There is a lot of hype around the “disruption of higher education” as dozens of education-technology startups seek to unseat the traditional universities. In my opinion this an extremely myopic view and dangerously misdirects public attention away from the real crisis facing higher education: fiscal sustainability. The goal of this blog post is increase public awareness of the unsustainable financial trajectory of America’s universities and to dispel common misconceptions through concise, evidence-based reason, not hype. It is my hope that through more accurately understanding these fiscal challenges that we can work together to create a sustainable model for higher education that will excel in the 21st century. To start us off, I turn to a quote by Drew Gilpin Faust, President of Harvard University, from Harvard’s 2013 Annual Report:
“..In light of advances in technology, a faltering economy has raised questions in the public’s mind about the value of a college education and every revenue stream upon which institutions of higher learning depend has come under pressure. Harvard has not been immune to these trends and we have to adapt.”
In light of skyrocketing tuition prices it may surprise many readers that President Faust claims every revenue stream is under pressure. Obviously, any business (for-profit or non-profit) can only sustain itself as long as its revenues continue to be greater than its costs, so let’s see how these revenue drivers and cost centers are changing at American universities:
Tuition is the typically largest share of operating revenue for both public and private universities, and over the past few decades institutions of higher education have been able to increase the price of tuition far in excess of the rate of inflation. However, more recently the prospective students, and their financial backers (ie. parents), have become increasingly price sensitivity which has suppressed the profitability of higher education institutions. Consequently, in fiscal year 2011, nearly 35% of private colleges and universities rated by Moody’s Investors Service did not achieve tuition revenue growth at the Federal Reserve’s target rate of inflation of 2%. Although many institutions continue to increase the “sticker price” of their degree, supposedly as a signal for relative institutional prestige, these price increases are often accompanied by scholarships to recruit prospective students.
Public and private institutions also rely heavily on government funds in the form of research grants and subsidies for public universities. However, increasing budget pressures on the Federal government are limiting the grant funding available for research universities, and state subsidies to public universities are under pressure. As a result federal spending on R&D grants declined by over 16% between 2010-2013, which was the fasted decline over a three-year period since the end of the space race in the 1970s (Lauren Morello, Nature 2013).
While surprising to some readers, the provision of medical services is one of the top revenue sources for prestigious American universities; in fact, it is the greatest source of revenue for Cornell University constituting 23% of their revenue compared to just 17% from tuition (Cornell University 2014 Financial Report). Similarly, Stanford University earns about $200 million more revenue from the provision of healthcare services than it does from student tuition (Stanford University 2014 Financial Report).
Increasingly prestigious universities build or become affiliated with academic medical centers (AMC). Some of the most notable AMCs and their affiliated universities are: Massachusetts General Hospital (Harvard Medical School), University of Pittsburgh Medical Center (University of Pittsburgh), Weill Cornell Medical Center (Cornell University), and Stanford Hospital and Clinics (Stanford University). The AMCs often serve as both teaching hospitals for the university’s respective medical schools, and as research hospitals to pioneer new biomedical devices or surgical techniques. Unfortunately, since AMCs generally take the most challenging patient cases and utilize novel technologies, many economists worry that AMCs will be adversely impacted by the passing of the Affordable Care Act (Becker et al 2010).
AMCs and other hospitals operate at very narrow profit margins, generally between 3-4% of revenue. In light of the Affordable Care Act and downward government reimbursement pressures, the average US hospital profit margins declined 0.5% between 2012 and 2013. In 2014, Vanderbilt University separated itself from Vanderbilt University Medical Center (VUMC) amidst financial difficulties.
Endowment Volatility & Annual Giving
A few institutions of higher education are fortunate to have a large endowment to help support their operating expenses. While the endowment is invested in perpetuity, institutions use a small percentage of the endowment each year to help run the university, generally between 4-6%, which covers 30-60% of their operating expenses in any given year (Moody’s 2013). While this might seem like a blessing it has recently proven to be a curse in the wake of the 2008 financial crisis, when the endowments of many prestigious universities declined roughly 30%, requiring these institutions to take out millions of dollars of debt to fund their operating expenses at higher interest rates. As a result of this increased “endowment volatility” many prestigious universities have sought to lessen their operational dependence on endowment disbursements. Additionally, in 2015 Sweet Briar College announced that it would be closing down due to “insurmountable financial challenges” even with $94 million in its endowment which it couldn’t touch.
While annual gift giving remains an important revenue stream of many top universities it is also tightly correlated to the macro economy, and therefore cannot be relied upon in an economic downturn. Additionally, as the tuition price of universities increase, more and more students believe that they adequately paid their “dues” through their tuition and thus feel less indebted to their alma mater after graduating. In other words, the opportunity to attend university becomes less of a “gift” and more of a “transaction,” as an example of the economic theory of Gift Exchange. Also, today’s graduating students tend to be saddled with greater student debt which will undoubtedly limit their ability or their willingness to donate back.
Cost Centers: Labor & Infrastructure
The main cost centers for universities are labor (consisting of administrative personnel and faculty) and buildings/infrastructure. These cost centers are steadily increasing due to excessive construction of non-revenue generating infrastructure (ie. athletic facilities) and because of increased costs of employing faculty (due to rising healthcare costs and/or salary increases). What makes controlling these cost centers particularly challenging is that many of them are fixed (not variable) cost centers, since it is nearly impossible to fire tenured faculty and infrastructure is often a fixed investment. In Bain Consulting’s 2012 Report named the “Financially Sustainable University” Bain noted that universities are increasingly levering up on debt in order to finance unnecessary construction which they coined the “Law of More.”
In summary, the real crisis in higher education is a lack of fiscal responsibility, not technological change. Each university relies on these revenue streams in differing proportions, and therefore each institution’s risk exposure to these economic pressures will vary. However, universities lacking a focused strategy are trapped in a competition for prestige leading to crippling costs. The history of higher education has always been one of constant business model evolution, from faith-based institutions of ancient Europe to modern research based institutions of the 20th century, and today we are yet again at the cusp of another inevitable change. As students, professors, and alumni we have the opportunity and the responsibility to help reinvent our institutions to meet the challenges of the 21st century and beyond.
Michael Morley is a an alum of Stanford Business School and InSITE. He has experience in project management at the Stanford Hospital Consulting Group and Oration.