| November 7, 2011

Our Profitable (and Profligate) Universities

Undergraduate education is a highly profitable business for nonprofit colleges and universities.

But how, you may ask, can a nonprofit have profits? Simply put, it happens when the revenue the nonprofit derives from providing a service exceeds the cost of providing that service. Such schools never report that they have realized profits, because profits are reported as expenses.

Nonprofit schools take their profits from undergraduate education (which is typically the main focus of policymakers who are seeking greater affordability, access, etc.) in the form of spending on some combination of research, graduate education, low-demand majors, low faculty teaching loads, excess compensation, and featherbedding.

The profligacy of nonprofit colleges is well known. As longtime Harvard president Derek Bok once quipped, “universities share one characteristic with compulsive gamblers and exiled royalty: there is never enough money to satisfy their desires.”

Thirty years ago, Howard R. Bowen, an economist and president of three different colleges, proposed what is known in education circles as Bowen’s Law. It can be summarized as “colleges raise all the money they can, and spend all the money they can raise.” Bowen’s Law is well accepted by scholars of higher education economics.

But don’t colleges try their best to keep costs low in order to keep tuition down? No. As Bowen points out: “The question of what ought higher education to cost—what is the minimal amount needed to provide services of acceptable quality—does not enter the process except as it is imposed from the outside. The higher educational system itself provides no guidance of a kind that weighs costs and benefits in terms of the public interest. The duty of setting limits thus falls, by default, upon those who provide the money, mostly legislators and students and their families.”

Robert E. Martin, an economics professor with substantial experience as a faculty member at both a large state research university and a small liberal arts college, recently expanded on Bowen’s Law. He concluded that “higher education finance is a black hole that cannot be filled. The relationship between revenues and subsequent costs has a dynamic feedback effect. Higher education responds to higher costs by raising tuition and fees or initiating fundraising campaigns. But because costs in higher education are capped only by total revenues, there is no incentive to minimize costs. The costs go up in tandem with revenues. The next year, the cycle begins again because the higher costs mean that the new programs must be financed by additional revenues. There is thus a never-ending spiral effect between revenues and cost.”

OCPA adjunct scholar Vance Fried, a lawyer and a Certified Public Accountant, serves as the Riata Professor of Entrepreneurship at Oklahoma State University. This article is excerpted from his recent report “Federal Higher Education Policy and the Profitable Nonprofits,” published by the Cato Institute.

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