Economic Equilibrium

First Published on Stevens Strategy Blog

Strengthening the Financial Condition of an Institution of Higher Education

Abstract: This article explains how to use the principles of economic equilibrium to rebuild, strengthen, and maintain the financial condition of institution of higher education.

Economic equilibrium is a state that defines the long-term financial viability of an institution of higher education. Richard Cyert^[1] defined the conditions needed to achieve economic equilibrium as:Introduction

• The organization fulfills its mission with adequate quality and quantity.
• The organization maintains the purchasing power of its financial assets.
• The organization maintains needed facilities in satisfactory condition.

Cyert’s statement of equilibrium is mission driven, which means that the mission can only be assured if an institution can achieve a state of economic equilibrium. How does an institution achieve the Cyert state of equilibrium? Equilibrium requires a financial system that produces sufficient excess revenue so that the purchasing power of financial assets are equal to or greater than inflation and the quantity and quality of plant and equipment accommodates foreseeable changes in their use.

Economic equilibrium requires more than understanding that dollar flows from operations will change net asset balances. Equilibrium is a fragile state that can be lost because of the following: the high cost of operations, uncompetitive tuition rates, loss of revenue from endowments and gifts, imposition of new government regulations, or major changes in student markets.

Boards of trustees must expect more from presidents and chief financial officers than a simple budget that only responds to current financial and economic conditions. They need to insist on financial strategies that achieve a dynamic state of equilibrium which responds to continuing and powerful changes in student markets, competitive forces, technology, government regulations, inflation, financial markets, and other internal and external stresses.

When an institution’s financial condition has eroded to the point where it has very little in the way of cash or financial reserves, developing a strategic plan for dynamic equilibrium is especially difficult. At those institutions, easy decisions such as raising tuition or cutting faculty can be counterproductive if it pushes the college outside its competitive boundaries^[2]. As Richard Cyert noted …

“[t]he trick of managing the contracting organization is to break the vicious circle which tends to lead to disintegration of the organization. Management must develop counter forces which will allow the organization to maintain viability.”^[3]

Cyert asserted that institutions need to achieve a continuing or dynamic state of equilibrium regardless of size or financial condition because even positive changes like large increases in enrollment can lead to further deterioration or upset a state of equilibrium.

Identifying the Equilibrium Gap

The first step is to identify the gap between the current financial state of the college and a dynamic equilibrium by doing the following:

1. Close the Purchasing Power Gap for Financial Assets:
   1. If the college is running a deficit, the net present value of deficits for the next five years should be determined (This estimate will entail a forecast of future revenue and expenses adjusted for: internal and external inflation using a compounded rate for the past five years, accrediting requirements, government regulations, and any plans that could increase/decrease costs or revenues.)
   2. If enrollment has been declining and this is expected to increase the deficit, then the estimated value of lost tuition adjusted for inflation should be included.
   3. The net present value of cash and short-term investments that can be easily converted into unrestricted cash should be considered (This estimate needs to be increased for maximum draws on credit lines, and the discount rate would be the rate of change in inflation over the past five years.)
2. Close the Gap in the Condition of Facilities (three alternative measures):
   1. Measure one: If the college has a maintenance schedule, then adjust each of the gap closing years; let’s assume a five-year plan; then multiply the five-year compounded rate noted in 1(b) times the current gap and follow this pattern by multiplying the rate times the preceding year’s gap closing amount for each of the subsequent years.
   2. Measure two: If the college has an accurate estimate of replacement values for buildings and equipment in its insurance policies, then estimate the future value of the sum for five years, and divide the total by five. This number provides the gap estimate for one year.
   3. Measure three (least accurate): The college takes its depreciation and organizes it by type, identifies the number of years depreciated, estimates the current (i.e., future value) of the items, sums the depreciation for the next five years, and divides by five. This step is the least accurate measure because adjusting depreciation may not fully account for current cost of replacement. Besides, this process is time consuming and assumes that there is an accurate record of when each item was purchased.

Here is a simple template for identifying an equilibrium gap; to discover a dynamic equilibrium gap, the cells in the template must be adjusted for inflation. The adjustment should cover inflation through the five-year compounded inflation rate.

