What Is Agency Cost?

Definition & Examples of Agency Cost

Business executives in a meeting
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Agency costs are the costs of disagreement between shareholders and business managers. Shareholders and managers often find themselves in disagreement about the best moves a company can make, and this is known as the "agency problem." Costs stemming from agency problems are agency costs.

Here's what you need to know about how agency costs affect corporations and some common examples you may find in the real world.

What Is Agency Cost?

A business's owners and managers don't always see eye to eye. Some actions would benefit one party over the other, so there's a level of tension that persists. It is from this tension that agency costs arise.

There are two types of agency costs, but they both stem from that same inherent tension between shareholders and managers. The first type of agency cost is when managers use resources to further their own goals—at the expense of shareholders' goals (like when a manager books a luxurious hotel room during a business trip). The second type of agency cost is when shareholders spend resources to monitor managers and ensure that the first type of agency cost doesn't occur (like when shareholders must review all travel expenditures to ensure that managers didn't book overly expensive hotels).

Shareholders sometimes have to decide which type of agency cost they prefer to incur. For example, implementing oversight accounting procedures and establishing budgets for managerial spending can become a significant part of a firm's operating expenses. At a certain point, these kinds of agency costs may actually exceed the agency costs shareholders would have incurred by simply letting managers spend as they please.

How Does Agency Cost Work?

Agency costs occur when the shareholders and management diverge on their ideas of actions a company should take. Shareholders may want to pursue one course of corporate action to maximize shareholder wealth, and the managers—including the board of directors, the CEO, and other high-level officials—want to pursue another course. Specifically, these two parties are diverging on whether or not to do something that may be particularly beneficial to these same managers.

Large corporations provide the clearest examples of agency problems and costs. In these big companies, ownership is spread across thousands of stockholders. Managers may feel like their policies and objectives have priority—they have a full-time dedication to management and an intimate understanding of the inner workings of the company, while many individual stockholders have just a small financial stake in the company and little knowledge about how the company operates.

While they may feel justified, a manager who acts in opposition to shareholders' wishes creates agency costs. In some cases, a manager doesn't even need to act to create agency cost; if shareholders have reason to believe a manager will act against their wishes, they may decide to spend time and resources preventing those actions, and those expenditures are an agency cost.

Agency costs don't just apply to large corporations. Anytime the owners and managers of an organization are different entities, the agency problem arises. That means agency costs can occur within social clubs, government agencies, religious organizations, and more.

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 risky projects that would benefit the business because, if the project fails, they may lose their jobs. Shareholders, on the other hand, want to take on that risk so they can try to maximize the value of their ownership.

Another fairly common example would include an increase in employee benefits. Shareholders may want to limit employee benefits to keep down costs and maximize profits (which may later be distributed as dividends).

Reducing the Agency Problem

Shareholders and managers aren't always at odds. The two parties can usually find plenty to agree on, and there are actions shareholders can take to minimize agency costs.

For example, shareholders can link managerial compensation to firm performance. This ties together their interests—if the goal of stockholder wealth maximization is reached, then managerial compensation is also maximized. Another strategy would be for shareholders to offer shares to managers below the market price, but only if the managers stay vested in the company for a certain number of years.

Agency problems can affect stock prices. Many investors seek out stocks of companies that maximize shareholder wealth. If investors think that there is a problem between management and shareholders within a company, they may shy away from buying and holding stock in that company. Ultimately, this will negatively affect the price of the company's stock.

While the scenarios above reduce the agency problem, they could be seen as agency costs in and of themselves. Dealing with the agency problem is never free. Extra compensation tied to firm performance is a cost that shareholders pay to reduce the agency problem—making it an agency cost. Offering shares at a reduced price—even if the shares have a vesting period—is another cost paid by shareholders.

Key Takeaways

  • Agency costs refer to costs incurred by shareholders due to disagreements between an organization's owners and managers.
  • One type of agency cost occurs when managers spend resources on ventures that benefit themselves, but not the shareholders.
  • The other type of agency cost is when shareholders spend resources to monitor managerial actions and ensure that the first type of agency cost does not occur.
  • The inherent tension between owners and managers is known as the agency problem.