Cost efficiency and financial flexibility in institutions of higher education

Donors frequently impose restrictions on the use of contributions to non-profit institutions. These restrictions may be imposed in an attempt to ensure that the objectives of the donors are achieved, to limit administrative accretion (lattice), and to discourage the pursuit of objectives deemed by donors to not be fundamental to the core mission. On the other hand, donor restrictions may be costly to the extent that administrators possess better knowledge of the underlying production/cost function. This study evaluates the degree to which the common perception that the lack of financial flexibility inhibits institutional efficiency is empirically valid in the context of institutions of higher education. The degree of financial flexibility (the ratio of unrestricted net assets to total assets) is used as a measure of the degree to which institutional performance may be constrained by donor restrictions. Our results show a positive relationship between the degree of financial flexibility and cost inefficiency for all types of private higher education institutions. Thus, contrary to common belief, enhanced financial flexibility appears to lead to higher cost inefficiency. Conversely, greater financial restrictions appears to lead to more cost efficiency. This finding suggests that line item budgeting, for example, may not be as ineffective a cost control mechanism as it is commonly perceived to be. More rigorous comparative studies are needed to support the anecdotal evidence often cited to show the inefficiency of line-item budgeting.