Agency costs refer to the costs associated with the relationship between a "principal" and an "agent"[1]. The principal is an organization, person, or group of persons who gives the agent the power to make decisions on their behalf. However, the two parties may have different incentives, and the agent generally has more information. The principal cannot directly ensure that its agent is always acting in its best interests[1]. The following are some key points about agency costs:
1. Types of Agency Costs: Agency costs can occur when the interests of the executive management of a corporation conflict with its shareholders[2]. 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[2]. Other stakeholders such as the government, suppliers, and customers all have their specific interests to look after and that might incur additional costs[1].
2. Examples of Agency Costs: Examples of agency costs include any fees associated with managing the needs of the principal, such as the cost of external auditors to assess the accuracy of the company’s financial statements[4]. Another example is the cost borne by the voters of a politician's district when the politician passes legislation helpful to large contributors to their campaign rather than the voters[1]. In the business context, agency costs can arise in the wake of core inefficiencies, dissatisfactions, and disruptions, such as conflicts of interest between shareholders and management[2].
3. Direct and Indirect Agency Costs: Agency costs are further subdivided into direct and indirect agency costs[4]. Direct agency costs are costs that are directly related to the actions of the agent, such as the cost of external auditors to assess the accuracy of the company’s financial statements[4]. Indirect agency costs are costs that are not directly related to the actions of the agent, such as the cost of shareholders selling off their shares in the business when the managers take the business in a direction that is disagreeable to them[5].
4. How to Reduce Agency Costs: There are several ways to reduce agency costs, such as aligning the interests of the agent and the principal, monitoring the agent's actions, and providing incentives for the agent to act in the best interests of the principal[3].
Citations:
[1] wikipedia
[2] investopedia
[3] wallstreetmojo
[5] accountingtools
[6] freshbooks
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