Strategic Business Leader · Governance scope and approaches

Agency Theory and the Agency Problem in SBL

Updated 11 October 2026 · Fact-checked

Agency theory describes the relationship where owners (principals) hire managers (agents) to run a business for them. The agency problem arises because agents may pursue their own interests, not the owners'. You solve exam questions by identifying the conflict, naming the agency costs, and recommending monitoring and incentive mechanisms.

Understand Agency Theory and the Agency Problem

A principal hires an agent to act on their behalf and gives the agent some decision-making authority. In a company, the shareholders are the principals and the directors are the agents. Shareholders own the business but cannot run it day to day, so they delegate.

The agency problem appears because the two sides want different things. Shareholders usually want long-term growth in share price and dividends. Directors may want higher pay, job security, status, a bigger empire or less personal risk. Directors also know far more about the business than shareholders do. This gap is called information asymmetry.

Typical examples of agent behaviour that harms principals:

Taking excessive pay, bonuses or perks.
Pursuing acquisitions to make the company bigger, not more valuable.
Being too cautious (or too reckless) with risk, compared with what diversified shareholders would want.
Focusing on short-term results to trigger a bonus, at the cost of long-term value.
Manipulating or hiding information to protect their position.

Agency costs are the costs that arise from this conflict. They include the cost of monitoring the agent (audits, board committees, reporting), the cost of bonding or incentivising the agent (share options, bonuses), and the residual loss, which is the value still lost even after controls are in place. You cannot remove agency costs entirely. The aim is to keep them at a sensible level.

Governance reduces the problem in two ways. Monitoring checks what the agent does: non-executive directors, audit committees, external audit, disclosure rules and shareholder voting. Incentives align the agent's interests with the principal's: performance-related pay tied to long-term measures, share options, and long-term incentive plans. Good answers also note limits. Agency theory focuses on shareholders only, assumes managers are self-interested, and ignores other stakeholders.

Key rules to remember

Agency relationship: Principal (shareholders) → delegates authority → Agent (directors); Name both parties and what is delegated. In groups, the same logic applies between boards and subsidiary managers, or between shareholders and lenders.
Agency costs: Agency costs = monitoring costs + bonding/incentive costs + residual loss; Use all three headings when asked about agency costs. Give a scenario example under each.
Core cause of the problem: Conflict of interest + information asymmetry = agency problem; Both parts matter. Without the information gap, shareholders could easily check the agent.
Reducing the problem: Monitoring + Incentives (alignment of interests); Link every recommendation to one of these two, then judge its limits.

How to solve Agency Theory and the Agency Problem questions

Use this method for any scenario question on agency theory, whether it asks you to explain, evaluate or recommend.

1Read the requirement and note the verb: explain, assess, recommend or advise. It sets the depth and structure.
2Identify the principal and the agent in the scenario. State the relationship clearly in one sentence.
3Pick out the evidence of conflicting interests from the case: pay, acquisitions, risk, short-termism, secrecy. Quote specifics.
4Name the agency costs the case shows, using monitoring, bonding/incentives and residual loss where they fit.
5Recommend mechanisms and link each to the problem it solves: monitoring (NEDs, audit committee, disclosure, auditors) and incentives (long-term share-based pay, clawback).
6Evaluate each mechanism. Note limits such as manipulable targets, cost, weak NEDs, or encouraging short-term focus.
7Add a professional judgement: note the wider stakeholders or ethical angle if the scenario hints at it, then give a clear conclusion.
8Check that your points are applied to the scenario and not just theory.

Quickest way: Principal, Problem, Cost, Cure

When to use it: Use this when time is short and you need a fast, structured answer in a few minutes.

Principal and agent: one line naming who is who.
Problem: two or three conflicts taken from the case, with figures or facts.
Cost: label the agency costs you can see.
Cure: two monitoring and two incentive measures, each tied to a case fact.
Catch: one limit or risk of the cure, then a short conclusion.

Common mistakes in Agency Theory and the Agency Problem

Writing a textbook definition of agency theory and stopping there.
It feels safe and the definition is easy to recall.
Fix: Give a one-line definition at most, then apply it to the people and facts in the scenario.
Saying the agency problem is only about directors being dishonest.
Students link it to fraud and scandals.
Fix: Explain it as a conflict of interest. Agents can act legally and still serve themselves, for example through empire-building or excess caution.
Listing governance mechanisms without linking them to the problem.
Students memorise lists of committees and codes.
Fix: For each mechanism, say which conflict it addresses and how. State whether it monitors or incentivises.
Treating bonuses and share options as a complete solution.
Incentives look like a neat alignment tool.
Fix: Point out that they can encourage short-termism, manipulation of results and excessive risk. Suggest long-term targets and clawback.
Forgetting to mention agency costs or residual loss.
Students focus on the conflict and skip the cost side.
Fix: Use the three headings: monitoring, bonding/incentive and residual loss. Give an example under each.
Ignoring the limits of agency theory.
Students assume the theory is the whole picture.
Fix: Note that it focuses on shareholders, assumes self-interested managers and ignores other stakeholders. Raise this in evaluation questions.

