Agency Cost

What is Agency Cost and who bears them?

An agency cost is a cost of reducing agency conflict among the owner/ principal (stockholders) and managers (agent). We can also say the cost which is bears by the company to reduce the agency conflict is basically known as agency cost and this cost must be maintained by the respective parties or by the company. To reduce agency conflict some effective measures can be taken which is cost worthy.

Managers can be encouraged to act in the stockholder’s best interests through incentives, constraints, and punishments. But these tools are effective only if shareholders can observe all of the actions taken by managers. A moral hazard problem, defined here as a situation in which agents take unobserved actions in their own interests, arises because it is virtually impossible for shareholders to monitor all managerial actions. To reduce agency conflicts and the moral hazard problem, stockholders must incur agency costs, which include all costs designed to encourage managers to maximize shareholder wealth rather than act in their own self-interests.

There are three major categories of agency costs

1. Expenses to monitor managerial actions, such as audit cost,
2. Expenditures to structure the organization in a way that will limit undesirable managerial behavior, such as appointing outside investors to the board of directors, and
3. Opportunity costs that are incurred when restrictions, such as requirements for stockholders to vote on certain issues, limit the ability of managers to take timely actions that would contribute to shareholder wealth.

 Agency costs must bear by shareholders. In the absence of any effort whatever to affect managerial behavior, and hence with zero agency costs, there will almost certainly be some loss of shareholder wealth due to improper managerial actions. Conversely, agency costs would be very high if shareholders attempted to ensure that every single managerial action coincided exactly with shareholder interests. Thus, the optimal amount of agency costs to be borne by shareholders should be viewed like any other investment decision.

Written by

Md. Nahian Mahmud Shaikat

Financial Analyst

Institute of Business Administration (IBA-JU)

Email: [email protected]

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