In a corporation, the principals would be the shareholders and the agents would be the managers. The shareholders want the managers to run the company in a way that maximizes shareholder value. Conversely, the managers may want to run the company in a way that maximizes the managers’ own personal power or wealth, even if it lowers the market value of the company. These divergent interests can result in agency costs. There are three common types of agency costs: monitoring, bonding, and residual loss.
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When the principals attempt to monitor or restrict the actions of agents, they incur. Learn about the types of agency costs below:
For example, the board of directors at a company acts on behalf of shareholders to monitor and restrict the activities of management. This is to ensure that behavior maximizes shareholder value. The cost of having a board of directors is therefore, at least to some extent, considered an agency monitoring cost. Costs associated with issuing financial statements and employee stock options are also monitoring costs.
Furthermore, an agent may commit to contractual obligations that limit or restrict the agent’s activity. For example, a manager may agree to stay with a company even if the company is acquired. The manager must forego other potential employment opportunities. Consider that implicit cost an agency bonding cost.
Residual losses are the costs incurred from divergent principal and agent interests despite the use of monitoring and bonding.
Calculate agency costs when setting prices and start pricing for profit. If you want to price for profit, then download the free Pricing for Profit Inspection Guide.
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