Factors largely outside of companies’ control continue to influence performance, wreaking havoc on comparisons to plan and related attribution analyses. The last number of years all seem to come with an annual theme – covid, supply chain, great resignation, inflation, interest rates – and many of these persist. Top-performing finance teams can isolate these constraints in budget builds and reporting frameworks, use the planning process to foster collaboration, influence decision-making around constraints, and deliver ongoing financial reviews without the cloudiness or binary impact of constraint impacts.
As one CFO put it, “For multiple years in a row, budgets were ‘thrown out’ for big exogenous factors (covid, supply chain, inflation). Many stakeholders, particularly investors, are fatigued and are channeling their angst into planning processes for the year ahead.”
Enter Constraint-Based Budgeting (CBB), a powerful tool for finance leaders seeking to create more accurate, aligned, and efficient budgets in restricted business environments.
What Exactly is Constraint-Based Budgeting?
CBB is a design element of the budgeting process that:
- Assesses and builds out core unit economics around one or more constraints
- Provides sufficient driver and assumption connectivity, and corresponding data capture, to enable finance teams to isolate the impact of the constraint during the budgeting process and throughout the following year in variance and attribution analyses
Think of CBB as a purposeful effort to align functional and departmental leads around the business’ constraints, especially those that impact functions or departments outside the ‘owner’ of the constraint. CBB is not a replacement for your current budgeting approach, but rather an enhancement that can be used with any method – whether it’s top-down, bottoms-up, driver-based, or zero-based budgeting.
The Power of CBB
By incorporating CBB into your budgeting process, you can:
- Drive Clarity and Collaboration Across Functions: Identify constraints and bring them to light, for those who own them and those impacted by them. For example, if your sales are limited by your ability to recruit and retain Direct Labor headcount (the constraint), than Sales needs to rely on that implied capacity rather than pipeline for planning purposes.
- Connect Related Drivers and Quantify Impact: Link related drivers to the identified constraint and quantify the flow-through impact on the P&L. This allows for more accurate forecasting and better scenario planning. Continuing the Direct Labor example, the Sales budget needs to incorporate the assumptions regarding Direct Labor recruitment.
- Support Investment Decisions: Provide quantifiable justification for recommendations. In this Direct Labor example, you might seek to invest more heavily, over-hire, or hire earlier than needed, to ensure capacity is there. CBB can help quantify costs, investments, and prospective ROI, and provide data and context for decision-making processes.
Implementing CBB: Key Considerations
- Identify Your Core Constraints: What are the primary factors restricting activity, growth, or efficiency? These could be labor, equipment availability, supply chain delays, customer bottlenecks, or regulatory factors.
- Build Out Unit Economics From the Perspective of Constraints: What might have previously been an output (e.g., how many people we need) could become a unit economics input (e.g., how many people we can get). Understanding how the inputs and assumptions will fit together in the build is a critical step (and could prospectively change year to year)!
- Create Data Connectivity: Functional or departmental level builds need to be connected to the constraints, especially when they come via other departments. Smart process is required to make sure the latest assumptions flow where they are needed for purposes of aggregation and updates.
- Engage Cross-functionally: CBB requires input and buy-in from various departments. Use the budgeting process as an opportunity to align the organization around key constraints, which can lead to risk mitigation dialogue and potentially uncovering alternative solutions (e.g., outsourcing vs. hiring).
- Prepare for Ongoing Analysis: Ensure your ongoing data capture is aligned with your budget build so that ongoing reporting allows for clear attribution analysis throughout the year.
As another CFO noted, “Acting earlier, to make sure you can act when called upon, is generally considered wise. However, it often comes with financial cost or commitment. Calling out these financial impacts communicates the investment being made to combat constraints.”
By honing in on core constraints and building your budget around them, you create a more collaborative and connected planning process. Plus, it helps you communicate your budget objectives and mechanics transparently, and early, leading to better buy-in and likely fewer iterations.
In an era where external factors can quickly render traditional budgets obsolete, Constraint-Based Budgeting offers a path to more resilient and useful planning processes. By embracing CBB, finance leaders can deliver more accurate and flexible forecasts, make better-informed decisions, and navigate uncertainty and binary outcomes with greater confidence.
————–
First Water Finance (FWF) is a finance solutions platform supporting finance leaders, business owners, and capital partners through FP&A, Corporate Finance, and Community. FWF has supported over 100 management teams and sponsors, concentrated in emerging and mid-market enterprises, professionalizing and accelerating the finance function in pursuit of growth, acquisition, and/or sale objectives.