Work in progress in accounting is inventory that has entered production but is not yet a finished product ready for sale. It sits on the balance sheet as a current asset, between raw materials and finished goods, and carries the accumulated cost of the materials, labor, and overhead spent on items still moving through the factory. Getting the number right matters for both financial statements and taxes, because the IRS generally requires manufacturers to capitalize those production costs into inventory rather than deduct them right away.
When Inventory Becomes Work in Progress
An item becomes WIP the moment it leaves the raw materials warehouse and enters production. A sheet of steel sitting in storage is raw materials. Once a machine cuts, bends, or welds that steel into a bracket, it shifts to WIP. It stays there until every production step, quality check, and finishing process is done. Only then does it move to finished goods, ready for sale or shipment.
You will sometimes see “work in progress” and “work in process” used interchangeably. Some accountants reserve “work in process” for short-cycle factory inventory and “work in progress” for long-term construction projects reported under property, plant, and equipment. Most manufacturers and textbooks treat the phrases as synonyms for partially completed manufacturing inventory, which is the sense used here.
The Three Costs That Build the WIP Number
Every dollar of WIP traces back to one of three categories: direct materials, direct labor, and manufacturing overhead.
Direct Materials
Direct materials are the physical inputs that end up in the finished product: lumber in a furniture factory, microchips in an electronics plant, flour in a commercial bakery. The recorded cost is what the company paid to acquire them, including freight and handling. When materials are pulled from storage into production, their cost moves from the raw materials account into WIP.
Direct Labor
Direct labor is the wages paid to workers who physically build or assemble the product. Base pay, overtime, and the employer’s share of payroll taxes all belong here. The employer portion of Social Security tax is 6.2% of wages, and Medicare adds another 1.45%.1Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates Those payroll costs flow into WIP alongside the worker’s wages.
Manufacturing Overhead
Overhead is the indirect cost of running the factory: electricity, equipment depreciation, building rent, quality inspections, and the salaries of floor supervisors who oversee production without physically building anything. Federal regulations require manufacturers to include all indirect production costs when valuing inventory, a method called full absorption costing.2eCFR. 26 CFR 1.471-11 – Inventories of Manufacturers
Because overhead cannot be traced to individual units the way materials can, companies use a predetermined overhead rate. A common approach divides total estimated overhead by total estimated machine hours (or labor hours) for the period, then applies that rate to each unit based on how many hours it consumed. A bad rate distorts every WIP balance downstream, so most companies revisit the estimate at least once a year.
Putting a Dollar Figure on Half-Built Goods
The hard part of WIP accounting is valuing something that is not finished. Two products at different stages of completion have absorbed different amounts of cost, and the accounting system has to reflect that. The right method depends on how production is structured.
Job Order Costing
If your company produces custom or batch orders, such as a furniture maker building 50 desks for one corporate client, job order costing is standard. Each job gets its own cost sheet. Materials, labor, and overhead are tracked to that specific job, and the WIP balance is simply the total charged so far. When the job is complete, the entire accumulated cost transfers to finished goods.
Process Costing and Equivalent Units
Manufacturers producing large volumes of identical items, such as bottled beverages, paper, or chemicals, use process costing instead. Costs flow through departments or production stages rather than through individual jobs. The key tool is the equivalent unit, which converts partially finished goods into the number of fully completed units they represent.
Suppose 1,000 units are 60% complete at month-end. That is 600 equivalent units. If total costs charged to the department were $120,000, the cost per equivalent unit is $200, and the WIP value for those 1,000 unfinished items is $120,000.
Materials and labor often reach different completion percentages. Raw materials might be added entirely at the start of production, while labor and overhead are only 40% applied by month-end. Accountants calculate equivalent units separately for each cost category and combine them. This keeps a batch that has all its materials but almost no labor from being valued the same as a batch that is nearly done.
Choosing a Cost Flow Assumption
Companies also have to pick how inventory costs move through the system: first-in, first-out (FIFO), last-in, first-out (LIFO), or weighted average. FIFO assumes the oldest costs leave WIP first, LIFO assumes the newest costs leave first, and weighted average blends them together.
