Going with the Flow

At Caltech, ''profit is a concept, cash flow is reality.''
Marie LeoneAugust 1, 2003

“Not knowing the cost of production is like not knowing your way to work,” bristles Alan Dunn, a lead instructor at the Industrial Relations Center for the California Institute of Technology (Caltech). Dunn, a proponent of activity based costing, says that a heavy reliance on profit measures is best relegated to in-flight magazines. Cash flow return on investment, he maintains, is a much more useful measure of performance.

His executive students seem to be cut from the same cloth. “If you know the cost of a product, you’re in the driver’s seat,” asserts Steve Rehnberg, CFO of Idaho Asphalt Supply. “We have a saying at our company: ‘Profit is a concept, cash flow is reality.’ “

Two years ago, Rehnberg was one of the first executives to take Dunn’s course “Measuring Business Performance: Aligning Strategy, Metrics, and Rewards.” Rehnberg, who was already a fan of activity based costing, worked with Dunn’s GDI Consulting and Training Co. to launch an integrated management performance (IMP) system. This management approach ties bonuses — for which all full-time employees at Idaho Asphalt are eligible — to free cash flow.

The IMP program underscores a major tenet of the Caltech course — cash flow is king — and puts the course’s theories into action. Consider Rehnberg’s goal of shrinking accounts receivables collection to 35 days. Because it’s an integrated approach, both the finance and sales departments are charged with reaching the goal. While the finance department works at collections, the sales department targets customers that pay on time. If the cash-flow-related goal is met, both teams get the bonus percentage assigned to the achievement; if they miss, the cash goes back into the bonus pool.

Rehnberg shares another conviction with Dunn: Just as a profit number gives an investor a sense of earnings potential, he observes, free cash flow gives an investor a sense of how company cash is deployed. Perhaps, for example, it’s tied up in payables and receivables. The study of cash flow often paints a very different picture than profits, says Rehnberg.

A former partner at Coopers and Lybrand, Dunn grew up on the manufacturing floor of his father’s specialty parts company. Like most of the school’s executive education instructors, he’s not an academic, says Nick Nichols, director of the Caltech center. Caltech doesn’t have a graduate school of business that Nichols can tap for faculty assignments, but Nichols maintains that this is an advantage; he’d rather troll the private sector for instructors who can impart current, real-world lessons.

That’s reflected in the structure of the two-day program, a no-holds barred foray into aggregate, functional, operational, and process metrics. Not only is the course chock full of illuminating examples, but most participants also receive a deep economic analysis of their company on the first day of class.

Dunn and Glenn Welling, a managing director at Credit Suisse First Boston (CSFB), work with the class before the course begins and run the numbers for participants who hail from publicly traded companies. (Private companies can provide the instructors with proprietary numbers if they want to see their own workup.) The financial modeling is provided through a special arrangement Caltech has with CSFB HOLT, the buy-side research arm of CSFB.

The evidence from the HOLT economic model “is irrefutable,” asserts Dunn, adding that “there isn’t a financial-related question that we can’t find the answer to.” No matter how enlightening the answers, however, the revelations also can be embarrassing.

Dunn recounts a the tale of a CFO of a major manufacturer who, against the instructor’s warning, insisted that his company’s numbers be used as an example for the entire class. The number crunching revealed high receivables, low payables, and ridiculously high inventory levels. The consensus of the class, when the CFO asked for their counsel, was “Polish your resume.”

Despite the sometimes painfully honest results, most course participants are invigorated by the Dunn-Welling tag team. After returning from the Pasadena-based course last April, George Brown barely had time to organize his desk before the board of directors asked him to gauge the performance of a three-year old acquisition. Brown, the CFO of Old London Foods, a $50 million privately held company, notes that the Caltech program helped him focus on cash flow rather than getting “lost in profit indicators.”

Using cash flow return on investment, or CFROI (sometimes referred to as the discounted internal rate of return), asset growth metrics, and a few homespun calculations, Brown concluded that the cash thrown off by the acquisition eventually will lead to a gradual increase in the owners’ equity.

Brown emphasizes that the board was impressed with the attention he paid to cash flow and his conclusions about the company’s performance relative to the cost of capital. “Cash flow is the real barometer for business,” he notes. “Profit numbers can be more easily manipulated.” Brown adds that Dunn and Welling proved the close correlation between stock price and CFROI. Indeed, Brown credits the straight-shooting Dunn with helping him cut through the day-to-day reporting quagmire that CFOs can get caught in. Another attraction of the class, says Brown, is that Dunn brings to life” the usually dry and abstract management function of determining financial statistics, ratios, and measurements.”

For his part, Dunn has noticed a change in the mindset of course participants. Before investor confidence was undermined by the corporate scandals of the past couple of years, most participants were concerned with measuring and linking compensation to performance. Now they are focused on how to drive the right behavior and structure compensation in light of Sarbanes-Oxley.

They talk more about measuring “real” performance, adds Dunn, who says that the term “real” usually refers to metrics that probe deep, like cost of capital, CFROI, and asset growth. He also stresses the need for companies to set appropriate parameters for shareholder value. Apparently, company owners value “value” differently.

Measuring Business Performance: Aligning Strategy, Metrics, and Rewards” will be presented at the California Institute of Technology on August 21-22 and November 3-4, 2003, and March 18-19, 2004.