Worked examples

Example 1

Zephyr Foods plc is listed. Its CEO has led three acquisitions in four years, each of which reduced earnings per share. The CEO's pay is mostly a fixed salary plus a bonus linked to revenue. Shareholders have little insight into how acquisitions are chosen. Explain the agency problem at Zephyr and its agency costs. (10 marks)

Show the solution

Relationship: shareholders are principals and the CEO is the agent, given authority to run the company.
Conflict: the revenue-linked bonus rewards growth in size, not value. Acquisitions raise revenue even when EPS falls, so the CEO benefits while shareholders lose.
Information asymmetry: the CEO knows the reasons and risks behind each deal. Shareholders see only the results, so they cannot easily judge decisions.
Monitoring costs: shareholders and the board must pay for deal scrutiny, due diligence reviews, extra reporting and audit work.
Bonding/incentive costs: the company pays a bonus that does not align the CEO's goals with shareholder value, so some pay is wasted.
Residual loss: value destroyed by the three acquisitions that reduced EPS, which is the loss that remains despite controls.
Conclude that the pay structure is the main cause. Linking pay to EPS, return on capital or total shareholder return over several years would reduce the conflict.

Answer: The shareholders (principals) delegate to the CEO (agent). A revenue-based bonus and information asymmetry let the CEO pursue empire-building acquisitions. Agency costs are monitoring costs, ineffective bonus costs and the residual loss from value-destroying deals. Changing the bonus to long-term value measures would help.

Example 2

Following the problem at Zephyr Foods, the chair proposes strengthening governance. Recommend two monitoring and two incentive measures and evaluate their limits. (10 marks)

Show the solution

Monitoring 1: appoint independent non-executive directors to a board that must approve major acquisitions. They challenge the CEO and bring outside judgement. Limit: they depend on information the CEO supplies and may lack time or expertise.
Monitoring 2: establish an audit committee and require post-acquisition reviews reported to shareholders. This exposes poor deals. Limit: reviews come after the money is spent and add cost.
Incentive 1: replace the revenue bonus with one based on EPS and return on capital employed over three to five years. This ties reward to value. Limit: accounting figures can be manipulated.
Incentive 2: pay part of the reward in shares held for several years, with clawback if results are later restated. This aligns the CEO with long-term shareholders. Limit: share prices can rise for reasons outside the CEO's control, and heavy share-linked pay may encourage risk-taking.
Balance: no single mechanism removes agency costs. A mix of monitoring and incentives is best, and the board should weigh the cost of each against the loss it prevents.
Wider view: shareholders are not the only stakeholders, so the board should also consider employees and lenders who are affected by acquisition decisions.

Answer: Recommend independent NEDs and an audit committee with post-acquisition reviews (monitoring), plus long-term EPS and ROCE-based bonuses and deferred shares with clawback (incentives). Each has limits, such as information dependence, manipulation and cost, so a combined approach is needed. Agency costs can be reduced but not eliminated.

Exam tips

Always apply the theory to named people and facts in the case. Generic answers earn few marks, and scenario application is also part of professional skills.
Check the requirement verb. 'Explain' needs cause and effect, 'evaluate' needs strengths and limits, and 'recommend' needs a clear action.
Use the three agency cost headings to structure answers, and give one case example for each.
When recommending pay changes, mention both the benefit and the risk, such as short-termism or manipulation. Examiners reward balance.
In longer tasks, finish with a short judgement. It shows commercial acumen and gives you a clear conclusion.

Practice questions from Governance scope and approaches

Agency Theory and the Agency Problem in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Agency Theory and the Agency Problem: frequently asked questions

What is the agency problem in simple terms?

It is the risk that managers act in their own interests instead of the owners'. It happens because the two groups want different things and managers know more about the business. Governance exists partly to reduce this conflict.

What are agency costs?

They are the costs of dealing with the conflict between principals and agents. They include monitoring costs, bonding or incentive costs, and the residual loss that remains after controls. They can be reduced but not removed.

How can agency costs be reduced in corporate governance?

Use monitoring tools such as independent non-executive directors, audit committees, external audit and disclosure. Use incentive tools such as long-term share-based pay and clawback. Each has limits, so a mix works best.

Is agency theory only about shareholders and directors?

It is mostly used for that relationship, but the logic applies to any principal-agent link. Examples include a parent company and a subsidiary manager, or lenders and the company. Exam answers should also note that the theory focuses narrowly on shareholders.