LIFO has a catch. If you elect LIFO for tax purposes, you generally must also use LIFO in any financial statements issued to shareholders, creditors, or other outside parties.3Internal Revenue Service. Practice Unit – LIFO Conformity The conformity rule prevents companies from taking LIFO’s tax benefit while showing investors a rosier number under a different method.
What the IRS Requires
The IRS does not let manufacturers deduct all production costs in the year they are incurred. Under Section 263A, businesses must capitalize both direct and indirect production costs into inventory. Those costs sit on the balance sheet as an asset until the product is sold, at which point they become cost of goods sold and reduce taxable income.4Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
The practical effect is that WIP is capital locked inside the production process. A company with $2 million in WIP has $2 million of costs that cannot cut its tax bill until the goods are done and sold. Long production cycles feel this hardest.
Small Business Exemption
Not every manufacturer has to follow the capitalization rules. A business that meets the gross receipts test under Section 448(c) is exempt from Section 263A. For 2026, the threshold is $32 million in average annual gross receipts over the prior three tax years.5Internal Revenue Service. Revenue Procedure 2025-32
Qualifying small businesses also get a simplified inventory option under Section 471(c). Instead of full absorption costing, they can treat inventory as non-incidental materials and supplies, or follow whatever method they use on their financial statements.6Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories That is real relief. Full absorption costing means tracking and allocating dozens of indirect cost categories; the simplified method lets a small manufacturer keep one set of books.
Reporting WIP and Writing It Down
WIP is a current asset, nested between raw materials and finished goods in the inventory section. The current-asset label reflects the expectation that these items will be completed and sold within one operating cycle. Investors and lenders watch this line closely. A WIP balance that grows quarter after quarter without matching revenue can signal bottlenecks, quality problems, or slack demand.
GAAP does not let companies carry WIP at a value higher than what they could recover by finishing and selling it. Under ASC 330, as amended by ASU 2015-11, inventory measured using FIFO or weighted average must be reported at the lower of cost or net realizable value.7Financial Accounting Standards Board (FASB). Accounting Standards Update 2015-11: Simplifying the Measurement of Inventory Net realizable value is the estimated selling price minus the costs still needed to complete, sell, and ship the product.
When net realizable value drops below recorded cost, whether from falling market prices, obsolescence, or damage, the company must write down the inventory and recognize the difference as a loss in that period. The write-down is not reversible under U.S. GAAP. For manufacturers sitting on large WIP balances during a downturn, these write-downs can meaningfully cut reported earnings.
What Happens If the WIP Number Is Wrong
Inaccurate WIP accounting is not just a bookkeeping issue. It changes taxable income. Overstating WIP inflates inventory and understates cost of goods sold, which makes taxable income look higher than it is. Understating WIP does the opposite and creates a tax underpayment the IRS will eventually catch.
The IRS imposes a 20% accuracy-related penalty on any portion of a tax underpayment caused by a substantial understatement of income tax. A substantial understatement exists when the understatement exceeds the greater of 10% of the correct tax or $5,000. The same 20% penalty applies as a substantial valuation misstatement when the property valuation claimed on the return was 150% or more of the correct amount, and doubles to 40% when the misstatement reaches 200% or more.8Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
Fixing a Bad Method
If you find that your business has been valuing WIP incorrectly, you cannot just switch methods on next year’s return. The IRS requires Form 3115, an application for a change in accounting method.9Internal Revenue Service. Instructions for Form 3115 Many inventory-related changes, including changes to how you allocate costs under Section 263A, qualify for automatic consent, which means you attach the form to a timely filed return without a user fee or advance IRS approval. Changes that do not qualify for automatic consent must be filed with the IRS National Office during the tax year of the change and require a user fee.
The form also requires a Section 481(a) adjustment for the cumulative difference between the old and new methods, so income is not permanently skipped or double-counted. A positive adjustment, meaning you owe more tax under the new method, is generally spread over four years. A negative adjustment is taken entirely in the year of change. Skipping this step is a common and expensive mistake.