Agency cost

Agency cost
See also
Net line Principal agent problem Committed capital Meaning of synergy Contingent staffing Pure risk Hybrid instrument Termination clause Joint venture

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:

1. Monitoring expenditures
2. Bonding expenditures
3. 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.

References

• Jensen M. C., Meckling W. H. (1976), Theory of the firm: Managerial behavior, agency costs and ownership structure, "Journal of Financial Economics", Vol 3 Issue 4.
• Mustapha M., Che-Ahmad A. (2011), Agency costs of debt and monitoring, "International Review of Business Research Papers", Vol 7 No 4.
• Pae J., Thornton D. B., Welker M. (2008), Agency cost reduction associated with EU financial reporting reform, "Journal of International Accounting Research", Vol 7 No 1.
• Peterson C. L. (2007), Preemption, agency cost theory, and predatory lending by banking agents: are federal regulators biting off more than they can chew, "American University Law Review", Vol 56 Issue 3.
• Rashid A. (2015), Revisiting agency theory: Evidence of board independence and agency cost from Bangladesh, "Journal of Business Ethics", Vol 130 Issue 1.
• Songini L., Gnan L. (2013), Family involvement and agency cost control mechanisms in family small and medium‐sized enterprises, "Journal of Small Business Management", Vol 53 Issue 3.

Author: Magdalena Wojslaw