Avoiding Financial Rollercoasters
Save the Rollercoasters for the Park
Summary
This post summarizes two anonymized examples of how easy it is for boards to inadvertently direct schools down financially unsustainable paths, which can be very painful to fix later, yet can be easily avoided by forecasting.
Intended Take-Aways:
Summary
This post summarizes two anonymized examples of how easy it is for boards to inadvertently direct schools down financially unsustainable paths, which can be very painful to fix later, yet can be easily avoided by forecasting.
Intended Take-Aways:
- The budget levers driving a school's short-term and long-term financials differ. Both have to be balanced, otherwise the school's future Net Income will be volatile. To fix these problems later will require a lot of people to accept significant changes, which will be the hard part. To fix these problems sooner requires much less change.
- Vetted financial forecasting is critical for avoiding and managing these problems since their buildup, and resolution, can span several cycles of trustee turnover.
- Transparent financial planning ensures everyone's views can be heard, helping to avoid doomed plans, errors, biases, and hidden agendas, while increasing buy-in. However, transparency doesn't help if the financial models are incomprehensible to all but the experts, or if trustees have not been given sufficient training on how their financial models work. Therefore:
- financial models should be made as simple as possible (but no simpler).
- trustee orientation should include an hour long session of playing with the models with the business office manager or treasurer, helping them to quickly grasp the trade-offs involved in future financial decisions and avoid traps like those seen in the following scenarios.
1. The goal is financial balance over time
Why bother forecasting if you have audited financials to support your budget decisions?
Of course, a school's audited financials should be part of what informs the board's budget decisions, but they only represent a snapshot in time, and they don't show where the current business model will take the financials in the future. Furthermore, even if the audited financials' revenues and costs are currently balanced, they won't be in a few years if the growth rates of the major levers of the budget are not balanced.
Major Levers of School Budgets
2. Can you see the trap?
Avoiding Traps #1: Lowering Tuition Growth due to an Enrollment Boost
Avoiding Traps #1: Lowering Tuition Growth due to an Enrollment Boost
Setup:
- A local school closes, boosting your applications. The board decides to increase enrollment by 22 students to 462 total.
- The current financials look fantastic as a result, and a group of trustees that are very concerned about the historical rate of tuition increases make a compelling case that the school should finally lower tuition growth from the previously balanced rate of 4%/yr to 3%/yr.
- The school operates with these two changes to the business model for the next 5 years, with all the other budget levers unchanged. Here is the resulting annual and cumulative Net Income:
5 Years Later:
Then, the closed school reopens as a member of a well-regarded school association, and your school looses the extra 22 students. In response to the drop in enrollment, the board decides to increase tuition growth back up to 4%/yr. Here's how Net Income would look if the school operated with this business model for another 5 years:
Yikes!
Fortunately, your finance committee built a financial model of the school in 2022, and its forecasts allowed you to avoid the above steep losses. However, the news is still sobering. How much does your finance committee say tuition would need to be raised in year 2022 to regain balance, so that Net Income = $0?
wait for it....
wait a bit more....
more still.....
OK, tuition would need to be increased by about 9% in 2022, followed by balanced 4% increases in subsequent years. Can you imagine the parking lot chatter if that decision was announced?
Of course, most schools would spread the additional 5% tuition increase over a few years, which they would have more flexibility in doing if previous boards had decided to save some of the $700,000 in excess cumulative Net Income in a reserve fund.
3. The Cumulative Differential
In the above scenario the 9% answer for the tuition hike can be easily estimated in your head if you keep track of the "cumulative change in the differential" mentioned in the above charts. The cumulative differential is the cumulative difference between tuition price growth and wage pool growth, and when their growth is in balance, the cumulative differential = 0%.
In the initial 5 years of the scenario, tuition grew 1%/yr less than its balanced rate for 5 years, so the cumulative change in the differential was -1% x 5 = -5%. Therefore, to get approximately back to balance in 2022 (e.g. ignoring compounding) the cumulative differential needs to be increased by 5%. The approximate balanced rate of tuition increase was previously 4%, so adding 5% to it for a total tuition increase of 9% puts the cumulative differential back to approximately 0%.
The cumulative differential can be a useful concept to help ensure business models remain balanced over time. If your school becomes profligate for an extended period of years, then re-balancing the cumulative differential (and the business model) will require you to address the entire period of profligacy.
Eventually, the piper has to be paid.
