How can agency costs be reduced? (your answer must consider three different mechanisms)

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Types of Agency Problems
Solutions to Agency Problems
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The agency problem arises in business when one party, known as the agent, faces the expectation of acting in the best interest of another party, known as the principal. Conflicts of interest can arise if the agent personally gains by not acting in the principal’s best interest. You can overcome the agency problem in your business by requiring full transparency, placing restrictions on the agent’s capabilities, and tying your compensation structure to the well-being of the principal.

Imagine receiving a windfall of money and hiring a financial advisor to invest it for you. In this relationship, you’re the principal, and the advisor is the agent. The advisor has a fiduciary responsibility to act in your best interest. Unfortunately, incentives may exist for the advisor to undermine your interests and put his needs first.

Suppose the advisor, after learning your financial goals, knows that a growth stock mutual fund is the best vehicle for your money. The advisor also knows they can make a higher commission by placing your funds in an annuity, even though doing so compromises your goals. This is an example of the agency problem. The conflict of interest stems from the financial advisor — the agent — having a clear financial incentive to act in a manner not in the best interest of you, the principal.

Agency problems are most prevalent when there’s a disparity in knowledge between the agent and the principal. It’s too easy and too tempting for the agent to exploit the knowledge gap for personal gain. When agent-principal relationships arise in your business, practising full transparency can help close the knowledge gap and prevent the agency problem from emerging. The agent should educate you, the principal, on everything that’s going on, rather than leaving you in the dark while the agent makes decisions on your behalf.

Giving the agent too much power to act on your behalf opens the door for future challenges and can lead the financial advisor to perhaps make poor choices. Most successful governments practice checks and balances because it tempers the power of any one individual or entity, keeping corruption to a minimum. You can practice the same principles in your business by limiting the power of the agent.

Perhaps the simplest method for eliminating the agency problem is to remove financial incentives that encourage conflicts of interest. Returning to the financial advisor example, the agency problem exists in that scenario because the advisor’s compensation is tied to the specific financial products he offers you.

The products that pay the highest commissions aren’t always the best choices for you, the client. Often the advisor is forced to choose between doing right by his client and maximizing his paycheck. If the advisor receives a set salary or earns commission based on total assets under management rather than specific product sales, the agency problem disappears.

The agency problem happens when conflicts of interest keep one party from acting in the best interest of another party. By taking specific steps and staying organized, you can minimize the chance of this happening in your business. The QuickBooks Self-Employed app helps freelancers, contractors, and sole proprietors track and manage your business on the go. Download the app today.

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The agency problem can be defined as a conflict when the agents entrusted with the responsibility of looking after the interests of the principals choose to use the power or authority for their benefits and in corporate finance. It is a conflict of interest between its management and stockholders.

It is a common problem in almost every organization, whether a church, club, company or government institution. A conflict of interest occurs when responsible people misuse their authority and power for personal benefits. However, it can be resolved if only the organizations are willing to fix it.

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Types of Agency Problems

Every organization has its own set of long-term and short-term goals and objectives that it wishes to achieve in a predetermined period. In this context, one must also note that the management’s plans may not necessarily align with the stockholders.

The management of an organization may have goals that are most likely derived to maximize their benefits. On the other hand, an organization’s stockholders are most likely interested in their wealth maximizationWealth maximization means the maximization of the shareholder’s wealth as a result of an increase in share price thereby increasing the market capitalization of the company. The share price increase is a direct function of how competitive the company is, its positioning, growth strategy, and how it generates profits.read more. This contrast between the goals and objectives of the management and stockholders of an organization may often become a basis for agency problems. Precisely speaking, there are three types which are discussed below: –

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Stockholders vs. Management – Large companies may have many equityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet.read more holders. It is always crucial for an organization to separate management from ownership since there is no reason to form a management part. Segregating rights from management has endless advantages as it does not affect regular business operations. The company will hire professionals to manage the key functions of the same. But hiring outsiders may become troublesome for stakeholdersA stakeholder in business refers to anyone, including a person, group, organization, government, or any other entity with a direct or indirect interest in its operations, actions, and outcomes.read more. The managers hired may make unjust decisions and misuse the shareholders’ money, which can be a reason for the conflict of interests between the two and agency problems.
Stockholders vs. Creditors – The stockholders might pick up risky projects to make more profits. This increased risk might elevate the required ROR on the company’s debtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more. Hence, the overall value of the pending debts might fall. If the project sinks, the bondholders will supposedly have to participate in losses, resulting in agency problems with the stockholders and the creditors.
Stockholders vs. Other Stakeholders – The stakeholders of a company may have a conflict of interests with other stakeholders like customers, employees, society, and communities. For example, the employees might be asking for a hike in their salaries which, if rejected by the stakeholders, there is a probability of agency problems occurring.

Example

ABC Ltd. sells gel toothpaste for $20. The company’s stockholders raised the selling price of the toothpaste from $20 to $22 to maximize their wealthWealth refers to the overall value of assets, including tangible, intangible, and financial, accumulated by an individual, business, organization, or nation.read more. This sudden unnecessary rise in the cost of toothpaste disappointed the customers and boycotted the product sold by the company. Few customers who bought the product realized a fall in the quality and were utterly disappointed. It resulted in agency problems between the stockholders and the loyal and regular customers of the company.

Causes

There can be various causes of agency problems. These causes differ from the position of an individual in the company. However, the root cause of these problems is the same in all mismatch or conflict of interests cases. When the agenda of the stockholderA stockholder is a person, company, or institution who owns one or more shares of a company. They are the company's owners, but their liability is limited to the value of their shares.read more clashes with the other groups, the agency problem will occur. In the case of employees, the reason would be the failure of stockholders to meet employees’ expectations concerning salary, incentives, working hours, etc.

In the case of customers, the cause would be the failure of stockholders to meet customers’ expectations like the sale of poor-quality goods, poor supply, high pricing, etc. In the case of management, the causes of agency problems could be the misalignment of goals, separation of ownership and control, etc.

Solutions to Agency Problems

The companies can resolve the agency problems between the stockholders and the company’s management by offering stock packages or commissions for the decisions taken by the administration and their outcomes on the shareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more. In addition, the companies can try to resolve these problems that can exist between its stockholders and management/ creditors/ other stakeholders (employees, customers, society, community, etc.) through taking instituting measures like tough screening mechanisms, offering incentives for good performance, and behavior and likewise penalizing for poor performance and bad behavior, and so on. However, an organization cannot completely heal from agency problems since the associated costs outweigh the total outcomes sooner or later.

Conclusion

Agency problems are the mismatch of interests between the company’s management/ creditors/ other stakeholders (employees, customers, society, community, etc.) and its stockholders, which may sooner or later result in a conflict of interest. Therefore, companies must address the underlying problems to ensure that their regular profit Profit refers to the earnings that an individual or business takes home after all the costs are paid. In economics, the term is associated with monetary gains. read moregeneration.” url=”https://www.wallstreetmojo.com/business-operations/”]business operations[/wsm-tooltip] are not impacted. This problem can exist anywhere: a company, club, church, or government institution.

The three types of agency problems: stockholders vs. management, stockholders vs. bondholdersA bondholder is an investor who buys or holds a government or corporate bond.read more/ creditors, and other stakeholders like employees, customers, community groups, etc. Companies can resolve it with the help of measures like offering incentives for good performance and behavior and penalizing for poor performance and bad behavior, tough screening mechanisms, etc. Of course, it is almost impossible for companies to eliminate agency problems, but it can still minimize the same implications.