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Agency cost is a term in economics that is used to identify the costs incurred by a business or other type of organization as part of the process of addressing issues like information asymmetry and differences in the goals and objectives of management and shareholders. The idea behind assessing agency cost is to attempt to identify what impact these differences in objectives and the flow of information between the agent or manager and the shareholders is having on the overall profitability of the organization. By correctly identifying and addressing issues of agency cost, it is possible to minimize the influence of those factors, at least enough to allow the organization to continue moving forward, rather than running the risk of failure.
The concept of agency cost recognizes there are fundamental differences in how shareholders, managers, and even bondholders interpret their respective relationships to an organization. While they may share some common goals and objectives, there is the potential for at least some objectives to emerge that are focused more on individual enrichment than on the well-being of the whole. For example, managers may be more focused on building a reputation for themselves, possibly creating their own power bases within the structure of the larger organizations. Shareholders may become more focused on earning dividends now and less on the future of the business. Bondholders may be concerned only with the project associated with the bond issue, and lose sight of how the overall stability of the company can have a negative impact on the return earned from that bond.
Determining the agency cost normally begins with looking closely at the potential costs or risks associated with including some type of agent or manager in the organizational structure. For example, one potential risk would be the possibility that the individual who is appointed as an officer in the company could seek to use company assets for his or her own personal gain, to the detriment of the company. At the same time, agency cost also looks at the expense involved in anticipating potential abuses of power and resources, and structuring the organization so that abuse is less likely to occur. This may include offering incentives to key employees that promote loyalty and lessen the chance of misappropriation of resources, or structuring the accounting process so that a series of checks and balances create a separation of control, effectively preventing any one individual from having too much power within the organization.
In the best case scenario, agency cost is managed in such a way that the interests of all parties is protected, and the organization is able to thrive as a result. Even if the various types of costs or expenses involved are identified, if the actions pursued to create a balanced divergence of control are not effective, the organization is highly likely to suffer, sometimes to the point of complete failure. When this occurs, the collective and personal goals and objectives of managers, shareholders, and bondholders are all undermined to some extent, resulting in losses for everyone concerned.