Financing Higher Education: Approaches to Funding at Four- Year Public Institutions

This paper examines declining state support for higher education and explores various funding models that colleges and universities in the United States employ, including incremental budgeting, formula budgeting, zero-based budgeting, program budgeting, performance-based budgeting, initiative-based budgeting, and responsibility-centered budgeting. The mechanics, advantages, and disadvantages of responsibility-centered budgeting are emphasized. This paper looks at the literature on declining state support and the various budgeting models and provides an analysis regarding information on dwindling state support for higher education, the importance of budgeting, terminology discrepancies and application differences. Hummell, FINANCING HIGHER EDUCATION 2 C4HE Working Paper Series Introduction One of the most contentious issues in American higher education involves finance and budgeting at four-year public colleges and universities. State support has declined significantly over the last several years, and “most state universities have gone from ‘publically funded’ to ‘publically supported’ to ‘publically endorsed’” (Curran, 2009, p. 1). According to Hearn, McLendon, and Mokher (2009), state investment in higher education has declined significantly in relation to various factors, including enrollment increases. Hearn et al mention that “in some research-oriented flagship institutions, state revenues have declined to as little as one-third or even one-tenth of total institutional revenues” (p. 687). While support for higher education varies by state, almost all public four-year institutions have had to cope with the reality of dwindling support, especially during the most recent recession. Many public institutions are now taking on ventures similar to those at private colleges, including fundraising campaigns, as well as increased fees for students, faculty, and staff, privatization of entities such as dining services and the bookstore. Public universities are also increasing pressure on faculty to bring in grant money (Curran, 2009). Without state support, four-year public colleges and universities cannot achieve their goals and objectives. The manner in which a four-year public college or university allocates its state funding and tuition dollars reflects the institution’s needs, mission, and strategic priorities. Budgeting becomes increasingly important as state support continues to decrease and as four-year public institutions move from state funded, to state supported, to state endorsed. Administrators at four-year public institutions need to understand various funding models, ranging from the most widely used model, incremental budgeting (IB), to the most recent trend in higher education finance, responsibility-centered budgeting (RCB). With fewer state dollars, public four-year institutions need to examine their mission and goals and choose an appropriate budgeting model or hybrid model that reflects their strategic priorities. Significance of the Study The objective of this paper is to examine the various funding models used within higher education, and to answer two research questions. These questions are: 1) what are the different types of funding models used by public four-year institutions, and 2) what are the advantages and disadvantages of moving to and using a responsibility-centered budgeting system at public four-year institutions? This study provides readers with an overview of the different types of funding models used by public four-year institutions. These funding models include formula budgeting, incremental budgeting, zero-based budgeting, program budgeting, performance-based budgeting, initiative-based budgeting, and responsibility-centered budgeting. This paper Hummell, FINANCING HIGHER EDUCATION 3 C4HE Working Paper Series focuses heavily on responsibility-centered budgeting, including its mechanics and the advantages and disadvantages of implementing and using an RCB model. Although private institutions almost exclusively use RCB, only a handful of public four-year institutions have moved to this model. RCB focuses on accountability and can serve “as a way to restructure the administration of a college or university” (Zierdt, 2009, p. 348). With decreased state support, this model has become more popular within the past five years as part of an era focused on budget reform (Zierdt, 2009). It is unlikely that state support for higher education will increase significantly in the future; therefore, more institutions may need to investigate moving to an RCB model not only to flourish, but to survive. Many public four-year institutions are considering new or improved budgeting tools “that will most effectively assist them in achieving institutional goals and objectives within their strategic plans” (Zierdt, 2009, p. 345), and are seeking to find the best ways to allocate scarce resources from state appropriations and tuition dollars. By providing a comprehensive overview of RCB as well as other types of funding models, this paper provides institutional leaders with ideas for budgetary practices or policies that may help them sustain their institution. Review of the Literature The demand for accountability and the decline in state support has