Agency costs refer to costs which arise due to an agency problem. Agency problem, which is also called principal–agent problem or agency dilemma, occurs when an agent acts on behalf of the principal. The problem arises because agents’ interests and priorities may be different from that of the principal.
Agency costs are costs that a principal incurs to decrease or eliminate the agency problem by providing agent with incentive to act in the best interests of the principal as well as by monitoring the agent’s actions to ensure the agent is acting honestly and in the best interests of the principal.
In the context of an organization
In the context of an organization, agency costs refer to the costs of eliminating or decreasing the agency problem which arises due to management (agent) acting on behalf of shareholders (principal).
Agency problem, in the context of an organization, refers to the tendency of management to pursue its own needs as a first priority, which may be at the expense of the needs of the shareholders.
Agency costs include costs which arise due to maintenance of corporate governance structure of the organization. The goal is to give the management incentive to treat the needs of shareholders as a priority as well as ensuring honest dealings of management and monitoring management’s performance.
A typical example of agency costs occurs when rewards of management are tied to shareholders’ wealth maximization or performance of the company.
As an example, to tie rewards of management to the shareholders’ wealth maximization, management may be given portion of shares of the company. Therefore, management becomes shareholders as well and their needs and interests become more aligned with other shareholders.
Alternatively, management is given stock options which will allow purchasing stock at the market price set at the time when stock options are granted at some point in the future. This gives management an incentive to be interested in shareholders’ wealth maximization since management will be able to benefit from it personally by buying appreciated shares at some point in the future at the price set at the time stock options were granted (at the lower price).
To tie rewards of management to the performance of the company, management may be evaluated based on their ability to achieve certain measures such as EPS. Performance shares or cash bonus may be given to reward management for meeting specific performance measures.
The other ways which help to decrease the agency problem in organisations is the pressure that shareholders place on the management and negative implications which will materialize if management cannot meet shareholders’ expectations.
Another factor that helps to decrease the agency problem in organisations is the threat of takeover by an individual, group or company which believes that company could be managed better. It serves as impetus for management to work harder in meeting shareholders’ needs.