Business issues

Finding One's Way By Losing It

As colleges across the country prepare to launch a new academic year, our normal anticipatory excitement is tempered by the cascading consequences of the prolonged recession. At the same time that mushrooming financial exigencies have forced colleges and universities to shrink budgets and temper their ambitions, at least temporarily, the economic turmoil has savaged our sense of order and predictability. “Uncertainty sometimes seems our only certainty,” President Drew Faust of Harvard told alumni in February. She added that “discipline and sacrifice” will be required to weather the financial crisis.

Indeed, for many of us, the exhilaration of certainty has given way to the weariness of worry; optimism has been overcome by doubt. It’s no wonder we feel bereft, even dazed and confused. Where are we headed? How can we regain our bearings?

Such questions recall the Buddhist story about a man on horseback galloping past a monk. “Where are you going?” yells the monk. The man replies, “I don’t know -- ask my horse.” In recent months we too have often felt that we’re riding on a runaway horse. We struggle to sort things out, to understand the complex causes of our sufferings. Yet uncertainty prevails -- even among the supposed financial experts. Who knows what the next six months or two years will bring?

It’s quite natural for people to feel perplexed -- and perhaps even paralyzed -- by the extraordinary circumstances that have converged to disorient and dishearten us. Despair is the absence of hope, and many people are despairing.

But despair will not get us very far -- just ask Chicago Cubs fans. Yes, lamentation has its place, but it’s not enough to bemoan our situation: we need to move forward. Trauma can be a great teacher. The economic crisis is beginning to reveal fresh opportunities to those bold and creative enough to seize them. For example, there is already considerable discussion taking place about compressing the typical undergraduate college experience into three years rather than four. The imperative need to reduce expenses, reassess priorities, and generate new sources of revenue will be healthy to the extent that our colleges emerge from this latest fiscal crisis leaner and more nimble.

Retrenchment, in other words, can lead to unexpected advances. Consider, for example, the panache displayed by the World War I French officer who reported to headquarters during the Battle of the Marne: “My center is giving way, my right is in retreat. Situation excellent, I am attacking.” Today, however, our enemy is more elusive. It’s not so much an advancing army as it is a stalemating fear. How do we deal with the unknown depth and duration of our economic malaise?

One option is to do nothing, to wait for clarity and direction. Another is to lash out against the people and forces that have caused the financial meltdown. A more constructive choice is to acknowledge that life sometimes poses mysteries to be embraced rather than problems to be solved. At times we attack uncertainty by leveraging the power of the unknown, as often occurs in the martial arts. On other occasions, we confront the unknown in an effort to absorb its energies. Out of the roiling darkness may come beneficial light. That is the theme of a provocative book with an intriguing title by the cultural essayist Rebecca Solnit. It's called “A Field Guide to Getting Lost.” The book’s lucid, lean narrative trumpets the counterintuitive notion that we occasionally benefit from being lost.

To never to have been lost, Solnit says, is never to have lived. Echoing the Jewish tradition at Passover of leaving a door open overnight for the prophet Elijah to visit, Solnit urges us to “Leave the door open for the unknown, the door into the dark. That’s where the most important things come from, where you yourself came from, and where you will go [in the end].” Solnit reminds us that it is important to remain open to chance and the unknown, for it is only by relinquishing certainty that we approach the divine.

There is, in other words, great value in exploring the unforeseen -- and in remaking ourselves in the process. The financial crisis has led all colleges to initiate or renew focused reassessments of their mission, their structure, their vision, and their constraints. Such exercises on many campuses have become more participatory because of the seriousness of the situation. That is a good thing. All campus constituents have both a direct stake in the dialogue and vital contributions to make to it; only a shared sense of responsibility -- and an unconventional willingness to reassess priorities and examine all options -- will enable many colleges to weather the storm and emerge even stronger by sharpening their focus. At Cornell University, for examples, 20 task forces have been created to “reimagine Cornell.” As Provost Kent Fuchs recently acknowledged, the streamlining process may have been prompted by budget cutbacks, but it has become an opportunity for institutional improvement: “It’s very scary, but there is a lot of freedom to think creatively.”

