The business model for higher education: I. What doesn’t work?

 

The economic downturn has led to numerous calls from a wide variety of sources for higher education to make hard choices and to think more strategically about cutting costs.  Thus far, there have indeed been many hard choices made in both public and private sectors (see e.g. the recent report by the Association of Public and Land-Grant Universities).  These choices almost universally reflect necessary short-term responses to the immediate situation. However, for both good times and bad times, history has shown that the current business model of higher education requires annual net tuition increases that are well in excess of increases in family income or CPI (Perspectives on the elephant of college pricing, Nov 19, 2009).   Clearly, such large increases cannot continue indefinitely.  Consequently , creative long-term strategies ultimately will have to be devised that lead to a significant re-imagining of the higher education landscape - one that results in a sustainable cost/price model that supports the multiple missions of higher education.   

In order to think about the constraints on a sustainable model for higher education, we can possibly get some insights by looking at some of the components of sustainable models in the corporate world. Obviously, a sustainable model for higher education must provide for the special nature of higher education, but if the economics don=t work out, nothing works out over the long term.

Let's consider an egregiously simplified, very fictional example from the corporate world, Varied Products Industries (VPI).  This year, VPI had costs of $X to design, produce, and sell their products, which they sold for a total of $Y.  Sales were higher than costs, so there was a nice profit of $Y-$X, which pleased the stockholders.  If VPI makes exactly the same products next year as it did this year, using the same employees and the same methods, their costs are likely to go up somewhat faster than the CPI.  One of the big reasons this is likely to happen is the cost of labor, particularly if VPI has a highly skilled work force. Competition for workers, increasing seniority, etc drives this component. And, in general, all of the suppliers of VPI have similar pressure on wages and components to one degree or another, which, if they also make no changes in the way they operate, is likely to lead to increased costs of supplies that go into VPI=s products. Of course, if VPI is not content to make the same products next year, but is continually trying to improve its products, then it will have additional costs for research, technology, facilities, etc. that drive its total costs up even faster.   Obviously, if the stockholders are to be happy at the end of next year, VPI must counterbalance the Anaturally@ increasing costs by increasing income from sales, or decreasing other costs, or both. And, if we imagine two years from now, VPI must have done something similar again in order to keep ahead of the naturally constantly rising cost curve.  In fact, VPI can never be content with the status quo if it hopes to remain solvent - it must continually work at a balance of increasing income from sales and decreasing costs to cancel out almost inevitable increases in costs in certain areas. 

On the side of decreasing costs, the most common approach is to increase productivity - use fewer people to make the same product.  This is commonly done by increasing use of technology, often accompanied by a reorganization of work functions. This is the approach generally used by industry in downturns, but it is ultimately self-limiting in that at some point increasing productivity becomes more expensive than its returns. For later use, let=s call this approach (A). Alternatively, product design can be changed so that the product becomes less expensive to produce. This can be done e.g. by finding substitute inputs that are equally (or perhaps, more) effective but less expensive (B), or by lowering the quality of the product generally (C). Similarly, these approaches have limited applicability - the number of cheaper equivalent substitute inputs is certainly finite, and one can only lower the quality so much before customers seek alternatives.

On the side of increasing income, the easy way is to increase price per unit, thus increasing income with a constant number of units sold (D).  This ultimately is likely to have a negative effect on the number of units sold as customers find less expensive suppliers or substitute a different kind of cheaper product with similar capabilities.  The other obvious approach is to sell more of the product (E).  Clearly, however, selling more only works if you make a profit on each sale, or if economies of scale intervene that enable you to make a profit on each sale at some volume.  A variation of (E) involves changing the product mix through introduction of new products that have higher economies of scale (F).  Introducing new products will, in any case, be important in order to enable sales to grow continuously over time - the market for existing products is likely to be limited in one way or another.

VPI is likely to use varying mixtures of all of these approaches over time in order to stay healthy. Decreasing costs will always play a role, but increasing sales of products with economies of scale is likely to be the mainstay of VPI=s continuing positive profits.  And, as described above, VPI will need to use more of each of these each year in order to stay healthy – there is no “one time fix” for the financial health of VPI.   

