Agency Cost

Agency costs are the costs incurred in having an agent do something on behalf of the principal. 

1. The most obvious agency costs in the shareholder/director relationship are that directors’ salaries have to be paid. As a company director there is an expectation of a reasonably high salary as well as additional benefits which may include a company car, fuel allowance, medical insurance and so on.
2. A key agency cost for the principal is the cost of monitoring the agent to ensure that the agent is doing what they are supposed to be doing. As there is potentially a lack of trust in what the directors report in the financial statements, one agency cost is the cost of the external audit to verify that information.
3. However, the external auditors are also agents as they are checking the financial statements on behalf of the shareholders. There are also regulatory bodies that check the auditors are doing their job properly.
4. A further cost is that of internal audit. Their role is as a monitoring agent to report to the board on risk management and internal control structures.
5. There is also a monitoring function needed for the board of directors. For this reason, there are two types of directors on the board: the executive directors who are responsible for the day to day running of the company and the non-executive directors who monitor how the executive directors run the company. In a large listed company, more than half of the non-executive directors should be independent with the aim that they bring balance to the board of directors and hopefully prevent the dominance of one individual or a small group of individuals.
6. Agency costs can also include costs of accepting higher risks than the principal would feel comfortable with. This occurs if the company’s strategy and operations are taking a different route than the one shareholders would prefer.

Typically, the higher the level of distrust between principal and agent, the greater the agency costs will be.