What are Agency Costs?

What are Agency Costs?

An agency cost is a type of internal company expense, which comes from the actions of an agent acting on behalf of a principal. Agency costs typically arise in the wake of core inefficiencies, dissatisfactions, and disruptions, such as conflicts of interest between shareholders and management. The payment of the agency cost is to the acting agent.

The key takeaway point is that these costs arise from the separation of ownership and control. Shareholders want to maximize shareholder value, while management may sometimes make decisions that are not in the best interests of the shareholders (i.e., those that benefit themselves).

For example, agency costs are incurred when the senior management team, when traveling, unnecessarily books the most expensive hotel or orders unnecessary hotel upgrades. The cost of such actions increases the operating cost of the company while providing no added benefit or value to shareholders.

Two categories of agency costs:

  • Costs incurred when the agent (management team) uses the company’s resources for his or her own benefit.
  • Costs incurred by the principals (shareholders) to prevent the agent (management team) from prioritizing him/herself over shareholder interests.

introduction of Agency Cost

Agency costs can occur when the interests of the executive management of a corporation conflict with its shareholders. Shareholders may want management to run the company in a certain manner, which increases shareholder value.

Conversely, the management may look to grow the company in other ways, which may conceivably run counter to the shareholders’ best interests. As a result, the shareholders would experience agency costs.

As early as 1932, American economists Gardiner Coit Means and Adolf Augustus Berle discussed corporate governance in terms of an “agent” and a “principal,” in applying these principals towards the development of large corporations, where the interests of the directors and managers differed from those of owners.

How Does Agency Cost Work?

Agency costs occur when the shareholders and management diverge on their ideas of actions a company should take. Shareholders may want to pursue one course of corporate action to maximize shareholder wealth, and the managers—including the board of directors, the CEO, and other high-level officials—want to pursue another course. Specifically, these two parties are diverging on whether or not to do something that may be particularly beneficial to these same managers.

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Large corporations provide the clearest examples of agency problems and costs. In these big companies, ownership is spread across thousands of stockholders. Managers may feel like their policies and objectives have priority—they have a full-time dedication to management and an intimate understanding of the inner workings of the company, while many individual stockholders have just a small financial stake in the company and little knowledge about how the company operates.

While they may feel justified, a manager who acts in opposition to shareholders’ wishes creates agency costs. In some cases, a manager doesn’t even need to act to create agency cost; if shareholders have reason to believe a manager will act against their wishes, they may decide to spend time and resources preventing those actions, and those expenditures are an agency cost.

Types of Agency Cost

Agency Cost of Debt

Agency cost of debt is the increase in the cost of debt of an organization. When there is a conflict between the shareholders and the debt holders, the debt suppliers like bondholders impose constraints on the use of their money. The debt suppliers in order to protect themselves from the ongoing conflict take preventive measures in form of higher interest rates. This leads to agency cost of debt.

Agency Cost of Equity

Agency cost of equity arises due to differences between the shareholders and the management of the company. When the management diverges from the interest of shareholders for any reason, the shareholders have to bear the cost. Therefore, agency cost of equity is the cost involved to keep a check on management’s decision-making by the shareholders.

Direct and Indirect Agency Costs

Agency costs are further subdivided into direct and indirect agency costs.

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There are two types of direct agency costs:

  • Corporate expenditures that benefit the management team at the expense of shareholders
  • An expense that arises from monitoring management actions to keep the principal-agent relationship aligned

The first type of direct agency costs is illustrated above, where the management team unnecessarily books the most expensive hotel or orders unnecessary hotel upgrades that do not add value or benefits to shareholders.

An example of the second type of direct agency cost is paying external auditors to assess the accuracy of the company’s financial statements.

Indirect agency costs represent lost opportunities. Say, for example, shareholders want to undertake a project that will increase the stock value. However, the management team is afraid that things might turn out badly, which might result in the termination of their jobs. If management does not take on this project, shareholders lose a potentially valuable opportunity.

This becomes an indirect agency cost because it arises out of the shareholder/management conflict but does not have a directly quantifiable value.

Agency Cost of Debt

The agency cost of debt is the increase in the cost of debt or the implementation of debt covenants for fear of agency cost problems. Debt financiers in a company are not in control of their money – company management is.

Agency cost of debt generally happens when debt holders are afraid the management team may engage in risky actions that benefit shareholders more than bondholders. For fear of potential principal-agent problems in the company, debt suppliers may place constraints (such as debt covenants) on how their money is used.

Reducing Agency Costs

The most common way of reducing agency costs in a principal-agent relationship is to implement an incentives scheme. There are two types of incentives: financial and non-financial.

Financial incentives are the most common incentive schemes. For example, it may be decided that if an organization achieves a certain goal, then the management team will receive a monetary bonus. Financial incentives based on performance help motivate agents to act in the best interest of the company. Examples of financial incentives are:

  • Stock options: Allow the person to buy a particular number of shares at a predetermined price
  • Profit-sharing: Management receives a percentage of the company’s profits
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Non-financial incentives are less commonly used and are often not as successful at reducing costs, as compared to financial incentives. Examples of non-financial incentives are:

  • New office or workspace
  • Training opportunities
  • Recognition from co-workers
  • Corporate car

It is important to note that agency costs cannot be fully eliminated. Incentives themselves are actually agency costs. The point of these incentives, if implemented correctly, is to lower those costs, as compared to allowing the management to act in his or her own interests (which would likely incur higher costs).

Benefits of Agency Costs

Some of the benefits are as follows:

  • They are targeted towards aligning the management and shareholders’ benefits and interests. This means keeping the company in good shape for both parties.
  • Due to the right application of these agency costs, the firm’s market value remains intact and improves in the eyes of the stakeholders of the company.

Limitations of Agency Costs

Some of the limitations are as follows:

  • It means the involvement of financial resources which ultimately impacts the company’s balance sheet.
  • It might involve higher or more resources than usual practice in some cases where both the parties – the principal and agent- are difficult to align with all incentives or costs involved.
  • They might impact the share price of the company’s stock in case a substantial size of the debt is involved.

Conclusion

It is important to note that agency costs are nearly impossible to be eliminated by any corporation. However, as mentioned, the incentive schemes should be appropriately used as they help to reduce agency costs. If left to handle the disagreements and competing interests, the management would mean acting in its good and incurring much higher prices.