required public fouryear institutions to begin adopting new budgeting models (Serban, 1998). This paper provides a background, as well as a discussion of the advantages and disadvantages of seven budgeting models: incremental budgeting (IB), formula budgeting (FB), zero-based budgeting (ZBB), program budgeting (PB), performance-based budgeting (PBB), initiative-based budgeting (IBB), and responsibility-centered budgeting (RCB). An expanded section on the mechanics of responsibility-centered budgeting is also included toward the end of the literature review. Incremental budgeting (IB) Incremental budgeting, also known as line-item budgeting, is the oldest and most widely used form of higher education budgeting (Zierdt, 2009). According to Varlotta (2010), incremental budgeting “makes incremental upward or downward adjustments to budget allocations, expressed as percentage increases or decreases from the previous year’s budget” (p. 15). Depending on the resources available, this form of budgeting either involves percentage adjustments that apply to all line items (e.g., colleges, programs, offices, departments, and other units), or involves incremental adjustments to specific line items (e.g., faculty salaries, new initiatives, facilities). Generally, colleges and universities will make unilateral downward adjustments when revenues decrease. When revenues increase, however, institutions may either apply a consistent upward adjustment to all line items, or they will adjust specific line items, such as faculty salaries (Varlotta, 2010). Institutions that use this method generally assume “the previous budget [has] Hummell, FINANCING HIGHER EDUCATION 4 C4HE Working Paper Series already been justified and it is used as a base upon which to make the decisions for the next fiscal year” (Linn, 2007, p. 21). Incremental budgeting has a few advantages. Zierdt (2009) highlights that this method is the most efficient budgeting tool that institutions can employ because it makes simple incremental adjustments to each unit’s budget. Varlotta (2010), who describes the model as “simple to operationalize and virtually automatic” (p. 15), mentions that because it applies consistent percentage adjustments to all units, conflicts are lessened and decision making is expedited. Incremental budgeting is best utilized when the institution’s basic objectives have not changed (Zierdt, 2009). It is simple, efficient, and easy to understand. Despite these advantages, incremental budgeting has several flaws. Varlotta (2010) mentions that the assumption upon which this budgeting method is based—that needs, priorities, and goals do not change from year to year—is flawed, and that because the incremental budgeting process is automatic, institutions that employ this model do not critically examine or challenge the previous year’s needs, priorities, and goals. This budgeting method focuses on changes on the margins of an institution’s budget, and because only small incremental changes are made, reallocation or “rightsizing” that could benefit some divisions, especially Student Affairs, typically does not occur (Varlotta, 2010). This model is “recognized as producing suboptimal results in terms of resources allocation” (Goldstein, 2005, p. 165). While incremental budgeting may appear to treat all units equitably, this model gives no financial incentive for performance, nor does it increase funding for units that might support the institution’s goals or priorities more than other units. As Varlotta (2010) mentions, “Units that are charged with or have taken the leadership role in addressing strategic priorities receive the same amounts of resources as units that have assumed none of these responsibilities” (pp. 15-16). This method treats each line item equally, and does not evaluate or challenge the status quo; however, relying on incremental adjustments to a historical allocation may no longer cover a unit’s new services or programs. Also, a historical allocation may over-compensate an office that has downsized, reduced programs or recognized new savings from technology. Varlotta (2010) provides an example of how such changes might impact a particular office, suggesting that a unit that has historically spent money on delivering hard copy materials via mail but switches to electronic distribution may receive an allocation that significantly exceeds their expenses. This form of budgeting is the least likely form to bring about change and the most likely form to maintain the status quo. Goldstein (2005) suggests that because it is the most widely used budgeting method in higher education, we can imply that “the need for efficiency in some administrative areas outweighs the desire for effectiveness” (p. 165). Hummell, FINANCING HIGHER EDUCATION 5 C4HE Working Paper Series Formula budgeting (FB) Formula budgeting (FB) is most often seen at higher education institutions in the Northeast and Midwest, as well as in elementary and secondary schools (Linn, 2007). This particular budgeting model is a quantitative approach to resource allocation that relies on complex formulas to distribute resources to units at an institution (Goldstein, 2005). Formula budgeting emerged in the 1950s and 1960s “as a means to ensure the equitable and rational distribution of resources” (Serban, 1998, p. 