Yes, gross margin includes labor, but only the labor tied to making your product or delivering the service you bill for. Wages for people on the production floor reduce gross margin. So do the wages of supervisors, quality inspectors, and maintenance workers who keep production running, even though they never touch the product themselves. Salaries for administrative staff, salespeople, executives, and other non-production roles sit below the gross profit line as operating expenses.
Direct Labor Reduces Gross Margin
Direct labor is the wages of employees who physically create the product or perform the billable service. On a factory floor, that means workers assembling, machining, welding, or packaging. In a service business, it means the technician doing the repair, the consultant delivering the engagement, or the developer writing code for a client.
The IRS defines direct labor as “the wages you pay to those employees who spend all their time working directly on the product being manufactured,” and it includes a proportional share of wages for employees who split time between production and other duties.1Internal Revenue Service. Publication 334, Tax Guide for Small Business These wages flow into cost of goods sold and reduce gross profit dollar-for-dollar.
A useful test: if you produced zero units next month and a worker had nothing to assemble, would that worker’s wages still exist? If no, it’s direct labor. The cost scales with output, which is what makes it a variable production cost rather than fixed overhead.
Indirect Factory Labor Also Lands in COGS
This is where owners often go wrong. Not every worker inside a production facility is “direct” labor, but that doesn’t push them out of gross margin. Supervisors, quality inspectors, and maintenance staff who keep production equipment running don’t build the product themselves, yet their wages still belong in cost of goods sold as part of manufacturing overhead.
The IRS draws the line explicitly: indirect labor costs are “the wages you pay to employees who perform a general factory function that does not have any immediate or direct connection with making the saleable product, but that is a necessary part of the manufacturing process.”1Internal Revenue Service. Publication 334, Tax Guide for Small Business Factory rent, utilities, equipment depreciation, and these indirect labor costs all fold into COGS as overhead.
Gross margin therefore absorbs two layers of production labor: direct wages and indirect factory wages. The distinction matters for internal cost accounting, but for the question of whether the cost hits gross margin, both do.
Labor That Stays Out of Gross Margin
Administrative staff, salespeople, marketing teams, HR personnel, and executive management do not reduce gross margin. Their compensation appears on the income statement as operating expenses, deducted below the gross profit line to arrive at operating income.
The IRS calls these “other labor costs not properly chargeable to your cost of goods sold” and treats them as selling or administrative expenses.1Internal Revenue Service. Publication 334, Tax Guide for Small Business The logic is straightforward: a CEO’s compensation doesn’t change because production ran 10,000 units instead of 8,000. These costs are largely fixed and reflect the overhead of running the organization, not the cost of making what you sell.
Keeping this separation clean is what makes gross margin useful. A business with a declining gross margin has a production or pricing problem. A business with healthy gross margins but shrinking operating income has an overhead problem. Mix the two categories together and you can’t tell which.
Contractors and Subcontractors Follow the Same Rule
Payments to freelancers, subcontractors, and other non-employees are classified the same way as employee wages. If the work directly produces what you sell, the fee belongs in COGS. A manufacturer that hires a contract welder for a production run includes that fee in cost of goods sold. A web agency that subcontracts design work on a client project treats the subcontractor’s invoice as a direct production cost.
The Schedule C instructions confirm that contract labor can be reported on the COGS line rather than as a general expense when the work relates to production.2Internal Revenue Service. 2025 Instructions for Schedule C (Form 1040) The math is easier with contractors because you don’t calculate a burdened cost: no employer payroll taxes, no benefits, no workers’ comp. The invoice amount is the cost.
The Full Cost of Direct Labor Is More Than Wages
For employees, gross margin absorbs every employer-side cost attached to the worker, not just the hourly wage or base salary. Leaving these out understates production cost and makes gross margin look better than it actually is. The main components:
- Social Security tax: Employers pay 6.2% on each employee’s wages up to $184,500 in 2026.3Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates4Social Security Administration. 2026 Cost-of-Living Adjustment (COLA) Fact Sheet
- Medicare tax: An additional 1.45% on all wages with no cap.3Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates
- Federal unemployment tax (FUTA): The gross rate is 6.0% on the first $7,000 of each employee’s wages, but most employers receive a 5.4% credit for paying into their state unemployment fund, bringing the effective rate to 0.6%.5Internal Revenue Service. Topic No. 759, Form 940, Employers Annual Federal Unemployment (FUTA) Tax Return
- State unemployment tax (SUTA): Rates vary widely by state and by claims history, from 0% in states with the lowest minimum rates to over 12% in states that penalize high-turnover employers.
- Workers’ compensation insurance: Premiums are based on industry classification and payroll size, with high-risk industries like logging or construction paying far more than office-based operations.6Insurance Information Institute. Workers Compensation Insurance
- Health insurance and retirement contributions: Employer-paid health premiums and matching contributions to 401(k) or pension plans often represent the largest non-wage component of labor cost.
For a production worker earning $25 per hour, these add-ons can push the true cost to $32 or more per hour depending on state, industry, and benefits. That difference compounds across a full workforce and can shift gross margin by several percentage points.
Tax Rules Enforce the Classification
This isn’t only an accounting preference. Federal tax law requires businesses that produce or acquire property for resale to capitalize their direct and indirect production costs into inventory rather than deducting them as current-year expenses. Section 263A of the Internal Revenue Code, known as the uniform capitalization rules, mandates that both direct costs and a proper share of allocable indirect costs are included in inventory value.7Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
In practice, direct labor and factory overhead don’t flow through COGS as a bookkeeping matter. They must be capitalized into inventory and recognized as an expense only when that inventory is sold. Expensing production labor immediately instead of capitalizing it overstates deductions in the current year and understates inventory value, which is the kind of mismatch that draws audit attention.8Internal Revenue Service. Tangible Property Regulations – Frequently Asked Questions Small businesses with average annual gross receipts of $30 million or less may be exempt from the full 263A requirements, but the general duty to categorize labor correctly as production-related or administrative applies to every business that reports cost of goods sold.
What the Numbers Look Like
The formula is simple. Gross margin equals revenue minus cost of goods sold, divided by revenue, expressed as a percentage. The work is in getting COGS right. Total COGS combines three components: raw materials, fully burdened direct labor (with the payroll taxes and benefits above), and allocated manufacturing overhead like factory rent, utilities, and indirect production labor.
Say your business brings in $500,000 in revenue. Materials cost $120,000, fully burdened direct labor is $130,000, and factory overhead (including indirect labor) runs $50,000. Total COGS is $300,000, leaving $200,000 in gross profit. Divide $200,000 by $500,000 and the gross margin is 40%. That means 40 cents of every revenue dollar survives production costs and is available to cover operating expenses and profit.
Exclude the employer-side payroll taxes and benefits from that $130,000 labor figure and you might report labor at $100,000 instead. COGS drops to $270,000 and gross margin inflates to 46%. The six-point gap between 40% and 46% is the difference between knowing your real production economics and fooling yourself.