What Is the Agency Cost for Business?

A look at the agency problem between shareholders and managers

Group of business executives in meeting in office
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Agency costs are the costs of disagreement between shareholders and business managers, who may not agree on which actions are best for the business. There is an inherent cost to this disagreement and leads to what is called "the agency problem."

The Problem

The principal-agent cost problem is complex and usually requires more than monetary incentives to solve. In essence, the agency problem occurs when the shareholders want management to pursue one course of corporate action in order to maximize shareholder wealth and the managers -- often the board of directors and C-suite principals such as the CEO, President, and Chief Operating Officer -- want to pursue another course, one that may be particularly beneficial to these same managers.

This disagreement is crucial to understanding agency costs. Investors only want to hold stocks of companies in their portfolios that maximize shareholder wealth. If investors think that there is a problem between management and shareholders within a company, they will likely shy away from holding the stock of that company. Ultimately, this will negatively affect the price of the company's stock.

The agency problem is pervasive in our society. It is evident not only in business; it also exists in clubs, government agencies, churches, and many other types of organizations whenever managers and owners are not the same.

Management Vs. Shareholder Goals

In very large corporations, ownership of the company is spread across thousands of stockholders. It is usually in this type of company that the agency problem is most severe because managers may perceive that their full-time dedication to management -- and often their better knowledge of how the company works -- means that their objectives, policies, and implementations deserve priority over the goals of many individual stockholders, each of whom may have only a small financial interest and a limited knowledge of how the company makes its money. The agency problem is most acute when management goals maximize the interests of management at the expense of shareholder wealth. For example, management may not take on projects that would benefit the business because if a project fails, management jobs may be lost. Shareholders may want to accept that risk because if projects succeed, shareholder wealth is maximized.

Other managerial goals might be an increase in employee benefits or in acquisitions that increase the size of the company in the hope that a company's dominance in its market will improve their job security. Shareholders may want employee benefits limited in order to keep down costs and maintain profits, or they may not want the company to spend cash on acquisitions, but instead want the money distributed as dividends.

It may be that, in many firms, managerial and shareholder goals may at least partially match. Shareholders can strengthen this alignment by tying managerial compensation to firm performance. If the goal of stockholder wealth maximization is reached, then managerial compensation is also maximized. Stockholders may also offer stock shares to managers below the market price, but require that managers stay vested in the company for a certain number of years before the stock can be sold.

Given the power of these and other similar incentives, managerial and shareholder goals may align to a degree and the agency problem may be lessened.

Unavoidable Costs

Dealing with the agency problem is never free -- there is an agency cost associated with coping with the agency problem. Such agency costs usually fall under the category of operating expenses. 

For example, company managers, when they travel, may book themselves into the most expensive hotel they can find or they may order extravagant upgrades of executive offices. These actions increase operating costs without any offsetting benefit to the shareholders. The costs associated with monitoring managers regarding these kinds of personal expenses are what makes up agency costs.

Monitoring techniques include proper accounting procedures and establishing budgets that put limits on expenditures. Unfortunately, not all agency costs can be eliminated. Monitoring costs are a significant part of a firm's operating expenses. At some point, they may actually exceed the agency costs.