Table of Contents
What is Agency Cost?
Agency cost is the cost incurred because of conflict that arises between the shareholders and the managers of a company. These conflicts arise because shareholders want the managers to take decisions that will benefit them. On the other hand, managers are willing to take decisions that will benefit them or expand the business. This cost of disagreement is also called the agency cost.
Types of Conflicts and Parties Involved in Agency Cost
As per agency theory, the conflicts in an organization can take place between different parties. Following are the types of conflicts in an organization.
- The first type of conflict arises between the owners of the business and its managers. The owners are the principal and the managers act as the agents. The conflict arises because the managers are not satisfied with the decisions taken by the owners. The reason for conflict can be manager’s remuneration, owners enjoying high perquisites, owners pursuing self-goals, etc.
- The second type of conflict arises between the owners. A business has two types of owners; one who have the controlling or majority stake in the firm and the others who have the non-controlling or minority stake in the firm. The conflict between them arises when the controlling owners fail to assure the minority holders that they will not be exploited. The lack of trust between them leads to conflicts. Here, non-controlling owners act as the principal and the majority owners as the agents of the company.
- The third type of conflict arises between the owners of the firm and its stakeholders. The stakeholders are the people or parties with whom the business does its dealings. The parties involved are government, creditors, employees, shareholders, customers, etc. The conflict arises when the stakeholders feel that the owners are taking undue benefit of their position.
Due to the above problems, the business faces two types of agency costs, they are
Types of Agency Cost
Agency Cost of Debt
Agency cost of debt is the increase in the cost of debt of an organization. When there is a conflict between the shareholders and the debt holders, the debt suppliers like bondholders impose constraints on the use of their money. The debt suppliers in order to protect themselves from the ongoing conflict take preventive measures in form of higher interest rates. This leads to agency cost of debt.
Agency Cost of Equity
Agency cost of equity arises due to differences between the shareholders and the management of the company. When the management diverges from the interest of shareholders for any reason, the shareholders have to bear the cost. Therefore, agency cost of equity is the cost involved to keep a check on management’s decision-making by the shareholders.
How to Reduce Agency Cost
Dealing with agency problems is never free. It involves agency cost to cope up with the conflicts. In the accounts, the cost incurred is usually categorized under operating expenses.
One of the examples of agency cost is, expenses incurred by the managers on booking most expensive hotels for business trips. Shareholders may find this as unnecessary cost leading to an increase in the operating costs of the company. Therefore, the cost incurred on monitoring the managers regarding such personal expenses is what forms agency cost.
Agency cost can be reduced by introducing monitory techniques in the organization. Such techniques include establishing budgets, following proper accounting procedures, getting approvals, etc. These techniques can eliminate or put a limit on the expenditures.
Agency cost is a part of every organization. These costs hurt the organization and the shareholders. Thus, it is the duty of the business owners and managers to be vigilant and prudent in decision-making. These costs can be avoided if the management is proactive and willing to take quick actions in case of any conflicts in the organization.1–4