At Cornell as well as many other campuses, people are asking truly strategic questions: Can unnecessary or mediocre programs and activities be cut back or cut out? What innovations might be spurred by the crisis? In other words, frugality and caution are not enough. The disorienting exigencies of the recession will be truly beneficial to the extent that they embolden campus communities to make hard decisions and consider fresh ideas and approaches that have been postponed too long.

While economic chaos and confusion beckons, clarity awaits those colleges and universities that transform the financial crisis into a catalyst for creativity -- and courage. By tapping the energies of shared sacrifice and the opportunities for revitalized innovation, campus communities can harness uncertainty and redirect its inertia. Somewhere amid the murkiness of our economic dilemma lies the opportunity for new discoveries, clarifying insights, and the impetus for streamlined performance. As Winston Churchill observed, “A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.”

So let us resolve to traverse the unmapped territory of our future not with gloomy foreboding or unspoken terror or vengeful rage but with eager anticipation for what good and unexpected things might emerge from the unknown and unfamiliar. By embracing the mystery of uncertainty, we will find its own forms of beauty and energy and coherence -- and we will discover in ourselves the ironic capacity to be renewed and even transformed by the shock of insecurity.

Author/s: 
David E. Shi
Author's email: 
david.shi@furman.edu

David E. Shi is president of Furman University, in South Carolina.

Breaking the Cost Spiral

In 1980, Howard R. Bowen’s revenue theory of cost was put forth to explain the financial trends of higher education. The basic idea was that colleges and universities will spend everything they have, so if you increase their revenue, you should expect their costs to go up too, creating a spiral.

In the decades since, we have witnessed the implications of this theory. It has now become apparent that American higher education has an insatiable appetite for more money; it is a black hole that cannot be filled.

Colleges are referred to as “cookie monsters” who “seek out all the resources that they can get their hands on and then devour them” (the higher education scholar Ronald G. Ehrenberg) and to “compulsive gamblers” for which “there is never enough money to satisfy their desires” (the former Harvard University president Derek Bok).

The main reason for this is that competition in higher education is based on reputation. The nonprofit status of most institutions of higher education and the principal agent problem (the fact that you typically don’t know that those you’ve hired aren’t acting in their own interests instead of yours) also contribute to the problem.

Spending and Reputation, a Costly Competition

The academic literature shows that when people don’t know the true quality of something, they tend to rely on the reputation of the supplier. For prospective students, it is virtually impossible to know the true quality of an undergraduate degree: the student purchases the service only once, participates in the provision of the service, the service provided is a capital asset, there is no secondary market for degrees, and the value of the degree may not be known for years after it is purchased.

If students and the public were certain about academic quality before they attended or donated to an institution, they would have no need for reputations. But because they are uncertain about quality, they rely on reputation. Knowing this, colleges compete based on reputation.

Unfortunately, this reputation-based competition contributes to the revenue-to-cost spiral because more spending is helpful in improving a reputation. The direct relationship between expenditures per student and reputation is demonstrated in Figure 1, where spending per student is on the vertical axis and the U.S. News & World Report “reputation” score is on the horizontal axis.

The figure clearly reflects the public’s perception that “price is a prior indicator of quality.” In effect, reputation competition becomes a race to spend as much as possible per student, since expenditure is a proxy for quality.

As reputation increases, the institution receives more funding from donors, grants and research contracts. The institution is less dependent on tuition, it has more diverse revenue sources, and it is wealthier.

Source: IPEDS, U.S. News & World Report

Thus we observe an untargeted “pursuit of excellence” as colleges strive to be the “very best that they can be in almost every area of their activities.” Over all, the colleges’ behavior is best understood as “prestige maximization.

Nonprofit Status

Costs at nonprofit institutions are capped by revenue. While they cannot run chronic deficits, nonprofits exist to provide as much service as possible, and internal constituents can always find ways to use financial resources. Therefore, nonprofit institutions spend all the revenue they have, implying that when revenues rise, costs rise. Among colleges and universities, any increase in student ability to pay lifts the lid on revenues and costs follow.

The Principal/Agent Problem

The principal/agent problem is capitalism's Achilles heel; it exists whenever one group makes decisions supposedly in the interest of another group. As an example of the problem, suppose your car is broken. When you (the principal) take your car to a mechanic (the agent), you would like to get it fixed at the lowest cost possible. But the mechanic is better off if you spend more money, giving him an incentive to recommend unnecessary repairs. In this and many other instances, there is a difference between the actions the principal would like to see occur and the incentives of the agent to actually take those actions.

