What are agency costs?

Agency costs refer to the expenditures associated with resolving conflicts that arise between principals (shareholders) and agents (managers) in a business context. These conflicts typically stem from differing interests—shareholders seek to maximize their returns, while managers may pursue personal goals or act in ways that are not aligned with the shareholders’ best interests.

To minimize these costs, a company may implement various mechanisms, such as performance-based incentives, oversight measures, and governance structures. These efforts to align the interests of managers and shareholders are integral to reducing agency problems, thus highlighting why the identification of agency costs specifically focuses on the costs associated with these conflicts and the actions taken to address them.

For instance, if a company experiences significant agency costs, it may require additional resources for monitoring management performance or restructuring compensation plans to ensure decisions benefit shareholders and not just the interests of managers. Understanding this concept is essential in corporate governance and financial management, as it underscores the importance of aligning incentives to mitigate the potential for inefficiencies in a business.