Table I

Equilibrium Gap Template

Gap Category	Gap
Tuition Lost to Attrition
Operational Deficit
Cash Flow Requirement
Credit Line (total amount borrowed)
Replacement Value: Infrastructure
Replacement Value: Buildings
Replacement Value: Instructional Equipment
Total Gap

Reaching Dynamic Equilibrium

Attaining a dynamic equilibrium calls for a plan that a) avoids an annual gap between the equilibrium state and the actual financial performance of the institution and b) for the long-term, the plan avoids a gap each year for a five-year period. As a rule, colleges and universities should build short-term equilibrium plans that lead to long-term dynamic equilibrium.

There are six critical areas – enrollment, endowment, gifts and grants, auxiliaries, and cost controls – that typically form the framework for building a strategic plan that yields a state of equilibrium. ^{[4] [5]} Determining which area or areas should be the basis for a strategic equilibrium plan will depend on what the leadership believes are internal and external opportunities and constraints that shape the options available to the institution.

Enrollment, Recruitment, and Retention is a critical barometer of the financial condition at 75% of the private colleges because it generates more than 60% of their revenue.^[6],[7] For most public institutions, enrollment is the single factor that determines their financial condition. Therefore, enrollment is an essential element of any strategic-equilibrium plan that is designed to eliminate the gap between actual performance and equilibrium. The structure of the plan will depend upon the college’s student market, competition, financial aid resources, academic offerings, and upon the willingness of state and accrediting authorities to let it redesign or add new programs to the curriculum.

There are three components (admissions, retention, and alumni) to an enrollment strategy that follow the flow of students through marketing, academic performance, and graduations. The success of admission strategies is contingent upon attracting potential students to apply, pay deposits, enroll, and begin classes.

Attracting new students is subject to a careful communication plan based on a mix of reputation, academic offerings, income, prior academic performance, parental and peer pressure, posted cost, financial aid, and degree of competitive demand for students. Aggressive enrollment campaigns are becoming the norm as colleges and universities pursue new students and “woo” them until they enroll.^[8] These hard-hitting campaigns are taking the form that athletic coaches have used to recruit student athletes. Enrollment campaigns identify, track, call, visit, and generally stay on top of potential students until an inquiry is converted into an admitted student who makes a deposit. The campaign does not end there but continues until the prospect is sitting in the classroom.

Keeping students once they enroll and attend college is imperative given the cost of finding and admitting new students. Every student lost before finishing a full course of study forces the college to find a replacement. The result is that new student campaigns have to be devised to produce excess enrollment to offset attrition during the period that the cohort is enrolled. Most students who leave will do so sometime by the end of the first year. There are volumes of studies, plans, and methods for keeping students. Keeping students usually requires a close fit between the student and the institution (student personality, expectations, fears, costs, and needs). Unfortunately, evidence suggests that retention is a function of prior history for incoming high school seniors. If a student did well in high school and has parents who believe that a degree is essential for success in life, then the probability of graduating in a reasonable time is high. If a student did not do well and college is a holding period until they are forced to earn her/his keep, then persistence is low. Unfortunately, for many colleges and universities (public or private), the unmotivated students (the latter group) make up a significant portion of their enrolled students.

Keeping unmotivated students in college is costly and often unsuccessful. In the stream of life, these students may become good students someday when they have worked, begun a family, and now understand the value of a degree and the work needed to earn the degree. Therefore, a good non-traditional program attracting older students can balance the loss of younger, unmotivated students.

Endowment, Gifts, and Grants can play a critical role in most institutions even tuition-dependent colleges because endowments, gifts, and grants may provide extra income to reach budgetary breakeven.

Endowment, gift, and grant plans need to consider the source and cost of eliciting new funds such as, alumni, friends of the college, corporate or foundation grants, and indirect costs from government grants. Calling potential donors or completing a grant application is insufficient; the institution must spend money to make money in these areas.

Auxiliaries cannot be ignored in a strategic-equilibrium plan because they should provide excess revenues to support the institution and cover any debt associated with their fixed costs. Too many colleges and universities overlook net revenues from auxiliary operations. Part of the problem lies in the separation of auxiliary revenue from auxiliary expenses in audits and budget reports, which obscure if they produce gains or losses in net income. It is always surprising to find colleges where residence halls, food services, or bookstores regularly yield deficits.

At a minimum, auxiliaries should cover their direct expenses plus related interest expense and principal payments. If the auxiliary cannot achieve this elementary financial goal, the CFO should devise a plan to align operational performance with this goal. If the institution does not have the resources to effectively manage its auxiliary operations, it should quickly take steps to outsource them without delay.