The problem in higher education arises because the interests of faculty members, administrators, and trustees (the agents) are not the same as the interests of students, parents, alumni, donors, and taxpayers (the principals). Since the agents make the decisions, they can pursue their own self-interest rather than the principal’s interest. The problem is well-known among professionally managed for-profit firms, despite the many constraints on agency abuse in the capital markets. Comparatively, there are few constraints on agency abuse in higher education. P/A problems always result in costs that are higher than necessary, contributing to higher education’s dismal cost control record.

How to Break the Spiral

The combination of quality uncertainty (and therefore competition based on reputation), nonprofit status, and the P/A problem leads to a persistent revenue-to-cost spiral. Because the spiral consumes any new funding, it undermines attempts to improve college access. Therefore, establishing effective cost control ought to be a prerequisite for any increase in higher education funding designed to improve access.

Fundamentally, the revenue-to-cost spiral will not be broken until uncertainty about college quality is reduced. This uncertainty leads to competition based on reputations, so larger expenditures are always in the institutions' interest under quality uncertainty. However, if output measures (by which we mean the value they add through teaching and research) were designed, the focus of competition would shift from its current reliance on reputation and prestige (who can spend the most) toward the more beneficial type of competition based on who provides the greatest value (who can produce the most value added education per dollar).

While reducing uncertainty about quality is essential, there are a number of complementary reforms that could also help break the revenue-to-cost spiral. Accreditation currently suppresses innovation and restricts competition, largely because the accreditors have been “captured” and now promote the interests of the institutions they are supposed to be regulating. Reform could correct these undesirable tendencies.

Moreover, the principal/agent problem can be addressed by improved transparency regarding the source and use of funds and operating policies such as teaching loads and staffing ratios. Before institutions can align teaching incentives, they must undertake serious studies to measure teaching productivity; once this is accomplished, professors can be rewarded for the quality of their teaching instead of just the quality of their research.

Lastly, institutional constraints could be strengthened by reforming governance arrangements and providing financial and other disclosures so that the media and other watchdogs could provide more oversight.

Author/s: 
Robert Martin and Andrew Gillen
Author's email: 
info@insidehighered.com

Robert Martin is an emeritus professor at Centre College and author of numerous works on the economics of higher education. Andrew Gillen is the research director of the Center for College Affordability and Productivity.

Provosts and business officers seek to work together

Smart Title: 

Provosts and chief financial officers may have different jobs, but they have to work together like a married couple, presenters at NACUBO say.

Spending Endowment Income in Today's Climate

As the U.S. economy has derailed, those colleges fortunate enough to have endowments have seen them shrink. Now more than ever, it is critical that they reconsider how they spend the income from those funds, diminished as it is. Colleges that let individual units or departments keep their own endowment revenues risk increasing the gap between their campuses’ “have” and “have-not” programs.

They also make it very difficult to spend their precious dollars effectively on the institutional priorities they deem most important -- something every college or university must do now.

The percentage of the operating budget that is supported by endowment income ranges widely among institutions, from those with no or very small endowments (and thus a negligible impact on operating budgets) to those where they account for 40 percent or more. On average, according to the 2008 Commonfund Benchmarks Study of Educational Endowments, 9 percent of institutional operating budgets are funded by endowment income, while the median percentage is 4.5 percent.

There are two distinct ways of budgeting endowment funds. One is the “allfunds” approach to budgeting, where the goal is to use every available dollar, whatever the source, as a way to support institutional priorities and to ensure equity in the distribution of funds. The other is what I call the “distinct funds” approach, where general funds are allocated “equitably” to all departments to provide base levels of funding, and endowment funds belong to the individual school, department or program to which they are restricted.

In the “all funds” approach, colleges consider restricted funds when allocating unrestricted funds, and use this interplay of endowment funds and general funds to mitigate differences in wealth among activities. Thus, a well-endowed department is likely to receive little, if any, general funding from the institution compared to a department with little or no endowment. This type of practice occurs despite the fact that, at such institutions, more than 75 percent of endowment funds may technically be restricted. Typically, the truly “restricted” spending tends to be used to award prizes, support museums, fund specialized academic endeavors or provide scholarship funds for students with unique skills and talents.