16). This approach estimates resources by relating program cost and program demand in the form of a mathematical formula. According to Serban (1998), this formula could “be as simple as a single student-faculty ratio or as complicated as an array of cost per student credit hour by discipline for many levels of instruction” (p. 16), and could be based on anything from historical data, to anticipated trends, to negotiated political agreements. Like incremental and other budgeting models, formula budgeting has its advantages and disadvantages. One advantage that Goldstein (2005) mentions is that “the quantitative nature of most budget formulas gives them the appearance, if not always the reality, of an unbiased distribution” (p. 170). Formulas are often seen as objective and, in the absence of political influence, can be a way to equitably allocate resources to units. Once a formula is in place, an institution can “reduce political competition and lobbying” by not changing the formula, and can communicate an understandable model to its units and the state providing part of the allocations distributed to the institution’s units via the formula (Serban, 1998). Although formulas may provide the appearance of an unbiased distribution, Serban (1998) questions the assumptions of this model. In terms of allocating resources to academic programs, he suggests that formulas may reduce academic programs “to a common level of mediocrity by funding each one the same” (p. 17). Serban (1998) further contends that though formulas are based on data, they “are only as accurate as the data on which they are based” (p. 17). He also argues the model “may perpetuate inequities in funding that existed before the advent of the formula, because formulas may rely on historical cost data” (p. 17). If a formula is based on enrollment, incremental budgeting may not meet needs related to new initiatives or programs, or may not serve new demographics of students (Serban, 1998). Additionally, Zierdt (2009) mentions that formula budgeting sometimes create incentives to keep programs that contribute funding, even if these programs no longer relate to an institution’s goals or objectives. Zero-based budgeting (ZBB) Zero-based budgeting (ZBB), when used in its most authentic form, recreates the institution’s budget from scratch (Linn, 2007). Zero-based budgeting emerged in the 1970s when institutions started to demand that units justify their use of resources and to link resources and results (Serban, 1998). Hummell, FINANCING HIGHER EDUCATION 6 C4HE Working Paper Series Zero-based budgeting requires that units develop decision packages that describe the unit’s activity, and involves administrators ranking the various decision packages in order of priority. The order of priority is typically based on institutional goals, cost/benefit analysis, or a subjective appraisal (Serban, 1998; Zierdt, 2009). Varlotta (2010) mentions that ZBB can be perceived as “the opposite of incremental budgeting [because it] starts from scratch every year [and] reconstructs each year’s or cycle’s budget anew” (p. 16). Two of the advantages of zero-based budgeting include analysis and justification. When creating decision packages, units must think about how their programs relate to the institution’s goals. If they do not analyze their courses and programs, their decision package may not receive priority. Units must justify why their programs relate to institutional goals, which is a benefit of this model. This model “not only initiates a budget-planning connectivity, but it also reexamines the basic elements—goals, objectives, measures, and benchmarks—of [a unit’s] strategic plan” (Varlotta, 2010, p. 16). Zero-based budgeting requires units to re-evaluate their programs and create action plans that achieve their goals, while also keeping the university’s goals in mind. With ZBB, this evaluation process should be completed before resources are allocated. Units must justify requests for resources and the final budget proposal “is directly correlated to the costs of implementing plans, reaching goals, and hitting benchmarks or objectives” (Varlotta, 2010, p. 16). Literature on zero-based budgeting suggests that the main disadvantage of this method is “the time-intensive nature of the process” (Zierdt, 2009, p. 346). The process is also labor intensive because of its comprehensive approach, and it is not widely used in higher education (Varlotta, 2010). Goldstein (2005) suggests that this model might be better utilized at a unit level, after the unit receives an allocation from the institution, rather than at an institution-wide level. Goldstein (2005) also suggests that “it may be feasible or even productive to use the ZBB approach for a portion of the university’s or division’s budget” (p. 167). Program budgeting (PB) Program budgeting (PB) is a method of budgeting in higher education that involves three components: a program plan, budget, and analysis of costs and benefits (Zierdt, 2009). According to Zierdt (2009), the program plan establishes a unit’s goals and objectives and relates them to the institution’s goals. The program budget includes a cost-benefit analysis of how the program plan for each unit will relate to the institution’s goals. The program plan may involve a number of alternate approaches