Fundamentals of Business Economics and Management · Stewardship Theory and Agency Theory of Management
Agency Costs and Ways to Reduce Agency Problems
Updated 10 October 2026 · Fact-checked
Agency costs are the costs a principal (owner) bears because an agent (manager) may not act in the owner's interest. They are monitoring costs, bonding costs and residual loss. You reduce agency problems by aligning interests with incentives and by controlling agents through audits, disclosure and good governance.
Understand Agency Costs and Ways to Reduce Agency Problems
Agency theory looks at the relationship between a principal (such as a shareholder) and an agent (such as a manager) who is hired to act for the principal. The trouble is that the two may want different things. The owner wants higher long-term value. The manager may want a bigger salary, perks or a quiet life. This clash is the agency problem.
The owner cannot watch every decision, and the manager knows more about the business than the owner does. This gap is called information asymmetry. It lets the agent act in their own interest without being noticed.
Solving the problem is not free. The costs of reducing or suffering from the conflict are called agency costs. Three types are taught: monitoring costs, bonding costs and residual loss. Think of them as: the owner watches (monitoring), the agent promises (bonding), and whatever loss still remains (residual).
The ways to reduce the problem fall into two groups. First, align interests: pay through bonuses, profit-linked pay or share options so the agent gains when the owner gains. Second, control behaviour: audits, a board with independent directors, reporting rules and disclosure. Exams ask you to name the cost, match a situation to a cost type, or pick the right remedy.
Key formulas to remember
- Total agency cost
- Agency cost = Monitoring cost + Bonding cost + Residual loss
- This is the usual way the three types are grouped. Remember it as a list, not a number to calculate, unless the question gives figures.
- Monitoring cost
- Borne by the principal
- Spent to watch the agent: audits, supervision, reporting systems, independent directors.
- Bonding cost
- Borne by the agent (often passed on to the owner indirectly)
- Spent to assure the principal: guarantees, contracts, reports, restrictions the agent accepts.
- Residual loss
- Loss that remains after monitoring and bonding
- The fall in owner's wealth because the agent's decisions still differ from what the owner would choose.
How to solve Agency Costs and Ways to Reduce Agency Problems questions
Use this method for any question on agency costs or on reducing agency problems.
- 1Identify the principal and the agent in the situation.
- 2Find the conflict: what does the agent want that the owner does not?
- 3If the question is about cost types, ask who spends and why: owner watching means monitoring; agent assuring means bonding; leftover loss means residual loss.
- 4If the question is about remedies, ask whether it aligns interests (incentives, share options) or controls behaviour (audit, board, disclosure).
- 5Match the keyword in the option to the idea: 'audit' or 'supervision' to monitoring, 'guarantee' or 'contract promise' to bonding, 'still lost value' to residual loss.
- 6Eliminate options that describe stewardship ideas (trust, intrinsic motivation) when the question is about agency theory.
- 7If figures are given, add the amounts of the stated types only.
Quickest way: Who pays and when: a 10-second test
When to use it: Use for MCQs that give a short situation and ask which agency cost or remedy it shows.
- Ask: who is spending? Owner means monitoring. Agent means bonding.
- Ask: is there loss even after the spending? That is residual loss.
- For remedies, look for pay linked to results (alignment) or checking (control).
- Cross out any option that is not about agent and principal.
Common mistakes in Agency Costs and Ways to Reduce Agency Problems
Calling an audit a bonding cost.
Students link audits with 'assurance' and confuse who is giving it.
Fix: An audit ordered by the owner to check the agent is a monitoring cost. Bonding is the agent's own commitment to the owner.
Treating residual loss as an amount spent.
The word 'cost' suggests spending.
Fix: Residual loss is a loss of value that remains even after monitoring and bonding. Nothing is paid out to prevent it.
Thinking agency problems can be removed fully.
Textbook remedies sound complete.
Fix: Remedies reduce the problem. Some residual loss usually stays, which is why it is a cost type.
Mixing up agency and stewardship views.
Both theories sit in the same chapter.
Fix: Agency theory assumes self-interested agents who need control. Stewardship theory assumes managers act for the organisation's good and need trust and freedom.
Treating incentives as monitoring.
Both are described as 'ways to control managers'.
Fix: Incentives align interests by sharing the gain. Monitoring checks behaviour. Keep these as two separate groups of remedies.
Worked examples
Example 1
Shareholders of a company appoint an independent firm to audit the managing director's expense claims every quarter. Which agency cost is this?
A. Bonding cost
B. Monitoring cost
C. Residual loss
D. Opportunity cost
Show the solution
- Principal: the shareholders. Agent: the managing director.
- The shareholders are spending money to check the agent's behaviour.
- Spending by the owner to watch the agent is a monitoring cost.
- Bonding cost would be the agent's own commitment, so A is out. Residual loss is leftover loss, not spending, so C is out. Opportunity cost is not an agency cost type, so D is out.
Answer: B. Monitoring cost
Example 2
A company gives its CEO share options that gain value only if the share price rises over five years. What is the main purpose?
A. To align the CEO's interest with shareholders' interest
B. To increase monitoring cost
C. To create residual loss
D. To remove the need for any audit
Show the solution
- Share options pay the CEO more when shareholders' wealth rises.
- This makes the agent's gain depend on the owner's gain, which is alignment of interests.
- B is wrong: options are an incentive, not a way of watching.
- C is wrong: the aim is to reduce residual loss, not create it.
- D is wrong: incentives reduce the problem but do not replace audits.
Answer: A. To align the CEO's interest with shareholders' interest
Exam tips
- Memorise one-line definitions of the three costs with the word 'who': owner watches, agent assures, loss remains.
- Questions often give a real-life situation without naming the cost. Spot who is spending.
- Watch for options that mix stewardship ideas into an agency question and eliminate them.
- Remedies come in two groups: incentives to align and controls to monitor. Place each option in a group before choosing.
- There is no negative marking, so always mark an answer after eliminating two options.
Practice questions from Stewardship Theory and Agency Theory of Management
- In agency theory, the party who delegates decision-making authority to another person to act on its behalf is called the:
- Shareholders of Arjun Steels Ltd. incur the following costs to reduce the agency problem: audit fees Rs 4 lakh, cost of bonding the manager …
- Which assumption about managers is central to stewardship theory?
- Which one of the following is a basic assumption of stewardship theory but NOT of agency theory?
- Which of the following measures is most directly aimed at aligning a manager's interests with those of shareholders and so reducing the agen…
Agency Costs and Ways to Reduce Agency Problems in other exams
The same ground in other exams, if you are preparing for more than one or want another angle on it.
Agency Costs and Ways to Reduce Agency Problems: frequently asked questions
What are the three types of agency costs?
They are monitoring costs, bonding costs and residual loss. Monitoring is spent by the principal to watch the agent. Bonding is spent by the agent to assure the principal. Residual loss is the value still lost after both.
How can a company reduce the agency problem?
It can align interests through bonuses, profit-linked pay and share options. It can also control behaviour through audits, an independent board, disclosure rules and good corporate governance. Most companies use a mix of both.
Is residual loss an actual payment?
No. It is the reduction in the owner's wealth that remains because the agent's decisions still differ from what the owner would want. It arises even after monitoring and bonding are in place.
How is agency theory different from stewardship theory?
Agency theory assumes managers may pursue their own interests, so it stresses incentives and control. Stewardship theory assumes managers want to act for the organisation, so it stresses trust and empowerment.