Cost Controls are essential because institutions can no longer support the assumption that its cost structure and its internal rate of inflation are beyond its control or they will soon discover that finding enough revenue to cover an expanding equilibrium gap is neigh impossible. There are several cost control solutions that are now being used and have proven effective: a) form consortia or outsources to reduce service costs; b) cut down on upper- and middle-level management; and c) monitor costs and identify high expenses that cannot be justified. Colleges will need to become more adept at managing costs if they expect to close equilibrium gaps and maintain a dynamic state of equilibrium.

New Initiatives are vital to devising a successful strategic-equilibrium plan, especially if they promise sufficient scale to quicken the pace to economic equilibrium. Too many presidents and chief administrative officers waste their scarce time tinkering around the edges to get small results from many little ideas when they should focus on projects that can yield large, positive financial results.

A new initiative can take many forms by either producing revenue or cutting costs. For example, major cost saving plans may include outsourcing information technology where a consortium holds the hardware and software, spreads capital costs, and bridges the learning curve for servicing the system that some colleges cannot afford.

A simple list of new initiatives which produce new revenue could include^[9]:

1. Joint ventures, (for instance, between community and four-year colleges);
2. New legal entities cutting across for-profit and not-for-profit structures;
3. New sites embedded in a local mall with high volumes of traffic;
4. Re-engineering administrative processes by replacing offices with administrative networks;
5. Refinancing debt to reduce interest expenses; or
6. Devising new academic programs that fit emerging labor markets.

Summary

Strategic-equilibrium plans require constant and regular monitoring of key activities by the board of trustees and president.^[10] Monitoring should include monthly reports and benchmarks for admissions, retention, endowment performance, gifts, and new initiatives. Whether plans are working well (and especially when they are not working well) key leaders must be ready to explain how a plan can be revised to reach a dynamic state of equilibrium. In some instances, a “Plan B” must be kept on the back burner, as when the original plan fails to produce results to eliminate the equilibrium gap.^[11] A “Plan B” is particularly important at colleges struggling to survive. Their “Plan B” may require soul searching to determine if they can best serve their mission and, in particular, their students through a merger.^[12]

Equilibrium is the boundary level for colleges and universities seeking to prosper. By reaching and maintaining equilibrium, the institution should be producing excess revenues that will permit the college to survive unexpected and financially destructive events and to grow to better serve its mission and its students.

1. Endnotes

   Ruger, A., J. Canary, and S. Land.; (2006); “The President’s Role in Financial Management” in A Handbook for Seminary Presidents; edited by G. Lewis and L.; William B. Erdman Publishing Company; Grand Rapids, Michigan. ↑

2. Competitive bounds refer to a square in a matrix with price and quality as axes. A specific market is depicted as a smaller square within the matrix which includes potential students who prefer to enroll at a college with a particular level of price and quality. ↑

3. Cyert, R. (July, August 1978); The Management of Universities of Constant or Decreasing Size; Public Administration Review; p. 345. ↑

4. The Association of Theological Schools and the Auburn Seminary have made practical contributions on how to reach a state of equilibrium. Several of the six areas – enrollment, endowments, gifts and grants – are recommended by them as paths for developing strategic – equilibrium plans. ↑

5. Ruger, A. (February 12, 2010); Institutional Viability and Financially-Stressed Schools (unpublished); presented at a conference conducted by the Association of Theological Schools. ↑

6. JMA Higher Ed Stats (2003); Management ratios 2002 private colleges, universities, catalog #3690103. Boulder, CO: John Minter and Associates. ↑

7. JMA Higher Ed Stats (2008) Strategic higher education trends at a glance: F2 2002.csv and F2 2007.csv financial data. Boulder, CO: John Minter and Associates. ↑

8. Hoover, E. (April 30,2010) The Sweet and Subtle Science of Wooing the Admitted; The Chronicle of Higher Education; pp. A1and A17-A18 ↑

9. Townsley, M. (2002); The Small College Guide to Financial Health. Washington, DC: NACUBO; pp. 157-182. ↑

10. Ruger, A. (February 12, 2010); Institutional Viability and Financially-Stressed Schools (unpublished); presented at a conference conducted by the Association of Theological Schools. ↑

11. Ruger, A. (February 12, 2010); Institutional Viability and Financially-Stressed Schools (unpublished); presented at a conference conducted by the Association of Theological Schools. ↑

12. Townsley, M. (2002); The Small College Guide to Financial Health. Washington, DC: NACUBO; p. 180. ↑