This report examines educational expenditures for all Minnesota public schools for the 1997-98 school year and finds that the cost of educating children in smaller schools was higher than in larger schools. Empirical evidence is presented to demonstrate that a more precise relationship between enrollment and expenditures is log-linear, rather than linear. The current formula for funding schools produces inequities that are detrimental to small rural schools. The current budget categories in the funding of Minnesota's public schools are reviewed, and introduction of a new category is recommended to supplement the existing operating sparsity category. A formula is developed that compensates smaller schools for the higher costs related to lower enrollments, and the additional costs to the state of the new budget category are estimated. It is estimated that the combined operating sparsity and the new "small school revenue" categories will represent just over 0.6 percent of total spending on education in Minnesota. Arguments are offered against consolidation as an answer to the problem. An appendix lists proposed small school revenue for all K-12 school districts in Minnesota. (Contains 15 references.) (Author/SV)