Agency theory
Agency theory explains management control as the response to a conflict of interest and information gap between principals (owners) and agents (managers), addressed through contracts and incentives.
See it move
Shareholders spend €50,000 a year on external audits and board oversight to monitor management, the chief executive agrees to a €10,000 restrictive covenant as a bonding cost, and even with both in place, an estimated €15,000 of value is still lost each year as residual loss. Adding the three gives a total agency cost of €75,000.
The formula
Variables
- Total agency cost (€)
- Monitoring costs (€)
- Bonding costs (€)
- Residual loss (€)
The total cost of delegating management to an agent, made up of the cost of monitoring the agent, the cost the agent bears to credibly commit, and the value still lost despite both.
Check yourself
A company's shareholders spend €30,000 a year on monitoring (audits and board oversight), the manager agrees to bonding costs of €8,000, and residual loss — the value still lost to imperfect alignment even after monitoring and bonding — is estimated at €12,000. What is the total agency cost?