The Cost Allocation Death Spiral and the University

The Cost Allocation Death Spiral and the University

Accountants, as people whose business it chiefly is to bring hard news to powerful people, generally avoid emotional terms. They prefer softer, nuanced and obscure technical terms, instead. These allow them to say what needs to be said and then leave the meeting before the explosive reaction. So, when they use a term like “death spiral”, you may take it as read that they are not messing about. But what is a cost allocation death spiral, and why does it matter so much to universities at the moment?

Knowing the limitations of knowledge

It's about management not understanding the limits of their own accounting systems and so destroying their own organisations. Last seen in the great British Leyland pile-up in the 1970s, it’s a result of using day to day, politically driven, internal accounting systems to make critical business decisions which are far beyond their scope. You didn’t think accounting systems could be political? Well, there is nothing more political, and that is particularly true in large, multi-departmental organisations.

British Leyland

British Leyland was put together in the 1960s from number of smaller automobile companies who had lost captive markets in the collapse of the British Empire and so needed to be subsidised. As a result, there were a lot of products, a lot of departments and a lot of egos. None of them talked to each other very much or very well. The accounting system was put together by people who unlike their more proficient colleagues in say, Shell Oil, didn’t have a great deal of experience in large conglomerates and were not highly respected by the engineers who really ran the organisation. Famously, for many years British Leyland did not know how much their most successful product, the Mini, cost to make. Universities, like British Leyland, tend to have a lot of departments, each pursuing their own area of knowledge, and not much depth of accounting experience. I leave it to the reader to decide what other similarities there may be.

The politics of costs and the cost of politics

In a large organisation, there are productive departments and support departments. Productive departments are easily identified; in British Leyland by vehicles rolling out of their gates, and in universities by students graduating and research produced. Support departments are notable for a lack of these easily identifiable products. When accounting for individual departments, however, the revenue from the product must pay for both the productive department and the support departments it needs to operate. The costs of the support departments are called overheads. In a university they consist of land and buildings, and such necessary items as vice chancellors and human resources departments. In order to compare the departments and understand what they cost and so have some hope of controlling the costs of the university as a whole, the overheads have to be divided between departments, because that is the level at which most controllable costs are managed. Now it’s easy enough to identify the cost of a laboratory with a STEM department, but how does one divide up a vice chancellor? The answer is politics.

Rationale politics

Every accountant will tell you that the allocation of costs to products through departments must be done on a rational and consistent basis. Every CEO will tell you that that has to be done in a visibly fair way, or they’ll never hear the end of it. But fair is a very, very subjective measure, and fair, rational and consistent measures quite often produce the “wrong” results. What is a “wrong” result? Well, universities are not commercial entities, but charitable trusts. They operate in an environment not so much determined by the immediate reception of their products, which anyway take lifetimes to assess, but more so by donors, governments, and above all by fashions.

To see how this works, let’s take a STEM department, the Mini of any university. They’re highly fashionable. To be taken seriously, a university must have them, and an extensive suite of them. However, a STEM department has high, easily identified overheads of its own, like laboratories, technicians and particle accelerators. Such a STEM department will (must) argue for a basis of allocating overheads which reduces their overhead burden to a minimum, or the cost allocation process might produce the “wrong” result. So as STEM departments tend to have a low ratio of professors to staff compared to Arts departments, they’re likely to argue for the allocation to be in ratio to the number of professors. That’s just one way of doing this, but there are thousands of others. The upshot of this, however, is that a department head can improve their department's numbers by winning an argument about how much cost should be allocated to them in a meeting. That's so much easier than actually being more productive. Worse still, management can favour a particular department by changing the basis of allocation, too, which gives them more control; what is given can always be taken away.

The death spiral

If this is all a bit morally scooby-dubious, it's fine and grand when money is coming in. It has the useful effect of keeping the big boys and wannabes at each others' throats and out of the hair of those who would prefer to spend their brief lives doing more worthwhile things. However, the system is useless for making critical financial decisions, even if it is fair and consistent and not hopelessly corrupted by politics. So, when the pressure is on, and money is tight, this otherwise harmless system for diverting the powerful from annoying ppl becomes a liability. It can turn a crisis into a drama and then a disaster.

What happens is this...

When an organisation's revenues fall, or look like they will, as was the case for British Leyland in the 1970s and is the case in 2024 in universities where it is the fashion to worry profoundly about reductions in the numbers of foreign students, panic sets in. The organisation starts looking at profitability and because it's all set up around departments in the first place, that's how management think in a crisis. Unproductive departments must go, so they look at the department accounts and pick a productive department with the least "profit", and close it. Wonderful! Next year will see a return to profit! Except that it doesn't.

Overheads denominated

Next year doesn’t see a return to profit because the central cost, the overhead, hasn't gone anywhere. That can't be cut. It belongs to the senior management and nobody ever likes to fire someone they have lunch with. Now the same overheads have to be allocated somewhere else, over fewer departments. As the Mathematics Department will tell you, reduce the denominator and the answer to a division calculation will increase. So all departments suddenly have to bear a larger cost. That means the next least profitable department will look even more unprofitable, so next year management close that, this time perhaps a little less optimistically. The following year, of course, more departments look unprofitable, more closures are made. Thus the death spiral begins, and it will destroy all of the productive units, one by one, until it all goes bust. Eventually, in the public sector context, a university will be left with a single administrative department, whose job it is to manage the massive cost implications of closing all the rest.

The hardest part

Close readers of this article will have noticed that above it says, “When an organisation's revenues fall, or look like they will…”. The latter phrase was not superfluous. It is important to understand that an organisation’s revenues do not have to actually fall to initiate the death spiral. When Leicester University commenced its redundancy programme “Shaping for Excellence” in January 2021, it intended to make 140 academics redundant. In the end 230 or more left. In a university of 2,000 odd academic staff, that is a 10%+ reduction in productive capacity and thus in likely revenues, even more in reputation. Wildly optimistic management may dream that the remaining staff can be stretched further, but in the real world that will just lead to further staff losses as the burden and stress on remaining staff increases. Aberdeen University initiated a round of redundancies, apparently fearing a fall in numbers of foreign students. However, no such fall has actually materialised. Sense prevailed and the redundancies were cancelled. In other places, however, the redundancies, initiated in panic at government policies, will do the job all by themselves. After all, the Mini is still a very popular product, produced in large numbers, even if British Leyland is but a ghost.

Copyright Jonathan Mills ACA