for which the costs and benefits, as well as an estimation of resource requirements and benefits to the institution, are codified. The program budget projects costs over a longer term to provide a “longterm view of the financial implications” of a unit offering various programs (Goldstein, 2005, p. 167). An overarching theme of program budgeting is that units must specify not only how the resources they are allocated will be spent, but also why they will be spent in that manner (Linn, 2007). Hummell, FINANCING HIGHER EDUCATION 7 C4HE Working Paper Series Zierdt (2009) mentions that one of the advantages of program budgeting is that it relates budgeting with institutional priorities, as well as the institution’s vision. Units must not only come up with a plan for the programs they offer, but also must discuss how their programs will align with the institution’s goals, and must justify why they want to offer their programs. Because it involves a cost/benefit analysis, program budgeting may appear more objective (Serban, 1998). Despite this, Serban (1998) notes that this model cannot stand on its own, but should rather complement other budget models, such as formula budgeting and incremental budgeting. Serban’s language implies that this model is rarely used in higher education anymore. Goldstein (2005) also discusses two flaws of program budgeting, mentioning that it is difficult to achieve consensus on what constitutes appropriate outcomes for each unit, and that occasionally, arbitrary allocations that do not relate to a unit’s activities are made. Performance-based budgeting (PBB) Performance-based budgeting (PBB) dates back to the 1940s, but has reemerged as a response “to calls from stakeholders for greater accountability for all the funding they provide and as a way to bring together the strategic planning process with the budget creation process, which other tools can easily separate” (Linn, 2007, p. 347). According to Wellman (2003), performance-based budgeting came about to address internal incentive structures. As an outgrowth of program budgeting, performance-based budgeting addresses some of the concerns related to formula funding, incentive-based budgeting, and incremental budgeting by linking performance with resource allocation. Linking performance with resource allocation makes funding dependent upon accomplishments, since resources are allocated after a unit achieves satisfactory and desirable results (Serban, 1998). Unlike other budgeting methods, PBB, according to Serban (1998) focuses on results rather than activity or processes. Serban (1998) also mentions that “performance funding departs from traditional funding methods of higher education, which focus on inputs and processes and neglect outputs and outcomes” (p. 24). Ideally, performance-based budgeting involves a discussion of indicators for performance. According to Zierdt (2009), performance-based budgeting’s key advantage is that resources are allocated equitably to units that perform well. Although Zierdt (2009), Linn (2007), Wellman (2003), and Serban (1998) all note that performance-based budgeting is used more often at the state level than at the institutional or unit level, some of the tenets of this method are still applicable and might “correct some of the apparent flaws in traditional budgeting” (Serban, 1998, p. 24) by focusing on performance. Performance-based budgeting focuses on results rather than needs, and this approach occasionally discourages units from reducing expenditures, restructuring, or reallocating resources (Serban, 1998). Serban (1998) also mentions that it is significantly easier to discuss and define performance-based budgeting and performance measures than it is to actualize the model. Additionally, Zierdt (2009) suggests that it is “difficult to define Hummell, FINANCING HIGHER EDUCATION 8 C4HE Working Paper Series performance criteria and performance measures when taking [into] account the diversity of various institutional missions” (p. 347). Although PBB can apply to resource allocation at the institution and unit level, all sources suggest that it may be more applicable in resource allocation by the state to state-supported institutions. In the 1990s, Tennessee and ten other states began implementing performance-based budgeting for state-supported institutions, and many continue to use some elements of this method today (Serban, 1998; Zierdt, 2009). Initiative-based budgeting (IBB) According to Linn (2007), initiative-based budgeting, also referred to as reallocation budgeting, is “an organized way of creating a pool of money for funding new initiatives” (p. 26). Unlike other budgeting methods, IBB is not a comprehensive system. Initiativebased budgeting contains many variations, but according to Goldstein (2005), a typical model involves “identifying resources that will be returned to central administration for redistribution in support of the priorities agreed upon during the institution’s planning process” (p. 174). In other words, funding at the unit level for low-priority initiatives— generally “a small percentage of department or unit budgets” (Varlotta, 2010, p. 18)—is returned to a central pool, where money is then allocated to higher-priority initiatives. This approach indirectly connects funding and results because