There is an agency cost that exists in every business that has owners or shareholders and managers who are not necessarily owners. Agency cost means that shareholders and business managers may not necessarily agree on the actions that are best for the business firm and that there is an inherent cost to that disagreement. That leads to what is called the agency problem. The principal-agent cost problem is complex and usually requires more than monetary incentives to solve.
What is the Agency Problem in a Company?
The agency problem in a company occurs when the principal (shareholders or owner) and agent (manager) do not agree on what actions to take to maximize shareholder wealth. Investors only want to hold stocks of companies in their portfolios that maximize the wealth of the shareholders as they are shareholders.
This makes the agency problem of crucial importance. If investors think that there is a problem between management and shareholders within a company, they will likely shy away from holding the stock of that company.
Why does the agency problem exist? Managers think that since they have some power and authority in the business firm, they can use it for their own benefit. The agency problem is pervasive in our society. It is not just evident in business. It also exists in clubs, government agencies, churches, and many other types of organizations.
In very large corporations with thousands of stockholders, ownership of the company is spread across many people. It is usually in this type of company that the agency problem is most severe because ownership is less clear to management. Management may have goals that maximize their own self-interests rather than the wealth of the shareholders. For example, they may not take on projects that would benefit the business because of the risk of the project. Why? If the project would fail, then management jobs might be lost even though if the project would succeed, the wealth of the shareholders would be maximized.
Other managerial goals might be an increase in employee benefits and acquisitions that would increase the size of the company in the hope it would improve their job security.
How Likely is it That Managerial Goals and Shareholder Goals Match?
It may be that, in many firms, managerial and shareholder goals actually match, at least to some extent. Shareholders often tie managerial compensation to firm performance. If the goal of stockholder wealth maximization is reached, then managerial compensation is also maximized. Stockholders also offer shares of stock to managers at a lower price than the market price in order to achieve this goal.
Given the power of these incentives, managerial and shareholder goals may somewhat match and the agency problem may be lessened.
Dealing with the agency problem is not free. Unfortunately, there is an agency cost associated with coping with the agency problem. Agency costs usually fall under the category of operating expenses. If employees of a company take a business trip and book themselves into the most expensive hotel they can find or if they insist on the best computer on the market for their offices, those are examples of agency costs. Those things do not maximize the wealth of the shareholders but instead minimize it.
Monitoring managers regarding these kinds of personal expenses is what makes up agency costs. Monitoring techniques include proper accounting procedures, establishing budgets, and establishing limits on expenditures. Unfortunately, all agency costs cannot be eliminated. The costs of monitoring, at some point, will exceed the agency costs. At that point, the concept of moral hazard enters into the equation. Moral hazards occur when agents act in a self-serving manner without monitoring. All in all, monitoring costs for the agency problem are a significant part of a firm's operating expenses.