What Are Agency Costs? Meaning, Definition & Examples

KEY TAKEAWAYS

• Agencies are specific cost centers within a business.
• They are responsible for managing a specific aspect of the business.

What Are Agency Costs?

An agency is a relationship between two or more people or entities. Here, one party is the “agent” who undertakes activities on the other’s behalf.

In common parlance, an agency relationship is the relationship between two or any number of parties. One person or entity acts on behalf of the other.

This definition of agency is the one used in accounting, and it is widely used by accountants and tax experts. The theory of agency can be a successful action between two parties. It can be a relationship with your board of directors. 

Here, you conduct corporate action on their behalf. One of the clearest examples would be improving stock performance. Public corporations encounter agency relationships on a daily basis.

Types Of Agency Cost

There are several types of agency costs that can arise in a business relationship. They fall under two categories: Direct Agency and Indirect Agency. Let’s first look at Direct Agency Costs.

Monitoring Costs

Monitoring costs incur when the principals (i.e., shareholders) attempt to ensure that the agents are acting in their best interests. These costs can take the form of direct monitoring expenses (i.e., hiring an external auditor). 

They can also be opportunity costs associated with the time and resources spent on monitoring activities.

Bonding Costs

Bonding costs incur when the agent takes action to signal to the principal that they are acting in the best interests of the firm. This can take the form of financial commitments (i.e., posting a bond) or non-financial actions (i.e., signing a contract).

Residual Costs

Residual costs are those that remain after the agent receives compensation for their efforts. They can take the form of suboptimal decisions made by the agent in an attempt to maximize their own interests (i.e., cutting corners on quality).

Now let’s look at Indirect Agency Costs

Indirect Agency Costs

These costs arise when the agent’s actions are not aligned with the best interests of the firm. But they are not easily observable or verifiable by the principals.

Why Have Agency Costs in Your Business?

In order to maintain control over the ongoing costs to run your business, you need to understand exactly what they are and why they’re important. An important reason to include agency costs in your business is to help you budget your cash flow. There are three main reasons why a business owner would want to control their agency costs.

• A business owner may want to attract, keep and increase sales to their business. If the cost of selling their product or service is too high, then a business owner may want to lower these costs to increase sales.
• A business owner may want to increase profits. This may mean finding ways to reduce certain agency costs. This may increase profits through decreased expenses and/or increased gross margin.
• A business owner may want to achieve certain business goals. For example, opening new sales, marketing channels, increasing brand recognition, or customer retention.

For example, let’s say your business requires $100,000 in annual payroll expenses to operate. You have two employees, each of whom costs $25,000 per year in salary and benefits.

This means the company will need $125,000 in annual payroll expenses. If you only budget for the bare minimum, then you will likely underestimate the actual expense.

This fast equates to risky projects on your business’s part. Moreover, it can affect your business at the expense of shareholders. If business managers want to avoid poor management, it’s vital to know ongoing costs.

Not only will you protect your business, but you will avoid corporation conflict. These are just examples of agency problems. 

Managing Agency Costs

As with any expense, you can control and manage your agency costs by keeping a close eye on them and adjusting your budget accordingly. One way to keep agency costs under control is to avoid hiring interns or apprentices as employees.

Instead of paying them a salary, you can pay them a stipend or give them a few hours of work each week to avoid the cost of benefits. If your business requires large amounts of travel or if employees must visit a large number of customers, you can try to cut these expenses. You can do so by avoiding unnecessary travel.

An agency is a contractual relationship recognized as a form of employment between an employer and an employee. In other words, it is a relationship between a principal and an agent. Agency is an agreement for another to act for him or for another person.

The principal undertakes to provide the agent with employment, either full or part-time or undertakes to do some work for the agent.

In return, the agent’s obliged to do certain things for the principal, such as attending meetings or taking phone calls on the principal’s behalf. This is the formal definition, but the phenomenon of the agency goes far beyond a legal definition.

If you don’t manage agency costs, you could end up spending more than you need to on your overhead costs. This is because, in some cases, a standard rate isn’t required.

For example, as long as an employee’s assigned to a task that they can earn payment for, they do not need a standard rate. This makes it easy for companies to under-report their expenses, which can lead to poor financial decisions.

Poor financial decisions, in turn, can lead to poor business decisions, which can result in lost revenue and customer trust. This is why it is so important for business owners to manage agency costs. Poor management could lead to an increase in your costs, which could result in lower profits for your company.

To be profitable, every aspect of a business needs accounting for. This includes things like payroll, employees’ salaries, and business expenses. One very important aspect of accounting for these expenses is managing agency costs.

By doing so, you’ll be able to track your time and expenses and make sure you’re not spending more than you need to on overhead costs. This is important for any company, but especially for startups.

These businesses have a lot of expenses that they need to account for. If managed the right way, agency costs can help these businesses stay healthy.

Examples of Agency Costs

Let’s take a look at a few specific examples of agency costs to highlight their meaning.

Benefits Package

This is the total compensation you will receive from your employees (and their employers). It consists not only of salary and benefits but also perks, incentives and bonuses.

Employee Benefits

This covers things like group health insurance, retirement plan contributions, and vacation time.

Employee Taxes (Social Security, Medicare, Federal Income Tax)

These taxes get charged to both the employee and the employer, which may include benefits.

Employer Taxes (State, County, and City Tax)

These taxes get charged only to the employer and may include benefits.

Employer Insurance (Workers’ Compensation, Employer-Provided Insurance, and Employer-Owned Assets)

This covers the costs of employees injured on the job.

Summary

In order to keep your agency costs under control, you need to be familiar with exactly what they are and why they are important. You can control and manage your agency costs by keeping a close eye on them and adjusting your budget accordingly.

One way to keep agency costs under control is to avoid hiring interns or apprentices as employees. Instead of paying them a salary, you can pay them a stipend or give them a few hours of work each week to avoid the cost of benefits.