the money in the pool is used for awards that are used to execute programs related to objectives and goals (Serban, 1998). Varlotta (2010) mentions that institutions who use initiative-based budgeting “often require an individual unit to submit a proposal that illustrates how it will use a portion of the pooled funds to directly support a specific priority or actualize an important university goal” (p. 18). One of the advantages of initiative-based budgeting is that it can fuel creativity, as units think of unique programs to offer that support the institution’s mission. Initiative-based budgeting also integrates budgeting with planning, and “allows departments that are awarded funds to respond in timely and unique ways to a contemporary issue” (Varlotta, 2010, p. 18). Goldstein (2005) mentions that initiative-based budgeting ensures that units remain productive by reviewing their current programs and activities. Goldstein (2005) also mentions that initiative-based budgeting allows departments “to achieve their targets in various ways on an annual basis” (p. 175). Although initiative-based budgeting may fuel creativity, programs sponsored by funding from an initiative-based budget may not be sustainable, since funds for initiatives are often allocated once, rather than on an ongoing basis (Varlotta, 2010). Varlotta (2010) mentions that initiative-based budgeting can be practical in the years in which institutions are flourishing, but will likely not work during a downturn, when it is difficult for units to “skim off a portion of their initial allocation without devastating their overall budget” (p. 18). Because initiative-based budgeting costs units money, units that do not receive any funding for initiatives will lose out, and allocating resources to any initiatives that other units consider superfluous could cause resentment between units (Varlotta, 2010). Hummell, FINANCING HIGHER EDUCATION 9 C4HE Working Paper Series Serban (1998), Goldstein (2005), Linn (2007), and Varlotta (2010) all indicate an additional weakness of IBB. They have each suggested that initiative-based budgeting is a short-term approach, not a system that a university can use long-term. Units that are required to give up a percentage of their budget annually will not be able to meet their institution’s needs if they do not receive any of the initiative funds and thus, this model is not sustainable over a longer term (Zierdt, 2009). Responsibility-Centered Budgeting (RCB) Responsibility-centered budgeting, which originated at Harvard University, is also known as cost-centered budgeting, value-centered management, responsibility-centered management, profit-centered budgeting, incentives-based budget systems, and revenue responsibility budgeting (Zierdt, 2009). Common in the for-profit sector and at private institutions, RCB “is becoming more than a private institution phenomenon [as] public institutions are increasingly taking steps to study and implement RCB models” (Zierdt, 2009, p. 349). According to Hearn et al (2006), recent economic and political conditions have encouraged four-year public institutions to begin to revise budgeting tools and management processes and to become more adaptable and efficient in the midst of having to make challenging financial decisions. As a result, more institutions are beginning to consider responsibility-centered budgeting. The overarching goal of responsibility-centered budgeting is guided by the statement, “Every tub has its own bottom” (Zierdt, 2009, p. 348). In this statement, the tub refers to academic units and the bottom refers to these units being responsible for their own revenue production. RCB shifts decision making and financial accountability to units, which the model refers to as “revenue centers,” “cost centers,” or “hybrid centers,” each of which is responsible for covering its own expenses (Varlotta, 2010, p. 17). Hearn et al (2006) describe the goal of an RCB system: “to grant each unit a degree of fiscal autonomy for deciding how revenues will be acquired and spent and how expenditures will be chosen and managed” (p. 288). RCB systems shift authority and accountability to individual units (Hearn et al, 2006). Goldstein (2005) compares the idea of shifting responsibility to units with the way in which decision making is treated in other models: Without RCB or one if its variants, many overhead costs are borne centrally and absorb institutional resources before allocations for other purposes are made. When costs are treated in this manner, faculty and staff tend to lack an appreciation of the true cost of the services being used on the campus. On the other hand, when they have access to this information, it changes the demand for services and resources. (p. 172) With RCB, each cost center must use its share of the university’s allocation to cover expenses such as faculty and support staff salaries, space within buildings and laboratories, and less-obvious charges, such as utilities, facilities, communication costs, and a tax on the external grant money it attracts (Varlotta, 2010). RCB gives units fiscal Hummell, FINANCING HIGHER EDUCATION 10 C4HE Working Paper Series autonomy and the ability to make more independent decisions. The mechanics of responsibility-centered budgeting models are covered in the next section.