What Are Agency Costs?
Typically, agency costs refer to conflicts between shareholders and their company's managers.
While shareholders prefer managers to make decisions which will increase the share value, managers prefer to expand the business and increase their salaries (which may not necessarily increase share value).
How Do Agency Costs Work?
In a publicly-held company, agency costs occur when company management (i.e. “agent”) places their own personal financial interests above those of the shareholder (ie. 'principal').
Agency costs may be incurred if the agent uses the company's resources for their own benefit. They may also occur from shareholders using techniques to prevent the agent from prioritizing their own interests over the shareholders'.
Agency Cost Examples
For example, when traveling for a conference, senior partners incur agency costs by dining at gourmet restaurants and upgrading to first-class flights. These expenses not only increase a company’s operating cost, but they also don’t provide any value to shareholders.
To keep their interests top priority, shareholders may offer the following examples of agency costs such as:
- paying bonuses to management if/when share prices increase
- making management’s salaries partial shares in the company.
If incentive plans work correctly, these agency costs will be lower than costs incurred by management acting in their own interests.
Why Do Agency Costs Matter?
Agency costs can take their toll on a company's share price when there is substantial debt involved.
Since they tend to have separate motivations, agency costs between shareholders and managers often strike a precarious balance. Agency costs are often difficult for accountants to track, and management often has more financial information than shareholders. This means they may be able to take advantage of their decision-making powers within a company. However, shareholders have administrative power that management lacks.