What are agency costs? Included Fees and Examples
Agency costs are internal company expenses resulting from an agent’s actions on behalf of a principal. Agency expenses often follow basic inefficiencies, dissatisfactions, and disturbances like shareholder-management conflicts. Agency costs go to the acting agent.
Understanding Agency Cost
When senior management and shareholders clash, agency expenses might result. If shareholders want management to run the company a certain way, shareholder value increases.
The management may also want to grow the company in ways that conflict with shareholders’ interests. Shareholders would pay agency costs.
In 1932, American economists Gardiner Coit Means and Adolf Augustus Berle discussed corporate governance as an “agent” and a “principal,” applying these principles to large corporations, where directors and managers had different interests from owners.
Principal-agent relationships mostly involve shareholders and management and constitute the opposing party dynamic. This scenario involves shareholders as principals and management as agents.
Other pairs of connected parties with similar power characteristics may also be principal-agent relationships. Politicians and voters (agents and principals) can incur agency fees. Agency expenses occur when politicians pledge legislative activities while competing for office but don’t follow through. The principle-agent dynamic is extended to “multiple principal problems” when one person acts on behalf of a group.
Closer Look at Agency Costs
Agency expenditures include fees for reviewing and resolving conflicts and managing competing parties’ needs. This is agency risk cost. Any organization with limited primary autonomy must pay agency charges.
Their failure to benefit their agents can hurt their profits. These costs include economic incentives like performance bonuses, stock options, and other carrots to motivate agents to do their jobs. The agent promotes a company’s success, aligning stakeholder interests.
Shareholders who disagree with management may hold the company’s stock less long-term. A mass sell-off could occur if a certain move causes enough stockholders to sell their shares, lowering the stock price. Therefore, corporations have a financial incentive to benefit shareholders and improve their financial condition to avoid falling stock prices.
A large share purge could also deter new investors, triggering a chain reaction that could lower stock values.
When shareholders are unhappy with a company’s top brass, they may try to elect new directors. If shareholders elect new board members, management can be ousted. This shocking move can cost money, time, and mental energy.
In top-chain power recalibration, such upheavals produce irritating and expensive red tape.
Real-World Agency Cost Example
Financial scandals like the 2001 Enron crisis highlight agency concerns. According to SmallBusiness.chron.com, the company’s board of directors and senior officers sold their stock shares at higher prices due to incorrect accounting information that inflated their value. The Enron share price plummeted, costing shareholders a lot of money.
The Journal of Accountancy explains the Enron scandal as “individual and collective greed born in an atmosphere of market euphoria and corporate arrogance.”
- Agency costs are internal expenses incurred by agents acting on behalf of principals.
- Inefficiencies, dissatisfactions, and disruptions raise agency expenses.
- Agency risk includes payments for handling conflicting parties’ needs.
- Company management and stockholders are agents-principals.