What Are Agency Costs?

An agency cost is a type of internal company expense which comes from the actions of an agent acting on behalf of a principal. Agency costs typically arise in the wake of core inefficiencies, dissatisfactions and disruptions, such as conflicts of interest between shareholders and management. Payment of the agency cost is to the acting agent.

As early as 1932, American economists Gardiner Coit Means and Adolf Augustus Berle discussed corporate governance in terms of an “agent” and a “principal,” in applying these principals towards the development of large corporations, where the interests of the directors and managers differed from those of owners.

The Principal-Agent Relationship of Agency Cost

As an example, shareholders may want management to run the company in a fashion which increases shareholder value. Conversely, the administration may look to grow the company in other ways which may conceivably run counter to the shareholders’ best interests.

This opposing party dynamic, known as the principal-agent relationship, primarily refers to the relationships between shareholders and management personnel. In this scenario, the shareholders are principals, and management operatives act as agents. However, the principal-agent relationship may also refer to other pairs of connected parties with similar power characteristics, such as the relationship between politicians, functioning as agents and communities of voters, functioning as principals. In an extension of the principal-agent dynamic known as the "multiple principal problems" describes a scenario where a person acts on behalf of a group of other individuals.

Key Takeaways

  • An agency cost is an internal expense that comes from an agent taking action on behalf of a principal.
  • Core inefficiencies, dissatisfactions, and disruptions contribute to agency costs.
  • Agency costs that include fees associated with managing the needs of conflicting parties are called agency risk.
  • An example of an agent-principal relationship is the relationship between a company's management (agent) and its shareholders (principal).

A Closer Look at Agency Costs

Agency costs include any fees associated with managing the needs of conflicting parties, in the process of evaluating and resolving disputes. This cost is also known as agency risk. Agency costs are necessary expenses within any organization where the principals do not yield complete autonomous power. Due to their failure to operate in a way which benefits the agents working underneath them, it can ultimately negatively impact their bottom lines. These costs mainly refer to economic incentives such as performance bonuses, stock options and other carrots which would stimulate agents to execute their duties properly. The agent's purpose is to help a company thrive, thereby aligning the interests of all stakeholders.

Dissatisfied Shareholders

Shareholders who disagree with the direction management takes, may be less inclined to hold on to the company’s stock over the long term. Also, if a specific action triggers enough shareholders to sell their shares, a mass sell-off could happen, resulting in a decline in the stock price. Additionally, a significant purge of shares could potentially spook potential new investors from taking positions, thus causing a chain reaction which could depress stock prices even further.

In cases where the shareholders become particularly distressed with the actions of a company’s top brass, an attempt to elect different members to the board of directors may occur. The ouster of the existing management can happen if shareholders vote to appoint new members to the board. Not only can this jarring action result in significant financial costs, but it can also result in the expenditure of time and mental resources. Such upheavals also cause unpleasant and exorbitant red-tape problems, inherent in top-chain recalibration of power.

Real World Example

Some of the most notorious examples of agency risks come during financial scandals which make headlines, such as the Enron debacle in 2001. As reported in this article on SmallBusiness.chron.com, the company's board of directors and senior officers sold off their stock shares at higher prices, due to fraudulent accounting information, which artificially inflated the stock’s value. As a result, shareholders lost significant money, when Enron share price consequently nosedived.

Broken down to its simplest terms, according to the Journal of Accountancy, the Enron debacle happened because of "individual and collective greed born in an atmosphere of market euphoria and corporate arrogance."