WIP inventory, or work in process inventory, is the value of goods that have entered production but aren’t yet finished. On a manufacturer’s balance sheet it sits between raw materials and finished goods, carrying every dollar of materials, labor, and overhead absorbed by items still on the factory floor. The standard formula is: Ending WIP = Beginning WIP + Total Manufacturing Costs − Cost of Goods Manufactured. Getting the number right matters for financial reporting and for federal taxes, because the IRS requires manufacturers to follow specific inventory accounting rules that feed directly into taxable income.
What Goes Into WIP
Every dollar of WIP value traces back to one of three cost buckets.
Direct materials are the raw inputs pulled from storage and issued to a production order. Once a circuit board or steel sheet moves to the assembly line, its cost shifts out of raw materials inventory and into WIP. Tracking the exact dollar amount of materials consumed keeps the books aligned with what’s physically on the floor.
Direct labor covers the wages and benefits paid to workers who physically build or assemble the product. If a machinist spends six hours on a housing unit, that compensation gets added to that unit’s WIP value. Administrative salaries and sales commissions don’t belong here; they aren’t tied to hands-on production.
Manufacturing overhead is the indirect cost of keeping the factory running: rent, electricity, equipment depreciation, and the pay of supervisors and maintenance staff. Because no single invoice maps neatly to one product, companies allocate overhead using a predetermined rate so every unfinished item carries a fair share of facility costs.
How to Calculate WIP
Start with the WIP balance carried over from last period. Add all manufacturing costs incurred during the current period (materials, labor, and overhead combined). Then subtract the cost of goods manufactured, which is the total cost of items completed and moved out of production into finished goods.
Written out: Ending WIP = Beginning WIP + Manufacturing Costs − Cost of Goods Manufactured.
Say your beginning WIP was $50,000. You spent $200,000 on manufacturing during the month, and $180,000 of goods were completed and transferred out. Your ending WIP is $70,000. That figure represents everything still on the production floor, partially built, absorbing cost but not yet generating revenue. Overstating materials issued, missing labor hours, or misallocating overhead throws off the ending balance and distorts both your balance sheet and your cost of goods sold.
Measuring Partial Completion With Equivalent Units
Items in WIP sit at wildly different stages. Some units are 90% done; others just entered the line. Accountants handle this by converting partial units into equivalent units, expressing incomplete work as a smaller number of fully completed units. A batch of 1,000 units that are 40% complete equals 400 equivalent units for cost-assignment purposes.
Under the weighted-average method, you take the units completed and transferred out (100% done by definition) and add the equivalent units still in ending WIP. Percentages of completion can differ across cost categories. A unit might be 100% complete on materials because all the parts are there, but only 60% complete on labor if assembly isn’t finished. That split determines how much cost gets assigned to ending WIP versus the goods that moved into finished inventory.
Where WIP Appears on the Balance Sheet
Ending WIP is reported as a current asset, grouped with other inventory categories. Within the inventory line, companies typically list raw materials first, WIP second, and finished goods third, mirroring the flow of production. The separate disclosure matters because WIP is less liquid than finished goods: finished products can ship tomorrow, while WIP still needs more labor and overhead before it can be sold.
Federal Tax Rules for Valuing Inventory
The IRS requires businesses to account for inventory whenever producing or selling merchandise is a factor in generating income. Under Section 471 of the Internal Revenue Code, inventory must be valued using a method that conforms to the best accounting practice in the taxpayer’s industry and most clearly reflects income.1Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories You can’t pick whichever method produces the lowest tax bill; the method needs to match how your industry tracks costs and has to give the IRS an accurate picture of what you earned.
Section 471 allows two primary approaches. Under the cost method, inventory is valued at what you actually paid to produce or acquire it, including materials, labor, and allocated overhead. Under the lower of cost or market method, inventory is valued at either its production cost or its current replacement cost, whichever is less, which prevents businesses from carrying inventory at inflated values when market prices have dropped.
Whichever method you pick, the IRS expects consistency. Once you adopt a method, you keep it unless you formally request a change.
