Agency costs are internal costs incurred due to the competing interests of shareholders (principals) and the management team (agents). Expenses that are associated with resolving this disagreement and managing the relationship are referred to as agency costs.
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.
Direct and Indirect Agency Costs
Agency costs are further subdivided into direct and indirect agency costs.
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.
The Principal-Agent Relationship
The principal-agent relationship plays a major role in agency costs. The principal-agent relationship is an arrangement between two parties in which one party (the principal) legally appoints the other party (the agent) to act on its behalf.
Principal-agent problems occur when the interests of the principal and agent are not aligned. As a result, agency costs are incurred.
To identify a potential principal-agent problem, consider the following example:
You hire the services of a roofer to fix your leaking roof. The hourly wage that you pay to the roofer is $40. A principal-agent problem can arise as the interest of the roofer may not be the same as yours. The roofer, knowing that he is paid hourly, may try to take as much time as possible to fix the roof so that he can make more money. You are unable to prevent this, as you know very little about repairing roofs. The agency cost is the extra amount you pay the roofer to get the roof fixed.
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
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
Recognition from co-workers
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).