Generally accepted accounting principles, commonly referred to as GAAP, prescribe specific accounting treatments for the recording of inventory costs. Small-business owners who are unaware of these rules may unintentionally misstate their financial records. Understanding the accounting for direct labor costs is one of the key components of understanding GAAP-compliant inventory accounting.

Labor Classification

To correctly account for labor costs, small-business owners first need to classify labor expenses as product or period costs. If the labor cost was incurred as part of the manufacture of products, it is considered a product cost, but if the labor was part of the general and administrative costs of the company, it is considered to be a period cost. Period costs are expensed immediately. However, product costs can be further broken down into direct and indirect labor costs.


Generally accepted accounting principles require that all product costs are included as part of the company's inventory balance until the products are sold. Direct labor costs, because they are easily traceable to products, are recorded as a debit to the work-in-process inventory account and a credit to wages payable. Indirect labor, such as the salaries of factory management, cannot be easily traced to products. Therefore, these expenses are debited to the manufacturing overhead account and credited to the wages payable account. As jobs are completed, these overhead costs will be applied to products through an allocation process.

Fringe Expenses

Both direct and indirect labor costs include more than just the gross wages paid to an employee. Small-business owners should consider fringe expenses when accounting for direct and indirect labor costs. In most companies, fringe expenses are considered the same type of labor costs as the employee hours they are associated with. For example, health insurance premiums paid on behalf of a direct labor employee are considered to be direct labor as well.

Inventory Cost Flows

Direct labor costs are included in the company's inventory accounts until the goods are sold. From the work-in-process inventory account, costs move to the finished goods account as the manufacturing process is completed. This movement is reflected in the accounting records with a debit to finished goods and a credit to work-in-process inventory. When the goods are sold, they are removed from finished goods inventory and shipped to customers. This movement is recorded in two journal entries. First, a debit is made to the cost of goods sold account and a credit is made to the finished goods account. This entry reflects the cost of inventory being removed from the books. Last, a debit is made to the accounts receivable account and a credit is made to the sales revenue account. This entry accounts for the funds owed to the company and the recording of sales.