Work in progress affects your profit and loss statement indirectly but powerfully: the costs of unfinished goods sit on the balance sheet as an asset instead of hitting the income statement, and they only flow through to cost of goods sold when the products are completed and sold. That timing lag means a rising WIP balance lifts your current gross profit, a falling WIP balance pulls it down, and neither movement necessarily reflects a change in how the business is actually performing.
Accrual accounting is built on the matching principle: costs should appear in the same period as the revenue they helped generate. Money spent on raw materials, wages, and factory overhead for products that haven’t shipped yet hasn’t produced any revenue, so it doesn’t belong on the income statement. It parks on the balance sheet as a current asset called work in progress and waits.
The IRS treats this as mandatory rather than optional. Businesses that produce or purchase goods for resale must account for inventories, and WIP is an inventory category that must be tracked.1Internal Revenue Service. Publication 538 – Accounting Periods and Methods
How WIP Moves Into Cost of Goods Sold
WIP reaches your profit and loss statement through one channel: cost of goods sold. The calculation is beginning inventory plus production costs incurred during the period, minus ending inventory. What’s left is COGS, and COGS is what gets subtracted from revenue to produce gross profit.1Internal Revenue Service. Publication 538 – Accounting Periods and Methods
Two directions, two very different effects on your P&L:
- When WIP grows from the start of a period to the end, the business put more into unfinished work than it completed. That increase stays on the balance sheet and reduces COGS, which pushes gross profit up. The business looks more profitable simply because production is outrunning completion.
- When WIP shrinks, previously unfinished work has crossed the finish line, and the accumulated costs finally land in COGS. Gross profit falls, sometimes sharply.
A manufacturer that spends $200,000 on steel and $80,000 on wages in March to build equipment shipping in June doesn’t report a $280,000 hit in March. Those outlays sit in WIP. In June, when the equipment ships, the costs move through COGS and the profit picture changes accordingly. Reading a single quarter in isolation misses this. Reading two consecutive quarters together tells the real story.
What Costs Live Inside WIP
Three categories go in: direct materials, direct labor, and a share of manufacturing overhead. Overhead is where things get tricky. It covers factory utilities, equipment depreciation, quality control, insurance on the production facility, and similar costs that can’t be traced to a specific unit but are real costs of making the product.
The IRS separates direct from indirect production costs and requires both in inventory. Direct costs are simple. Indirect costs need an allocation method, and getting that allocation wrong misstates WIP, which flows straight through to COGS and to reported profit.2Internal Revenue Service. Section 263A Costs for Self-Constructed Assets
The Uniform Capitalization Rules Widen What Must Be Capitalized
Section 263A of the Internal Revenue Code, the uniform capitalization (UNICAP) rules, requires businesses that produce property or acquire it for resale to capitalize both direct costs and their proper share of indirect costs into inventory.3Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses Costs you might prefer to deduct now get folded into WIP and only reduce taxable income when the product sells.
The indirect costs subject to UNICAP reach further than most owners expect: officer compensation allocable to production, employee benefits, purchasing and handling, storage, insurance, utilities, and even cost accounting services performed for the production function.2Internal Revenue Service. Section 263A Costs for Self-Constructed Assets A business that fails to capitalize these costs overstates its current deductions and reports lower taxable income than the law allows.
The Small Business Exemption
Not every business has to comply. Section 263A(i) exempts taxpayers that meet the gross receipts test under Section 448(c).3Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses For tax years beginning in 2026, that threshold is $32 million in average annual gross receipts over the prior three-year period.4Internal Revenue Service. Revenue Procedure 2025-32 Businesses under the line can use simpler inventory methods and deduct many production costs immediately. During heavy production periods, the reported profit difference between a business that capitalizes indirect costs and one that expenses them right away can be significant.
Valuation Method Choices Shape the Number
The method used to value WIP directly changes both the asset shown on the balance sheet and the COGS figure hitting the P&L. The IRS generally permits three approaches: cost, lower of cost or market, and the retail method.1Internal Revenue Service. Publication 538 – Accounting Periods and Methods For WIP, most manufacturers use one of the first two.
