What it means
In business, this dynamic appears everywhere. Owners are principals, while managers and employees are agents.
Shareholders act as principals, while company executives act as agents. The core challenge is that each party wants different things, or has access to different information.
While shareholders want long-term share value growth, executives might focus on short-term bonuses or personal prestige. This separation of ownership and control creates what economists call the agency problem.
To manage this tension, organisations use governance structures, incentives, and monitoring systems. For example, tying executive pay to company performance aligns their goals with those of the owners.
Clear reporting lines and independent audits also help principals verify that agents are acting in good faith and protecting company assets. Understanding this concept helps non-finance managers recognise why certain controls, approvals, and performance metrics exist.
They are not merely bureaucratic hurdles, but deliberate tools designed to bridge the gap between what is good for the individual worker and what is good for the wider business.
In practice
Real-world examples.
Example
As an entrepreneur, you hire a sales manager (agent) to grow your revenue. While you want maximum profit, they might prefer easier sales quotas and a lower workload, creating a mismatch in daily effort.
Example
An SME owner hires an external accountant to manage tax filings. The owner expects meticulous compliance, but the busy agency might rush the work to take on more clients, risking costly penalties for the business.
Example
A retail chain employs store managers to run local branches. The head office principal wants strict cost control, but the local agent might overspend on local marketing to boost their own store's sales targets.
Think of it
“Imagine hiring a dog walker to exercise your pet. You want the dog safely walked and cared for, but the walker might prefer chatting on their phone or cutting the walk short to get home early.
Formula
Calculation
Agency Cost = Monitoring Expenses + Bonding Expenditures + Residual Loss
For example, if a firm spends 5,000 pounds on audits (monitoring), 2,000 pounds on performance bonds, and loses 10,000 pounds due to suboptimal executive decisions (residual loss), the total agency cost is 17,000 pounds.Case study
Seen in the real world.
At Apex Logistics, the founder and owner (principal) hired a new operations director (agent) to streamline supply chain costs. The owner offered a fixed salary with no performance incentives. Within six months, supply chain expenses rose by twenty percent. The owner discovered that the director had awarded lucrative delivery contracts to personal acquaintances without competitive bidding, prioritising personal gain over company savings. To fix this, Apex restructured the compensation package to include profit-sharing tied to cost reductions and introduced a mandatory blind bidding policy for all major vendor contracts. This aligned the agent's financial rewards with the principal's goals, reducing unnecessary spending and restoring trust.
Watch out
Common mistakes.
- Assuming agents automatically share the exact same priorities and risk tolerance as business owners.
- Failing to implement proper oversight, assuming mutual trust is enough to prevent poor decision-making.
- Designing incentive structures that reward short-term metrics while harming the long-term health of the firm.
Questions
People also ask.
What is the main problem in a principal-agent relationship?
The main issue is the conflict of interest and the information gap, where the agent has more details about their own efforts than the principal, often leading to decisions that benefit the agent rather than the principal.
How can businesses reduce agency problems?
Businesses use performance-based pay, regular audits, clear performance targets, and governance boards to align the agent's incentives with the goals of the principal.
Does this concept only apply to large corporations?
No, it applies to any situation where delegation occurs, including small business owners hiring staff, homeowners hiring contractors, and clients hiring financial advisors.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related