrators earn wages that are classified as operating expenses. These are deducted in the period paid, regardless of when inventory sells.1Internal Revenue Service. Publication 334 – Tax Guide for Small Business
The line the IRS draws is clear: the only labor that belongs in COGS is direct and indirect production labor plus certain overhead charges tied to the manufacturing process. Everything else is a period expense.1Internal Revenue Service. Publication 334 – Tax Guide for Small Business This separation is why gross profit (revenue minus COGS) and operating profit (revenue minus COGS minus operating expenses) tell you different things. Gross profit isolates production efficiency; operating profit reflects the full cost of running the company.
Wholesalers and retailers are a special case. If your business buys finished goods and resells them without altering them, you typically have no production labor to include. Your COGS is mostly the purchase price of the merchandise plus freight and similar acquisition costs. Employee wages for stocking shelves, running the register, or managing the store are operating expenses.
What About Service Businesses?
Service businesses do not manufacture goods, but they still incur direct costs to deliver their services. The labor of an attorney working on a client matter, a consultant on an engagement, or a dog groomer during a session is analogous to direct production labor.
Service companies often report these as “cost of revenue” or “cost of services” rather than COGS. The principle is the same: if you would not have incurred the labor cost but for delivering a specific service, it is a direct cost of that revenue. Base salaries for employees who perform the services may qualify; salaries for office managers or marketing staff do not.
Without physical inventory on a shelf, a service firm does not capitalize labor into a balance-sheet asset the way a manufacturer does, unless it has significant work-in-progress spanning reporting periods. Most service providers deduct their cost of revenue as they earn the corresponding revenue, which simplifies the bookkeeping but makes correct classification between direct service delivery and general overhead even more important.
Why Timing Matters: The UNICAP Rules
The legal backbone is Section 263A of the Internal Revenue Code, the Uniform Capitalization rules, or UNICAP. Section 263A requires any business that produces or resells tangible property to capitalize both direct costs and a proper share of allocable indirect costs into inventory. “Produce” is defined broadly enough to cover constructing, manufacturing, developing, or improving property.3Office of the Law Revision Counsel. 26 USC 263A – Certain Costs Must Be Capitalized
In practice, UNICAP prevents you from deducting production labor immediately. The cost sits in inventory on the balance sheet until the goods sell, then flows to COGS. A business that manufactures goods in December but sells them in March does not get to deduct that December labor until the following year’s return.
The Small Business Exemption
Not every business has to wrestle with UNICAP. Section 263A(i) exempts businesses that meet the gross receipts test in Section 448(c).3Office of the Law Revision Counsel. 26 USC 263A – Certain Costs Must Be Capitalized For tax years beginning in 2026, you qualify if your average annual gross receipts over the prior three tax years do not exceed $32 million.5Internal Revenue Service. Revenue Procedure 2025-32 Tax shelters are excluded regardless of size.
A related provision in Section 471(c) lets qualifying small businesses use simplified inventory methods. You can treat inventory as non-incidental materials and supplies, or follow whatever method you use in your financial statements, rather than maintaining detailed inventory cost accounting.6Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories For a small manufacturer or retailer, this cuts out a tremendous amount of bookkeeping. You still need a method that clearly reflects income.
The threshold is inflation-adjusted annually, so check the current revenue procedure each year. And the test runs on a three-year average, so one strong year will not automatically disqualify you and one weak year will not automatically qualify you. Run the calculation before filing.7Internal Revenue Service. Instructions for Schedule C (Form 1040)
What Happens If You Misclassify
Classifying production labor as an operating expense, whether on purpose or through loose bookkeeping, lets you deduct costs faster than the tax code allows. The IRS treats that as an underpayment, and the consequences go beyond paying what you owe.
The accuracy-related penalty under Section 6662 adds 20% on top of the underpaid tax. It applies when the underpayment results from negligence or a substantial understatement of income tax. For individuals, a substantial understatement means the underpayment exceeds the greater of 10% of the tax that should have been reported or $5,000.8Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
The most common mistake is expensing indirect production labor that should have been capitalized. A growing manufacturer that hires a plant supervisor and books the salary entirely as an administrative expense is the classic UNICAP problem on audit. The fix is to reclassify the cost and capitalize it into inventory. Discovering the error years later means amended returns, interest on the underpayment, and potentially that 20% penalty on top.