What it means
In business, owners often hire managers to run day-to-day operations because the owners lack the time or specialised skills to do it themselves. The owners are the principals, and the managers are their agents.
Problems arise when the goals of these two groups do not align. For example, a manager might want to build a massive corporate empire to boost their personal prestige and salary, even if that expansion hurts short-term profits for the shareholders.
Why does this matter? Because unmonitored managers can quietly drain company value through excessive spending, unnecessary risks, or overly cautious strategies that protect their jobs rather than growing the business.
If left unchecked, this dynamic creates tension, wastes valuable capital, and damages trust between the people funding the business and the people operating it. To manage this tension, companies use several practical solutions.
They design performance-based compensation packages, such as granting shares or stock options, so managers benefit directly when the company succeeds. They also establish independent boards of directors to oversee executive decisions, implement regular financial audits, and tie bonuses to specific metrics like return on investment.
Ultimately, understanding the agency problem helps non-finance managers see the bigger picture. When you know why top management sets certain targets or why board members scrutinise your budgets, you can align your departmental goals with the long-term health of the entire enterprise, creating a win-win scenario for both owners and staff.
In practice
Real-world examples.
Example
A startup founder gives a hired CEO a fixed salary. The CEO cuts marketing budgets to ensure safe, stress-free operations, prioritising job security over growth, even though investors want aggressive expansion.
Example
A retail SME owner funds a company car for the general manager. The manager chooses a luxury vehicle far above the business budget because it boosts their personal status, increasing company expenses needlessly.
Example
A manufacturing plant manager delays routine machinery maintenance to artificially boost annual bonus targets, saving money today but risking catastrophic equipment failure for the company next year.
Think of it
“Imagine hiring a house-sitter while you are on holiday. You want them to care for the property carefully and economically, but they might throw a party or use your expensive groceries because they do not bear the cost.
Formula
Calculation
Agency Cost = Monitoring Expenses + Bonding Expenses + Residual Loss. For example, if a firm spends £10,000 on audits, £5,000 on executive incentives, and loses £15,000 in suboptimal manager decisions, the total agency cost is £30,000.Case study
Seen in the real world.
Consider Apex Widgets, a mid-sized manufacturing firm run by hired director Sarah, while the founding family owns 70 percent of the shares. Sarah wants to acquire a failing software company for 5 million pounds to make her resume look impressive, adding a tech division to her portfolio. The founding family objects, knowing this distracts from their core widget profitability and burns cash reserves.
To resolve this tension, the board updates Sarah's compensation plan. They tie her annual bonus to widget division profitability and share price growth over three years, rather than company size. Sarah drops the software acquisition idea, refocuses her team on core manufacturing efficiency, and reduces production waste by 12 percent. Profits rise, boosting her bonus legitimately while increasing shareholder value.
Watch out
Common mistakes.
- Assuming all employees automatically share the exact same financial goals as the business owners.
- Believing that simply paying higher base salaries will prevent managers from making self-serving choices.
- Neglecting to monitor executive decisions on the assumption that trust alone is enough.
Questions
People also ask.
Can the agency problem happen in small businesses?
Yes, whenever an owner delegates authority to an employee who has different personal incentives, such as managing a local branch or handling petty cash.
What are agency costs?
They are the total expenses incurred to monitor managers, align their interests with owners, and cover any leftover losses from poor decisions.
How do stock options fix the agency problem?
They give managers a financial stake in the company's long-term success, so they benefit personally when share prices rise.
From the founder's library
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