In the "distinct funds” approach, those schools, departments or programs with large endowments operate with substantially greater resources than those that lack endowments. General funds at these institutions are used only at the margin and in small amounts to mitigate serious inequities in resources among departments; departments with little or no endowments of their own tend to receive only slightly more in general funds than do other departments.

To clarify the differences in these two approaches to budgeting, if a department at an all-funds institution were to receive a generous restricted gift, a nearly equivalent amount of the department’s general funds would be taken back and replaced by the funds from the restricted gift. Thus the department would not see much difference in its budget as a result of the new gift. On the other hand, if the gift were given to an institution that uses distinct funds budgeting, the department that received the new gift would experience a significant increase in its funding in future years.

Unavoidably, at some all funds institutions, there are times when endowments have been restricted to activities that are not considered central to the institution’s mission or when the specific fund provides more income annually than the institution would otherwise have chosen to spend on this activity. In these instances, which tend to be relatively few in number, endowment funds do influence institutional priorities. Activities endowed in this manner tend to receive no general funds, and in years when income from the restricted endowment declines, the colleges do not provide general funds to offset the loss in endowment income. Put another way, if these endowments did not exist, general funds would not support these activities.

The significant endowment declines that most institutions are experiencing differ in their impact on individual programs depending on the budget methodology their campuses use. The decline in endowment income has led institutions that take an all funds approach to reevaluate their distribution of all funds across the institution, and to redeploy general funds to ensure that strategic priorities are supported. (For example, if a significant part of an institution's need-based aid comes from endowment funds, a college that uses an all funds budget approach and wants to preserve its commitment to meeting the financial needs of its students will reevaluate the general fund allocations to all programs and make a significant reallocation in favor of financial aid.) These colleges and universities need only to continue to apply their normal budget process, albeit with significantly constrained resources.

At institutions with distinct funds budgeting, the well-endowed areas in this environment will experience significant decreases in resources, which may prove quite disruptive to institutional priorities, while those areas dependent on revenue sources that are not being seriously impacted by the recession will continue to enjoy relative stability in funding. Many of the well-endowed programs have until recently experienced large annual increases in resources and have operated with a level of resources significantly above other programs or departments at their institution that either have no or small endowments. The current situation is a new one for many institutional leaders, as we have not faced this kind of serious downturn in endowments in more than 50 years.

At institutions that use distinct funds budgeting, mission critical programs that have relied primarily on endowment income as their funding source will be sorely underfunded relative to institutional priorities. This will leave the institution with two choices: change its budget practices to look more like those used by all funds schools or operate in a sub-optimal way relative to institutional priorities.

Changing budget practices is difficult in any environment, but it will be especially difficult in this fiscally constrained environment. Now, the “have-nots” will continue to be “have-nots” to preserve those areas of the university that have always benefited from higher levels of funding. Some institutions may not politically be able to make these adjustments, and serious damage may occur to programs that are mission critical.

Institutions that do not use an all funds approach to budgeting should consider reevaluating how they distribute funds so they can better deal with overall institutional priorities in times like these. If colleges change their budget procedures to move toward a more institution-wide approach to fund distribution, irrespective of source of income, they should make clear the ”rules of the game” so they don’t revert to the old way of doing things when endowments recover, once again moving the institution to a situation of “haves” and “have-nots.”

Author/s: 
Lucie Lapovsky
Author's email: 
info@insidehighered.com

Lucie Lapovsky is an economist who is the former president of Mercy College, in New York. She currently writes and consults on issues related to higher education finance, leadership and planning. This article was adapted from a piece that ran in Trusteeship.

New financial strategies for three wealthy universities

Smart Title: 

After already announcing plans to deal with the economic crisis, three of the nation's wealthiest universities are employing new strategies.

Deal Dead in Ohio

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Under heavy faculty criticism, private company that offered distance learning support to U. of Toledo cuts off negotiations.

Economic crisis impedes recovery from 2001 recession

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Just as public colleges were starting to recover from 2001 recession, the current economic crisis threatens to reverse gains, a new report finds.

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