What are Agency Costs?

Agency costs are costs incurred to handle agency problems. These problems occur due to conflicts between the shareholders (principal) and managers (agents). The agency costs are used to mitigate the conflicts. Usually, there should be no conflicts between principals and agents in a company setting but if shareholders think that managers are utilizing too many funds for their self-interest agency problems may arise.

Types of Agency Costs

There are two broad categories of agency costs. The first arises when the managers use the company's resources for self-benefits and the second when shareholders spend money to discipline the managers.

There are two sub-types of agency costs associated with an agency problem.

Note −Agency costs are divided broadly into two categories − direct and indirect agency costs

Direct Agency Cost

The direct agency cost has two types −

• Corporate expenses that benefit the managers at the cost of shareholders' resources.

• The expenditure required to monitor the management team's activities so that the principal's resources stay intact and no agency problems occur in the future.

One example of the first type of agency cost is when the managers book the most expensive air ticket for travel when it is unnecessary.

An example of the second type of agency costs is the money spent on auditing the company's performance and management's productivity.

Indirect Agency Costs

The agency costs that represent lost opportunities are known as indirect agency costs. For example, the shareholders might think that undertaking a project might add value to the stock but management may think that it will lead to erosion of stock value. In the conflict, shareholders may lose a valuable and important opportunity. This is called indirect agency cost.

Note −The resources that are lost due to missing an opportunity due to agency problems are known as indirect agency costs.

The Relationship between Principal and Agent

The principal-agent relationship plays a key role in agency cost. The principal or shareholders appoint managers (agents) to act on behalf of them. In case the agents start to deviate from the given and responsible path agency problems may occur.

For example, if you provide a project to a manager at an hourly rate rather than a contract for the whole project, he or she might take a longer time to earn more money. Here the extra money spent on the project is the agency cost.

Reducing Agency Costs

Although it is not possible to eliminate agency costs completely, principals and agents may agree upon some issues at the outset of their relationship. The most common procedures of maintaining a positive agency situation are −

• Stock Options − Management may be offered shares of the company.

• Monetary benefits − Management may be recognized with monetary benefits.

Note − Agency costs are hard to mitigate because agency problems cannot be nullified completely.