The internal costs incurred due to the competing interests of shareholders (principals) and the management team (agents) are called Agency Costs. It mainly refers to the expenses that are associated with resolving this disagreement and managing the relationship. When there is a separation between 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) we can see an increase in the agency cost during this period.
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Factors such as core inefficiencies, dissatisfactions, and disruptions contribute to agency costs. The fees that are associated with managing the needs of conflicting parties, while evaluating and resolving disputes, is known as agency risk. They are necessary expenses of any organization where the principals do not yield complete autonomous power.
Types of Agency Costs:
- Monitoring Costs: When the board of directors of a company acts on behalf of the shareholders to monitor and restrict the management activities, the cost of being a director is termed as Monitoring Costs.
- Bonding Costs: When an agent commits to contractual obligations that limit or restricts the agent activity is called Bonding Costs.
- Residual Costs: Costs that are insured from divergent principal and agent interests despite using monitoring are termed as residual costs.
- Agency costs incur when the agent (management team) uses the company’s resources for their own benefits or when the principals (shareholders) bear the costs to prevent the agent (managerial team) from giving preference to the company over the interests of shareholders.
- Another example of Agency costs is when the senior management team, when traveling, ends up booking the most expensive hotel or orders unnecessary hotel upgrades. The cost of such actions increases the operating cost of the company while failing to provide any added benefit or value to shareholders.
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How to reduce Agency Costs:
In a principal-agent relationship, the most common method of lowering agency cost is by a reward program. However, when implementing an incentives scheme, we’ve to realize that there are two types of incentives:
- Financial Incentives: Buying shares at a pre-determined price, management receiving a percentage of the company’s profit.
- Non-financial incentives: New office or workspace, Training opportunities, Recognition from co-workers, Corporate car.
Agency costs are not fully eliminated. While it is difficult for an accountant to track the agency costs, it is difficult to prevent them, since principals and agents can have separate motives. They can significantly impact the company’s share price when there is significant debt involved. Many investors seek the ownership of companies that optimize shareholder capital, and they may be worried about buying and holding stocks in a company if they think that there is a problem between management and shareholders within the company.
Author: Mahek Medh
About the Author: Currently, I am in my second year and over the period of time I have realized that I enjoy learning about numbers and money, and I find topics of Finance very interesting thus this is the domain and space where I wish to etch my long term career.