Why This Is the Most Important Accounting Change an A/E Firm Can Make

Most A/E firms have never separated direct and indirect labor in their books. Not because it's complicated — because nobody told them they needed to.

QuickBooks defaults to a single payroll expense account. Every payroll dollar lands in the same place regardless of whether the employee's time went toward a client project or toward an internal meeting. The books balance. The P&L closes. The firm runs for years without knowing what it's missing.

What it's missing is the ability to calculate its overhead factor.

Without the overhead factor, the firm cannot calculate true project cost, cannot build defensible billing rates from real cost data, cannot benchmark its net multiplier against anything meaningful, and cannot know — with any precision — whether it is pricing work to make money or pricing work to stay busy.

The payroll separation is the fix. It is a structural change to the chart of accounts — not a software switch, not a new system, not a significant disruption to existing workflows. Two payroll expense accounts instead of one, populated with the correct figures each period.

Everything that depends on the overhead factor becomes calculable the moment that separation exists.

→ Read: Why QuickBooks Fails Architecture and Engineering Firms

How to Set Up the Separation in QuickBooks

The setup requires four steps. None of them is technically complex. The most important prerequisite is having a project management system that tracks time against project phases — without it, the payroll figures cannot be accurately determined.

Step 1: Create two payroll expense accounts

In QuickBooks, navigate to your Chart of Accounts and create two expense accounts:

• Payroll Direct — for compensation allocated to direct labor (hours charged to client projects)
• Payroll Overhead — for compensation allocated to indirect labor (all other time)

If you currently have a single payroll expense account — often called "Payroll Expense," "Salaries and Wages," or similar — these two new accounts sit alongside it or replace it, depending on how your payroll is currently being processed. Do not delete the existing payroll account until the new setup is working correctly and your current period is reconciled.

Step 2: Get the payroll separation figures

The figures that go into Payroll Direct and Payroll Overhead each period are not available in QuickBooks. They come from your project management system.

Specifically, you need to know — for each pay period:

• Total payroll for the period (QuickBooks already has this from payroll processing)
• Total direct labor dollars for the period (the dollar value of all hours charged to client projects)
• Total indirect labor dollars = Total payroll minus Direct labor

BaseBuilders produces a payroll separation report that provides exactly these figures — direct labor dollars by employee for any given period, derived from the time entries logged to active project phases. That report is what tells you how much to allocate to each QuickBooks account each pay period. Without a project management system that connects time entries to payroll dollars, this step requires manual calculation — which is both time-consuming and prone to error.

Step 3: Make the journal entry each pay period

The journal entry must be made per pay period — not monthly. Because pay periods frequently span month-end boundaries, a monthly entry would require either splitting a pay period's time data across two accounting periods or approximating the incomplete period. Either approach introduces timing errors into the direct/indirect split that compound across the year.

The pay period is the natural unit of measurement — each payroll run corresponds to a specific set of time entries, producing a clean and accurate direct labor figure. Make the journal entry for each pay period when payroll is processed, using the direct labor figure from your project management system for that same period.

The entry itself:

• Debit Payroll Direct for the direct labor dollar amount
• Debit Payroll Overhead for the indirect labor dollar amount
• Credit the payroll clearing or bank account for the total payroll amount

The result: payroll flows into two accounts that reflect the actual split between billable and non-billable labor for that specific pay period — cleanly, without approximation.

Step 4: Verify the split makes sense

After the first several pay periods, review the ratio of Payroll Direct to total payroll. For most A/E firms, direct labor runs between 55–70% of total payroll — meaning roughly 55–70 cents of every payroll dollar is charged to client projects.

If the ratio looks significantly different from this range, investigate:

• Above 80% — overhead time may be getting charged to projects rather than to overhead, inflating direct labor and understating the true overhead factor. This produces an artificially low overhead factor and systematically underpriced work.
• Below 50% — the team is spending more time on non-billable activities than the firm's billing rates are designed to support. Margins are compressing. The payroll split is surfacing a utilization problem that gross revenue reporting was hiding.

The split is not just an accounting entry. It is a management signal.

→ Read: How to Calculate Your Overhead Factor

How to Calculate Your Overhead Factor Once Direct Labor Payroll Is Separated

Once Payroll Direct and Payroll Overhead are correctly populated, the overhead factor calculation becomes straightforward — and every financial metric that depends on it becomes accessible for the first time.

The overhead factor calculation

Here is what the overhead factor calculation looks like on a real A/E firm P&L once direct labor payroll is correctly separated from overhead labor:

• Total expenses: $809,625
• Less direct labor (Payroll Direct): $310,000
• Overhead: $499,625
• Divided by direct labor: $310,000
• Overhead Factor: 1.61

That number is now derived from the firm's actual financial data — not estimated from industry averages, not approximated from inflated labor rates. It is calculated from the books, updated each period, and accurate to the firm's real cost structure.

Billing rates built from real data

With the overhead factor established, minimum billing rates can be calculated for each staff member:

Raw Labor Cost per Hour × (1 + Overhead Factor) × Target Multiplier = Minimum Billing Rate

For a staff member earning $78,000 annually at 1,650 billable hours per year:

• Raw labor cost: $47.27/hour
• Fully loaded cost: $47.27 × 2.61 = $123.38/hour
• At 3.0 multiplier: $47.27 × 3.0 = $141.82 minimum billing rate

That rate is now defensible — calculated from actual overhead data, not from a competitor's rate sheet or an industry benchmark that may not reflect the firm's cost structure.

Net multiplier visibility

With net revenue correctly calculated — gross revenue minus COGS — and direct labor visible as a separate P&L line, the net multiplier becomes calculable at the firm level for any period:

Net Revenue ÷ Direct Labor = Net Multiplier

$1,004,138 ÷ $310,000 = 3.24

A firm running a 3.24 net multiplier is performing above the 3.0 benchmark. A firm running 2.6 has a problem — and now has the data to identify whether the issue is in billing rates, utilization, overhead levels, or all three.

What to do with historical periods

If your firm has been running QuickBooks without payroll separation, prior periods will not have the split in the accounts. There is no need to restate historical years. Begin the separation from the current period forward.

For the overhead factor calculation, a trailing 12-month figure using only the correctly separated periods will be available after 12 months of correct entries. In the interim, use the available separated periods and supplement with time tracking data to estimate the split for earlier periods — or use the current period ratio as a reasonable approximation for the full trailing year.

The priority is getting the structure correct now. Precision improves with each correctly recorded period. A slightly approximated overhead factor calculated from real data is still significantly more accurate — and more actionable — than no overhead factor at all.

→ Read: Utilization Rate for A/E Firms

→ Read: How to Set Billing Rates for Architecture & Engineering Firms

→ Read: Financial Metrics for A/E Firms