What is Agency Cost?

Agency cost is commonly referred to as the company’s disagreements between shareholders and managers and the expenses incurred to resolve this disagreement and maintain a harmonious relationship. This form of dispute becomes obvious as the principals or the shareholders want the company’s managers to run it to maximize the shareholders’ value. On the other hand, the managers want to operate to maximize the wealth. This might even affect the market value of the company. Therefore, the expenses to handle these opposing interests are termed agency costs.

Example of Agency Cost

Let’s take the example of agency costs.

Key Takeaways

  • Agency cost refers to a typical corporate situation due to disagreements between shareholders and managers; the cost incurred to resolve the conflict and maintain a cordial relationship is known as agency cost.These costs are of two types: Direct agency costs include monitoring costs, bonding costs, and residual losses. Indirect agency costs refer to costs incurred when companies cancel potential projects. It intends to harmonize the interests and benefits of management and shareholders. On the other hand, if a debt is involved in agency costs, it may affect the share price of the company’s stock.

If the management involves building an office area and premises on huge acres of land and then hiring 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 companyOperating Costs Of The CompanyOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more. This reduces the company’s profits and thereby affects 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 cost 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 company’s management are aligned to the benefits of the shareholders, and these restrict the activities of the administration. The cost of maintaining the board of directorsBoard Of DirectorsBoard of Directors (BOD) refers to a corporate body comprising a group of elected people who represent the interest of a company’s stockholders. The board forms the top layer of the hierarchy and focuses on ensuring that the company efficiently achieves its goals.
  • read more therefore to a certain extent, is also a part of the monitoring costs. Other examples of the monitoring costs are the employee stock options planEmployee Stock Options PlanEmployee stock option plan (ESOP) is an “option” granted to the company employee which carries the right, but not the obligation, to buy a promised number of shares at a pre-determined price (known as exercise price). read more available for the employees of a company.Bonding Costs: Contractual obligations are entered between the company and the agent. A manager stays with a company even after it is acquired, who might forgo the employment opportunities.Residual Losses: If the monitoring bonding costs are not enough to diverge the principal and agent interests, additional costs are incurred, called the residual costs.

#2 – Indirect Agency Cost

The indirect agency costs refer to the expenses incurred due to the opportunity lost. For example, there is a project that the management can undertake which might result in the termination of their jobs. However, the company’s shareholders believe that if the company undertakes the project, it will improve its values. If, however, the project is rejected, 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 implementing an incentive scheme, which can be of two types: financial and non-financial incentives schemes.

#1 – Financial Incentives Scheme

Financial incentives help the agents by motivating them to act for the interest of the company and its benefits. The management receives such incentives when performing well on a project or achieving 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 predetermined number of shares are available to be bought by the employees at a price that 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 in reducing 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.

Benefits

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

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.

This has been a guide to what agency costs are and their definition. Here we discuss its types and examples of agency cost along with benefits and limitations. You can learn more about accounting from the following articles –

We employ two alternative efficiency ratios that accountants often use to calculate the firm’s agency costs: the expense ratio, which is calculated by dividing operational expenses by annual sales, and the asset utilization ratio, which is calculated by dividing yearly sales by total assets.

The costs associated with an agent-principal relationship that occurs due to inefficiency. Agency expenses occur due its executives (the agents) may act against shareholders’ interests when acting in their own best interests (the principals).

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