In the initial 5 years of the scenario, tuition grew 1%/yr less than its balanced rate for 5 years, so the cumulative change in the differential was -1% x 5 = -5%. Therefore, to get approximately back to balance in 2022 (e.g. ignoring compounding) the cumulative differential needs to be increased by 5%. The approximate balanced rate of tuition increase was previously 4%, so adding 5% to it for a total tuition increase of 9% puts the cumulative differential back to approximately 0%.
The cumulative differential can be a useful concept to help ensure business models remain balanced over time. If your school becomes profligate for an extended period of years, then re-balancing the cumulative differential (and the business model) will require you to address the entire period of profligacy.
Eventually, the piper has to be paid.
Managing the cumulative differential is critical for financial stability over time
4. Financial impact of changing different levers over time
- Changes to tuition price and wage pool growth rates have by far the biggest impact on Net Income over time. They are long-term levers.
- But in the initial years, changes to tuition and wage pool growth rates have less impact. This delayed impact can fool schools into choosing unsustainable paths
Tuition price growth and wage pool growth have the most impact over time - they are "long-term" levers
Without forecasting, it's easy for schools to fall into the trap of letting tuition and wage pool growth get out of balance due to temporary improvements in "short-term" levers such as higher enrollment, reductions in financial aid, increased gifts to the operating budget, or reduced spending on campus preservation. While the current financials may show that the business model is balanced, forecasting can reveal the risks of future imbalances, and allow you to make small changes now, rather than big changes later.
5. Can you see the trap?
Avoiding Traps #2: Increasing Wages Growth due to Increased Gifts to the Op Budget
Avoiding Traps #2: Increasing Wages Growth due to Increased Gifts to the Op Budget
Setup:
- A generous donor gives your school a gift to the operating budget of $350k/year for 5 years.
- The current financials look fantastic as a result, and a group of trustees that feel your faculty are underpaid make a compelling case that the school should increase the wage pool growth rate from the previously balanced 3%/yr to 4%/yr.
- The school operates with this new business model for the next 5 years. Here is the resulting annual and cumulative Net Income:
5 Years Later:
When the gift ends in 5 years the finance committee builds a financial model of the school to determine how the business model should be modified. Here's the forecast if the wage pool growth rate was lowered back down to the previously balanced 3%/yr for 5 more years:
Yikes again!
|
|
What should 2022’s wage pool growth be to regain balance, so that Net Income=$0?
wait for it again........
more annoying carriage returns....
OK, the wage pool would need to be cut by -2% in 2022, followed by balanced 3% increases in subsequent years. Be ready for the torches and pitchforks if that news gets announced!
Instead of using the gift to increase wage pool growth, it should have been directed to the endowment or reserve fund, or to a "short-term" lever like campus-related capital projects.
6. Fixing imbalances: easier said than done
Of course, most schools would fix the previous wage pool imbalance with smaller staff raises over an extended period (along with revenue increases) as opposed to an actual cut, but even this would be stressful from the staff’s perspective, generating responses like:
Such rollercoasters of unanticipated change have destroyed many schools, and the tragedy is, many of these schools may well have been able to avoid their problems if they had incorporated forecasting into their budget decision processes.
“Any change comes down to people: first how you help them face it and then how you help them move with it.” -- School Principal
“The fallacy of rationalism is the assumption that the social world can be altered by logical argument. The problem, as George Barnard Shaw observed, is that “reformers have the idea that change can be achieved by brute sanity.”" - Michael Fullan
- I’ve been receiving raises of 4%/yr for 5 years, so this is my expectation.
- Now management is saying that we will only receive 1% raises for a few years? Why are they punishing hard working teachers? I don’t trust them.
- Is the school going to make it? Maybe I need to look for another job?
- Etc.
Such rollercoasters of unanticipated change have destroyed many schools, and the tragedy is, many of these schools may well have been able to avoid their problems if they had incorporated forecasting into their budget decision processes.
“Any change comes down to people: first how you help them face it and then how you help them move with it.” -- School Principal
“The fallacy of rationalism is the assumption that the social world can be altered by logical argument. The problem, as George Barnard Shaw observed, is that “reformers have the idea that change can be achieved by brute sanity.”" - Michael Fullan
Save the Rollercoasters for the Park
7. Other ideas for getting budgets back in balance
Source: Financial Sustainability for Independent Schools, NAIS presentation by CFO Corey McIntyre
- Grow enrollment (without growing staff)
- Capitalize upon intellectual property
- Full utilization of physical assets
- Enhanced fundraising to build endowment
- Increase “productivity” of staff
- Moderate the arms race for new facilities
- Sunset programs. Undertake periodic “sacred cow” hunts.
Wade Vagle, CFA, CAIA
Get in touch at Wade@SchoolsThatLast.com