Released through freedom of information laws, Delivering Value for Money through Infrastructural Change was commissioned by the former Learning and Skills Council and inherited by the Skills Funding Agency in April 2010.
The majority of colleges are rated as good or outstanding by Ofsted, however, KPMG warns a small number are suffering financially and face closure as the sector downsizes.
"Quality provision in FE must be maintained as the sector down-sizes the number of general further education college providers, possibly by up to 50 colleges," the report says.
"For many failing, struggling and vulnerable colleges, merger may either take too long ... or represent the last resort."
Geoff Russell, chief executive of the Skills Funding Agency, acknowledges all colleges are under pressure to deliver "better for less".
Mr Russell said: "This report will hopefully trigger further debate about how we can all achieve greater efficiencies without affecting the quality of delivery. The Skills Funding Agency wants to contribute to sector thinking, not to impose solutions.
"Having shared and discussed the report with key opinion formers, the sector recognises the challenges and we believe they will rise to those challenges. The Skills Funding Agency and the Department for Business Innovation and Skills will continue to work with the sector in this regard."
Although college income is set to decline in line with public finances over the next few years, Association of Colleges chief executive Martin Doel believes KPMG's report is overly bleak.
"Colleges are right to plan for harder times ahead, but they are also quick to seize opportunities," said Mr Doel.
"Apprenticeships, part-time higher education, courses for 14-year-olds and privately funded adult education are all possible areas of future income growth, in addition to the core areas of 16 to 18 education."
(Pictured: Geoff Russell, chief executive of the Skills Funding Agency)