Agency Cost – an Economic Concept

An agency cost is an internal expense that comes from an agent taking action on behalf of a principal. It is an economic concept concerning the fee to a “principal” (an organization, person or group of persons) when the principal chooses or hires an “agent” to act on its behalf. It is a type of internal company expense that comes from the actions of an agent acting on behalf of a principal. Because the two parties have different interests and the agent has more information, the principal cannot directly ensure that its agent is always acting in its (the principal’s) best interests. It typically arises in the wake of core inefficiencies, dissatisfactions, and disruptions, such as conflicts of interest between shareholders and management. Expenses that are associated with resolving this disagreement and managing the relationship are referred to as agency costs.

As an example, shareholders may want management to run the company in a fashion which increases shareholder value. Agency costs that include fees associated with managing the needs of conflicting parties are called agency risk. Common examples of this cost include that borne by shareholders (the principal), when corporate management (the agent) buys other companies to expand its power or spends money on wasteful pet projects, instead of maximizing the value of the corporation’s worth; or by the voters of a politician’s district (the principal) when the politician (the agent) passes legislation helpful to large contributors to their campaign rather than the voters. Agency costs usually refer to the conflicts between shareholders and their company’s managers. Though the effects of agency costs are present in any agency relationship, the term is mostly used in business contexts. A shareholder wants the manager to make decisions that will increase the share value.

Sources of the costs

The costs consist of two main sources:

  • Costs incurred when the agent (management team) uses the company’s resources for his or her own benefit. The costs inherently associated with using an agent (e.g., the risk that agents will use organizational resource for their own benefit) and,
  • Costs incurred by the principals (shareholders) to prevent the agent (management team) from prioritizing him/herself over shareholder interests. The costs of techniques used to mitigate the problems associated with using an agent—gathering more information on what the agent is doing (e.g., the costs of producing financial statements) or employing mechanisms to align the interests of the agent with those of the principal (e.g. compensating executives with equity payment such as stock options).