LIFO and the Conformity Rule
Businesses can also elect last-in, first-out (LIFO), which assumes the most recently produced or purchased items are sold first. During periods of rising costs, LIFO increases cost of goods sold and reduces taxable income, which is why the IRS imposes a conformity requirement. If you use LIFO for tax purposes, you must also use it in your financial statements reported to shareholders and creditors. You can’t report lower LIFO income to the IRS while showing investors a rosier picture using a different method. Violate conformity in your annual financial statements and the IRS can force you off LIFO entirely.2Internal Revenue Service. Practice Unit – LIFO Conformity
Accuracy-Related Penalties
Inventory valuation errors create tax exposure. If misstating WIP leads to underreported income or overstated deductions, the IRS can impose an accuracy-related penalty of 20% on the resulting underpayment. This applies to underpayments caused by negligence or disregard of tax rules, and to substantial understatements of income tax.3Internal Revenue Service. Accuracy-Related Penalty Thorough records of labor hours, material receipts, and overhead allocations are the simplest defense.
UNICAP: Indirect Costs You Have to Capitalize
Section 263A of the Internal Revenue Code, commonly called the uniform capitalization or UNICAP rules, requires manufacturers and resellers to capitalize both direct costs and a proper share of indirect costs into inventory. This goes beyond what many businesses would naturally include. Indirect costs like taxes, storage, handling, insurance, and depreciation on production equipment must be allocated to inventory rather than deducted as current-year expenses.4Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
The practical effect is that these costs stay on the balance sheet as part of inventory value until the goods are sold, then flow through cost of goods sold. That delays the tax deduction. You can’t write off factory insurance in the year you pay it if some of that insurance protected inventory still on hand at year-end. UNICAP compliance adds complexity to WIP calculations because overhead allocation has to follow specific rules about which costs are allocable to production, not just the ones your accounting software groups together by default.
Small Business Exemption
Not every manufacturer has to deal with the full inventory regime. Section 471(c) exempts businesses that meet the gross receipts test under Section 448(c). For tax year 2026, that means average annual gross receipts of $32 million or less over the prior three-year period.1Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories The threshold is adjusted annually for inflation; for 2025 it was $31 million.5Internal Revenue Service. Revenue Procedure 2024-40
Qualifying businesses get two simplified options. They can treat inventory as non-incidental materials and supplies, deducting costs when items are used or consumed rather than when sold. Or they can follow whatever inventory method is reflected in their financial statements. The same gross receipts threshold also exempts small businesses from UNICAP under Section 263A(i), eliminating the requirement to capitalize indirect costs into inventory.6Federal Register. Small Business Taxpayer Exceptions Under Sections 263A, 448, 460, and 471
The exemption isn’t automatic. You confirm your three-year average gross receipts each year, and tax shelters are excluded regardless of size.
Changing Your Inventory Method
Switching from one inventory valuation method to another, whether moving from cost to lower of cost or market or electing LIFO, requires IRS approval through Form 3115, Application for Change in Accounting Method. Many inventory-related changes qualify under automatic change procedures, meaning you file the form with your tax return without waiting for IRS consent or paying a user fee.7Internal Revenue Service. Instructions for Form 3115
If your change doesn’t fall under the automatic procedures, you request approval through the non-automatic process, which requires a user fee and takes longer. Either way, the IRS doesn’t allow you to start using a new method mid-year without filing. Making an unauthorized change can result in the IRS requiring you to revert and adjusting your taxable income for the years the unauthorized method was in use. The form also calculates a Section 481(a) adjustment, a catch-up amount that prevents income from being permanently skipped or double-counted because of the switch.
State Inventory Taxes
Federal rules aren’t the only tax consideration. A majority of states exempt business inventory from property taxation, but roughly a dozen states still tax it in full or in part. Where inventory is taxed, WIP is included in the assessed value of business personal property, meaning the cost built up in unfinished goods creates an annual tax obligation separate from income taxes. If you operate in a state that taxes inventory, accurate WIP valuation affects both your federal return and your local property tax bill. Rules vary significantly by state, so check with your state’s department of revenue before assuming your inventory is exempt.