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Definition of 'Agency Costs'

A type of internal cost that arises from, or must be paid to, an agent acting on behalf of a principal.

Agency costs arise because of core problems such as conflicts of interest between shareholders and

management. Shareholders wish for management to run the company in a way that increases

shareholder value. But management may wish to grow the company in ways that maximize theirpersonal power and wealth that may not be in the best interests of shareholders.

Some common examples of the principal-agent relationship include: management (agent) and

shareholders (principal), or politicians (agent) and voters (principal).

Agency costs are inevitable within an organization whenever the principals are not completely in charge;

the costs can usually be best spent on providing proper material incentives (such as performance

bonuses and stock options) and moral incentives for agents to properly execute their duties, thereby

aligning the interests of principals (owners) and agents.

What It Is:

Agency costs usually refers to the conflicts between shareholders and their company's managers. A

shareholder wants the manager to make decisions which will increase the share value. Managers,

instead, would prefer to expand the business and increase their salaries, which may not necesarrily

increase share value.

How It Works/Example:

In a publicly-held company, agency costs occur when a company's management or "agent" places hisown personal financial interests above those of the shareholder or "principal."

Agency costs can be either:

A) the costs incurred if the agent uses to company's resources for his own benefit; or

B) the cost of techniques that principals use to prevent the agent from prioritizing his interests over the

shareholders'.

To prevent the agent from acting to benefit himself, shareholders may offer financial incentives to keep

shareholders' interest as the top priority. This typically means paying bonuses to management if and

when share price increases or by making the management's salary partiall shares in the company. These

monetary incentives are an example of agency costs. If the incentive plan works correctly, however,

these agency costs will be lower than the cost of allowing the management to act in his own interests.

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Why It Matters:

Agency costs really take their toll on a company's share price when there is substantial debt involved.

Shareholders and bondholders have severe conflicts of interest, but shareholders have administrative

power. They will pursue selfish strategies which will impose agency costs and lower the market value of

the whole firm.

Though they are difficult for an accountant to track, agency costs are difficult to avoid as principals and

agents can have separate motivations. Management can have more information than share holders and

can take advantage of their decision-making power over the company.

A non-financial way to consider agency costs is often the conflict of interest between voters and

politicians. Voters select their representatives to act in their best interests, but the representatives gain

the law-making power and will often act to maintain their positions of power instead of to fulfill their

promises to constituents.