What it is:
Agency costs usually refers to the conflicts between shareholders and their company's managers. A shareholder wants the manager to make decisions which will increase the share value. Managers, instead, would prefer to expand the business and increase their salaries, which may not necesarrily increase share value.
How it works (Example):
In a publicly-held company, agency costs occur when a company's management or "agent" places his own personal financial interests above those of the shareholder or "."
Agency costs can be either:
A) the costs incurred if the agent uses to company's resources for his own benefit; or
B) the cost of techniques that principals use to prevent the agent from prioritizing his interests over the shareholders'.
To prevent the agent from acting to benefit himself, shareholders may offer financial incentives to keep shareholders' interest as the top priority. This typically means paying bonuses to management if and when share price increases or by making the management's salary partiall shares in the company. These monetary incentives are an example of agency costs. If the incentive plan works correctly, however, these agency costs will be lower than the cost of allowing the management to act in his own interests.
Why it Matters:
Agency costs really take their toll on a company's share price when there is substantial debt involved. Shareholders and bondholders have severe conflicts of interest, but shareholders have administrative power. They will pursue selfish strategies which will impose agency costs and lower the market value of the whole firm.
Though they are difficult for an accountant to track, agency costs are difficult to avoid as principals and agents can have separate motivations. Management can have more information than share holders and can take advantage of their decision-making power over the company.
A non-financial way to consider agency costs is often the conflict of interest between voters and politicians. Voters select their representatives to act in their best interests, but the representatives gain the law-making power and will often act to maintain their positions of power instead of to fulfill their promises to constituents.