Let’s now see how these approaches to financial health are typically used in higher education.  In particular, I focus on the private research university, but much of what I say applies with slight modification to other types of higher education.  Increasing productivity, (A), is typically done by increasing class size, so that more students are taught by a single professor.  Occasionally, faculty are asked to teach more classes in a pinch, but over time the average number of classes taught by a professor has tended downward in research universities.  We also lower cost by finding substitute inputs, (B).  Since the major input is the teacher in front of the class, this is done by replacing high cost tenure track faculty with lower cost non-tenure track teaching faculty, or with graduate TA’s.  Whether either (A) or (B) is actually an example of (C), lowering the quality of the product, is the subject of much contention.  The answer almost certainly is that it depends on how it is done, and that is some cases quality could actually be increased (e.g. if the teaching faculty were more effective at teaching than the regular research oriented faculty).  In any case, the traditional rhetoric of higher education makes a strong case to parents and students that both (A) and (B) are always examples of (C), thus making meaningful moves in either of these directions delicate.

Historically, most of private higher education has not followed approach (E), selling more of its product. So long as institutions hold to their place-based identities, defined in large part by their wonderful (and hugely expensive) campuses, there are limits to the number of students who can be welcomed to those campuses.  And, since the cost of educating a student in the traditional manner is always more than the student can or will pay in tuition –i.e. we lose money on each student – there is no financial reason to simply expand campuses.  However, recently there has been some increased attention to variation (F), changing the product mix by introducing new products with higher economies of scale – for example, distance learning.  Distance learning actually can make a profit per student in most cases, and has economy of scale over some range of number of students.  In addition, recent studies show that distance learning should not be considered a move towards lowering of quality (C), since in many cases learning outcomes are superior with this approach.   Nevertheless, distance learning is a small component of the portfolio of major institutions at this point.  Another variation of (F) involves offering programs in new settings that lack some of the more costly ancillary aspects of the historic home, such as athletic teams, residence halls, gymnasiums, research, and buildings built to last for centuries. This major lowering of fixed costs enables a profit per student to be made, thus opening up the potential of economy of scale.  Often, these campuses are in other countries, thus opening up a large and entirely new set of potential students.  Considerable care must be taken to assure that quality is not lowered, but that is not an insurmountable issue.  Continuing education, yet another variation of (F), is often some mixture of distance learning and lower cost settings.  All three of these variations are likely to use primarily teaching faculty, rather than research oriented faculty (another manifestation of (B)).

Thus far, all of these approaches have provided relatively minor increases on the revenue side of budgets in for most higher education institutions. The overwhelming mainstay of higher education’s portfolio of revenue enhancement has been (D), increasing the price per unit, that is, increasing tuition faster than the CPI.  Over the past 2-3 decades, real increases in tuition have exceeded even real increases in health care costs! If there is no limit to this approach, then higher education is in great shape – why bother to do any of the other things when raising tuition is so easy? 

However, for the sake of discussion, it is interesting to contemplate the situation in which tuitions could not regularly be increased significantly more rapidly than the CPI.  In that case, following VPI, higher education would continually need to seek to both cut costs and increase revenues by means other than simply raising prices.  And, as with VPI, the emphasis ultimately will probably need to be on increasing sales of products with economies of scale. What might this radical state of affairs mean for higher education? In my next post,The business model for higher education:II. How might it be fixed?,  I will throw out for discussion some possible scenarios for such a situation.

Comments

[work at home business]

Very interesting and informative article to be read...

[Mary Churchill]

Thank you for a very informative and provocative post. I agree with you on most points and look forward to part II. One thing that I have noticed with non-profit higher ed in the US - there seems to be an uneven opting in process with regards to corporate practices. For instance, the business model is applied to revenue generation and cost-cutting but not to change in cultural practices - resulting in a very top-heavy endorsement of business practices with very little buy-in from faculty and staff.

Thanks again,

Mary Churchill, University of Venus