Agency cost is a cost that arises in the situation where the interest of the managers is satisfied at the expense of the shareholders. Agency costs emerge from the agency relationship. Agency relationship is a type of contract where the principal (usually shareholders) engage an agent (usually managers) to act on his behalf. Some of the principal's authorities are often delegated to an agent. If both parties aim to maximize their profits, it is likely that the agent will not always perform in the principal's best interest.
Agency costs do not arise when ownership and management overlap in the company. It can be achieved in the organizations based on family ownership. On the other hand, family firms are facing conflicts and costs coming from different sources.
Benefits and disadvantages of agency agreements
Agency relationships tend to be mutually beneficial. Shareholders hire managers to take advantage of their skills and insights. While undoubtedly advantageous, agency relationships have also certain disadvantages. One of the reasons is the fact that principals and agents have different incentives to manage the organization's fund: while shareholders have invested in the company the actual wealth, agents are standing on a position where they have less to risk.
Types of agency costs
Agency costs can be defined as the sum of the following:
- Monitoring expenditures
- Bonding expenditures
- Residual loss
Monitoring expenditures are the costs of observing an agent's behavior. It includes some of the audit costs, budget restrictions or internal policies. The second type, bonding expenditures, can be incurred when a premium is paid to an agent. The aim of bonding expenditures is to decrease the risk that the agent will act in a way that is harmful to the principal. Increasing the cost of bonding may reduce the need of incurring the monitoring costs.
If it is not possible to monitor or bond the agent, it is likely that the interest of the principal and the agent will vary. The cost incurred as a result of that situation is called residual loss. Residual loss is usually the dominating agency cost.
Examples of Agency cost
- Agency cost is the cost associated with the conflict of interest between owners (principals) and managers (agents) of a company. It can arise when agents act in their own best interests instead of acting in the best interests of the principals.
- One example of agency cost is when a company’s management team is incentivized to pursue their own goals instead of the company’s goals. For example, if a company's CEO is given a bonus if the company's stock price increases, they may be tempted to pursue short-term strategies that could benefit them personally, but not the company or its shareholders in the long run.
- Another example of agency cost is when agents have access to confidential information about a company and use it for their own benefit. For example, if a company's management team has access to inside information about a potential merger, they may use that information to purchase stock in the company before the news is released to the public, leading to a potential conflict of interest.
- A third example of agency cost is when agents are incentivized to take risks that may not be in the best interests of the principals. For example, if a company's management team is given a bonus if the company's profits exceed a certain threshold, they may be tempted to take on excessive risks in order to achieve the bonus, which could have long-term negative consequences for the company.
- A fourth example of agency cost is when agents do not act in the best interests of the company due to their own biases. For example, a company's management team may be biased towards certain suppliers or vendors, leading to decisions that are not in the best interests of the company.
Financial management and agency cost are closely related. Agency costs arise when the interests of the agent (e.g. a manager) and the interests of the principal (e.g. the shareholders) are not perfectly aligned. Other approaches related to agency cost include:
- Aligning incentives: Aligning the incentives of the agent and the principal through, for example, performance-based compensation and stock options, can help to reduce agency costs.
- Monitoring: Monitoring the agent's behavior through, for example, internal control systems and external audit, can help to reduce agency costs.
- Governance: Establishing good corporate governance practices, such as independent directors and a strong board of directors, can help to reduce agency costs.
In conclusion, financial management and agency cost are closely related, and there are various approaches to mitigating agency costs, such as aligning incentives, monitoring, and establishing good corporate governance practices.
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Author: Magdalena Wojslaw