Overview of Agency Theory Perspective, Part II

Mechanisms for Controlling Agency Costs

Agency costs are the sum of incentive costs, monitoring costs, enforcement costs and individual financial losses incurred by the principals in using governance mechanisms. These mechanisms cannot ensure total compliance by the agent and are likely to increase if a firm is diversified as it is more difficult to monitor what is going on in the firm. The mechanisms which may control agency costs are both internal and external to the firm. Internal to the firm, financial incentive schemes can bring agent-principal alignment, such as increasing manager share ownership (cf. Denis et al., 1997) and through compensation arrangements based upon accounts, markets,5 and contingencies (such as long term incentive plans ‘LTIPs’ (Shleifer and Vishny, 1997)). If managers receive compensation subject to the successful completion of shareholder objectives, such as long term rewards tied to firm performance, or an earn-out for instance, they will be motivated to behave in a manner consistent with stockholder interests. Such schemes are particularly desirable when the manager has a significant informational advantage and monitoring is impossible. However, these mechanisms can be counterproductive (Tosi and Gomez-Mejia, 1994; Byrd et al., 1998) as in earn-outs for instance, a manager could distort short run performance in order to obtain personal rewards, but harm the medium term future of the business in the process.

Other internal mechanisms include improving internal controls (Jensen and Meckling, 1976) and monitoring, through (i) the performance and pay review process (Fama,1980), and (ii) corporate governance (The Cadbury Report, 1992). Boards of directors keep potentially self-serving managers in check by communicating shareholder’s objectives and interests to managers and performing audits and performance evaluations.

There are also external mechanisms for controlling agency costs. These include: (i) the managerial labor market as a process of ex-post settling up (Fama, 1980); (ii) the existence of large minority shareholders and activist investors as they have the incentive to collect information and monitor management, and, externally; (iii) the hostile takeover (Walsh and Seward, 1990).

Sumber:
Jenkins, M., Ambrosini, V., & Collier, N. (2016). Advanced Strategic Management. New York: Palgrave.