What is Agency Cost?
Agency Cost is commonly referred to as the disagreements between shareholders and managers of the company and the expenses incurred to resolve this disagreement and maintain a harmonious relationship. This form of disagreement becomes obvious as the principals or the shareholders want the managers of the company to run it to maximize the shareholders’ value, while, on the other hand, the managers want to operate in a way to maximize the wealth. This might even affect the market value of the company. The expenses to handle these opposing interests are termed agency costs.
Example of Agency Cost
Let’s take the example of agency costs.
If the management involves in building the office area and premises on huge acres of land and then hire personnel to maintain the same, where the land does not add value to its costs and the employees – The management is simply adding up the operating costs of the company. This reduces the profits of the company and thereby affecting the value of the benefit received by any shareholder. This is a form of opposing interests and needs to be addressed – which involves a type of cots named the agency costs.
Types of Agency Cost
Agency costs can be broadly classified into two types: Direct and Indirect Agency costs.
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#1 – Direct Agency Cost
- Monitoring Costs: When the activities of the management of the company are aligned to the benefits of the shareholders and these restrict the activities of the management. The cost of maintaining the board of directors therefore to a certain extent is also a part of the monitoring costs. Other examples of the monitoring costs are the employee stock options plan available for the employees of a company.
- Bonding Costs: Contractual obligations are entered between the company and the agent. A manager continues to stay with a company even after it is acquired, who might forego the employment opportunities.
- Residual Losses: In case the monitoring bonding costs are not enough to diverge the principal and agent interests, additional costs are incurred which are called the residual costs.
#2 – Indirect Agency Cost
The indirect agency costs are those that refer to the expenses incurred due to the opportunity lost. For example, there is a project that the management can undertake but might result in the termination of their jobs. However, the shareholders of the company are of the opinion that if the company undertakes the project it will improve the shareholders’ values and if the management rejects the project it will have to face a huge loss in terms of shareholders’ stake. Since this expense is not directly quantifiable but affects the interests of the management and shareholders, it becomes a part of the indirect agency costs.
How to Limit Agency Costs?
The most common method to handle the agency costs involved in a company is by way of implementing incentive scheme, which can be of two types: financial and non-financial incentives scheme.
#1 – Financial Incentives Scheme
Financial incentives help the agents by motivating them so that they can act for the interest of the company and its benefits. The management receives such incentives when they perform well on a project or achieves the required goals. Certain examples of the financial incentives scheme are :
- Profit-Sharing Scheme: The management becomes eligible to receive a certain percentage of the company’s profits as a part of the incentive scheme.
- Employee Stock Options: A pre-determined number of shares are available to be bought by the employees at a price which is usually lower than the market.
#2 – Non-financial Incentives Scheme
This scheme is less prevalent than the financial incentives scheme. These are less effective to reduce the agency costs when compared to the financial incentives scheme. Some of the common examples are :
- Non – financial rewards and recognition from peers and colleagues.
- Corporate services and added benefits.
- Better workspace.
- Better or improved opportunities.
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 market value of the firm remains intact and improves in the eyes of the stakeholders of the company.
Some of the limitations are as follows:
- It means the involvement of financial resources which ultimately impacts the company’s balance sheet.
- 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.
It is an important point 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 really help to reduce agency costs. The management, if left to handle the disagreements and the competing interests, would mean to act in its own interest and lead to incurring much higher costs.
This has been a guide to what is Agency Cost and its definition. Here we discuss its types and examples of agency cost along with benefits and limitations. You can learn more about accounting from following articles –