Education and the fixed-cost dilemma

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I wrote a post back in February that looked how an accounting problem called the fixed-cost dilemma skews many medical costs like drugs and ambulances. The same problem occurs in spades in higher education, and that is the focus of this post. If you are going to advocate for “free college education,” I suggest that it is very helpful to understand this important bit of accounting.

In brief, the fixed-cost dilemma occurs in any industry where most of the costs underlying the creation of “the product” don’t change very much in the short-run, regardless of the quantity of “the product” delivered. The marginal cost of delivering one more ambulance ride, or manufacturing one more prescription pill, or matriculating one more student is often very low in comparison to the “absorbed” fixed costs, which can be very large, and whose allocation can be quite arbitrary. My go-to example is of a new drug that has cost $10 million to get to market, but now only costs one dollar per pill to manufacture. What is the “appropriate” price to set for this pill? There is no easy answer. It depends on how you spread the “absorption” of that big initial cost.

And in another prior post, I have suggested that the real “product” of the higher education system is not education, per se (which can often be obtained nearly zero cost outside the institution), but rather a market-recognized credential, a degree that certifies the more amorphous quality of your education, at least to the level of reputation of the certifying college or university.

The low marginal cost of each credential

It turns out that the marginal cost of delivering this credential to one additional person, if the college or university is running under its capacity, can be very low indeed. If there is excess classroom space available, one additional student in the class creates only a small, and often immeasurable, incremental cost in terms of instructor time. If there is just one unused dormitory room available, then a new student occupying that room only creates a small incremental cost in food consumed and utilities used.

Clearly, some students, somewhere, must bear the financial weight of the total fixed costs of the college campus and dormitory costs, allocated to them in some “fair” manner. But every institution operating below capacity (and there are many these days) is fighting this “fixed-cost dilemma” in order to determine how much to expend to obtain one more student, and to determine how much of a tuition and housing discount (discussed in this earlier post) to award that incremental student in calculating “the price of admission.”

The opposite problem occurs if the institution is at capacity, if all of the classroom slots and the dormitory rooms are filled. In this case, the expansion of that capacity can get quite expensive, adding a new layer of mostly-fixed costs, such as a new classroom building, now needing to be allocated “fairly” to the overall student body and campus “cost centers.”

When buildings are liabilities

A college dean I once worked under, also a philosophy professor, once noted that the one campus activity that seemed to survive any challenge to tight budgets was the careful maintenance of the many acres of campus lawn, and the mowers seemed to target his class times to be making a racket right outside his classroom window. His famous observation was that “the primary purpose of the college is to cut the grass.”

I noted in that earlier post that the direct “academic costs” of graduating any one student may well be less than half of the tuition price charged the typical student, even if the fixed costs of “the academic side” of the school are allocated across the student body. The fixed costs of the non-academic parts of the campus, such as top administration, the development and finance offices, admissions, student social services, grounds maintenance, and the common areas have to be paid for somehow. These costs can be very large, and they have, on most campuses, grown at a faster rate than more direct academic costs. Students in this century demand much better facility services than they did in the past as a consideration in opting for their favored institution.

Even the “academic” budget as reported by most colleges and universities is quite inflated beyond the total salaries of the teaching professors. Academic deans are “responsible” in an accounting “cost center” sense for their allocated share of fixed costs of the academic buildings and laboratories, and sometimes for indirect “student academic support services” like remedial classes and tutoring, as well. All costs of the university, whether fixed or not, need to be budgetary allocated somewhere. This makes the actual marginal cost of educating that one additional student very difficult to measure.

There is an old “accounting theory” conjecture as to whether some buildings on a college campus ought to even be seen as “assets.” In a for-profit business, fixed assets generate additional income, and usually have “market value” in and of themselves. A factory, for example, could often be sold at some price, establishing a base market value for that asset (which may be widely different from its “book value” as shown on the balance sheet). A factory building that can no longer “pull its financial weight” must be “written down” in asset value according to accounting standards.

What is the “market value” of the “Old Main” building on the college campus, however? It can’t really be sold, and it likely sucks a lot of cash for maintenance now and will into the future without visibly generating any tuition revenue except through some fuzzy “tradition value.” There is an accounting term for future cashflow obligations that don’t generate revenue, and they are called liabilities. Many college campuses have learned that the campus “fixed assets” of buildings and grounds consume, over time, a bigger and bigger percentage of the budget, forcing more direct “academic” costs into a smaller and smaller “box.”

I’m not advocating here that schools tear down their “Old Main” buildings, rather that accounting for an institution of higher learning is very different in many respects from “running a business,” and sometimes “the accounting rules” can yield counter-intuitive results. These differences leave the education system ripe for a re-think in terms of how we fund it.

Rising technology costs

One source of fixed costs that was a few orders of magnitude lower in universities of years past is technology. Today’s university requires a huge investment in high-speed internet infrastructure, computer and classroom hardware, and the staff to maintain it. Much of that expenditure is allocated to “academic costs,” and unlike building assets, the depreciation rate on this technology is much higher due to very short technology life spans.

But again, it is very hard to nail down the direct contribution to “student education” provided by that technology. I spent a large part of my career developing technology related to academic textbooks, and some of that technology crashed real barriers to student learning, delivering “immersion education” far more effectively than the printed book could, as much as I love books. Other technologies, however, simply presented textbook information in more expensive high-tech forms, with less-demonstrable improvement. A lot of these technologies have come and gone over the years (remember videotape?). The price of this technology is often embedded in the price of textbooks and other instructional materials, and that was a primary driver to rising textbook costs over the last three decades. Much of this cost has also been borne by the student through larger tuition and “technology fee” costs.

Back to the question of “What are we paying for?”

The impetus behind this series of posts is the current push toward “free college for all.” In general, I support increased aid to education. We citizens have responsibility to the commonweal, and outside of defense spending, that citizen commitment, especially to education, has clearly waned in recent years.

I have to reiterate that back when my fellow “baby boomers” hit the college campuses in an unprecedented demographic wave, our government was there, supported by both political parties, expanding universities, building new campuses, and financing graduate programs to train new college professors to meet expending needs. My Republican governors in Michigan in the late 1960s provided me with nearly-free tuition and housing. My only debt incurred was used to purchase an old car to drive the long distance to campus.

Clearly, there are some different and larger costs for university education now as compared to the late 1960s and early 1970s. But in those days an economy that was still emerging from World War II and the Korean War only a couple decades earlier found the “surplus” required to fund that education for millions of Americans. Ironically, the halls of Congress are filled with men and women around my age who benefited from that taxpayer commitment, and those same people are now denying an equivalent opportunity to the next generation of young people.

The cost of “the credential” of higher education is expensive and complicated. However, I believe that it is possible to re-think the process and the funding of higher education in order to deliver both “the education” and “the credentials” required to keep the country moving. And like Sears stores, there will inevitably be casualties along the way.

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