The cost method values each item at all direct and indirect costs incurred so far. It’s the more straightforward approach and tends to produce higher inventory values in stable markets. Lower of cost or market compares accumulated cost to current market value and takes whichever is smaller. If raw material prices drop or a product becomes partially obsolete mid-production, this method forces a write-down that immediately reduces the asset and can increase COGS for the period.
Once you pick a basis, you keep it. Switching valuation methods requires IRS permission.5eCFR. 26 CFR 1.471-2 – Valuation of Inventories Damaged or partially obsolete WIP can be valued at no less than scrap value, but the taxpayer has to prove the goods are subnormal, generally through evidence of an offering, an actual sale, or a contract cancellation within 30 days of the inventory date.6Internal Revenue Service. Lower of Cost or Market
Long-Term Contracts and the Revenue Side
For businesses with long-term contracts, WIP also drives when revenue gets recognized, not just when costs come out. A construction company building a bridge over 18 months can’t wait until the final month to record all its income. Months of expenses with no matching revenue would create exactly the distortion WIP accounting exists to prevent.
ASC 606, the revenue recognition standard from the Financial Accounting Standards Board, allows a business to recognize revenue as work progresses when the customer consumes the benefit as work is performed, controls the asset as it’s built, or the work produces something with no alternative use to the seller and the seller has an enforceable right to payment for work done so far.7Financial Accounting Standards Board (FASB). Revenue Recognition Construction, custom manufacturing, and many professional service contracts commonly meet at least one condition.
Companies measure progress with output methods (milestones, units delivered) or input methods (costs incurred relative to total expected costs). The cost-to-cost approach is the most common input method and functions much like the older percentage-of-completion method. Spend 40% of estimated total cost, recognize 40% of expected revenue. WIP and recognized revenue move together, keeping the income statement aligned with actual progress rather than billing cycles.
Overbilling and Underbilling
Billings rarely match earned revenue exactly. Bill more than you’ve earned based on progress and the excess is a liability called overbilling. Bill less and the shortfall is an asset called underbilling. Both sit on the balance sheet and both trace back to the WIP calculation. A contractor that consistently overbills looks profitable now but is borrowing from future periods. Underbilling makes current performance look weaker than it is. Lenders and sureties read these figures closely because they show whether reported profits are backed by real progress or by aggressive invoicing.
WIP Applies to Service Businesses Too
Factories and construction sites aren’t the only places WIP shows up. Any business that performs work before billing accumulates WIP. Law firms, accounting practices, consulting shops, and agencies all track unbilled time this way. An attorney who logs 30 hours on a case at $400 an hour is holding $12,000 in WIP as an asset until the invoice goes out and the client pays.
The mechanics are identical to manufacturing, with different inputs. Instead of raw materials and machine time, service WIP holds labor hours and allocated overhead. For firms billing monthly, WIP turns over quickly. For contingency work or milestone-based contracts, WIP can build for months or years. The longer it sits, the more likely something forces a write-down, which is when it finally hits the P&L.
What Goes Wrong When WIP Is Mishandled
Two consequences follow from sloppy WIP accounting: misleading financials and tax exposure.
A company that expenses all production costs as incurred, skipping WIP, shows deep losses during heavy production months and abnormally high profits when finished goods sell. A manufacturer spending $500,000 on a production run that ships three months out would report a large current-quarter loss even though the money bought a real asset. Investors and lenders see instability where the business is fine. Erratic reporting like this can trip loan covenants, lower credit ratings, and make capital harder to raise.
The tax exposure is more concrete. Deducting costs that should have been capitalized understates taxable income. If the IRS finds a substantial understatement, the accuracy-related penalty is 20% of the underpayment. For individual filers, a substantial understatement means tax was understated by the greater of 10% of the correct tax or $5,000. Businesses claiming the qualified business income deduction under Section 199A face a lower trigger: the greater of 5% of the correct tax or $5,000.8Internal Revenue Service. Accuracy-Related Penalty
Consistency matters too. Inventory methods can’t switch without IRS permission, and the chosen method has to conform to the federal regulations on inventory accounting.5eCFR. 26 CFR 1.471-2 – Valuation of Inventories Auditors will want physical counts, written count procedures, and a clear trail from raw inputs to the balance sheet numbers. Without that documentation, defending your reported profits during an examination gets difficult fast.