Separation of Ownership and Control, and Agency Costs - Term Paper Example

Separation of Ownership and control, and agency costs Table of Contents Introduction 3 Agency cost related with separation of ownership and control 3 Critical analysis of agency theory 6 Conclusion 7 Reference 9 Introduction Separation of control reflects a state in the organisation where the shareholders have no direct influence on the management related activities. Such separation of ownership and control is often introduced to facilitate better decision making in the contemporary organisations. Contrary to the traditional family owned business where the owner runs the business with his own capital and claims the profit generated by the company; the publicly traded organisations run on the shareholders invested capital, who might not take active part in managerial activities. The management team is responsible for running the business and taking decisions as and when required but have almost negligible claim on profitability. In such organisations, separation of ownership and control is clearly visible. Many authors have described this relationship, between the shareholders and the management of the firm, as ‘pure agency relationship’. This concept will be further discussed in the essay with the help of ‘agency theory’. The concept of separating ownership and control was aimed to assist the firms to achieve the sole motto of profit maximisation. This concept held the view that organisations should strike a balance between profit maximisation and development of society, which is corporate governance. In the later section, different theories associated with separation of ownership and control will be analysed to determine the cost of agencies. Agency cost related with separation of ownership and control The concept of separation of ownership and control was first introduced by Berle and Means in the year 1932. The agency theory explains that the owner (shareholders) of the firm is the principal and the one who take the responsibility of running and managing the business (management) is the agent. Both the principal and the agent think of their personal gains. The Principal tries to design the governance system for maximising his utility. In the same way, the agent tries to manage the firm for fulfilling his utility. If utility of both principal and the agent coincides, they both enjoy increment in their individual utility. However, often the utility of the agent differs from that of the principal, and the agent tries to maximise his utility at expense of the principal. To minimise such incidences, principal needs to introduce internal control, which results in an extra cost. Thus, the concept of separation in ownership and control is related to agency cost. For minimising the cost, the agency theory introduced different governance to be followed by the company. Often companies introduce the concept of financial incentive before the agents (management). The management should feel motivated to ensure successful completion of shareholders objective with the help of monitory or financial incentives. There are other methods that can be used to merge the interest of both these parties (principal as well as agent). The owner of the company can introduce several policies like regular audit or performance evaluation. All these activities will assist the firm in controlling the performance of the management, albeit by incurring extra cost. Hence, the agency theory provides a solution by merging the individual interest. However, this theory was criticised because of several distinctive reasons. Hence, before drawing the final conclusion regarding separation of ownership and control in relation to agency cost, major advantages as well as disadvantages should be taken into account (Sridharan & Braendle, p.2-8). ‘Wealth of Nations’ introduced by Adam Smith in 1776 opines that if a firm is controlled by a person or group of person other than owner, there is a high possibility that the objective of the owner might get diluted. Jensen and Meckling also argued that separation of ownership and control will create problem for the firm. They argued that the principal (owner of the firm) should develop the corporate agencies in such a manner. In a company, managerial hierarchy is introduced to ensure effective functioning of the organisation. Undoubtedly, most of the organisations have the motto of profit maximisation. If organisations try to motivate managers to make high profit, then they may undertake certain unethical policies. For example the management may develop policies whereby payments are made late to the creditors and early collection from the debtors (customers). Though such strategies help to increase the cash flow and keep the firm under the false impression of high profitability, in reality such strategies are harmful for the company. In the long run, the company may lose its creditworthiness and the creditors may deny providing credit because of the poor market image. Even the customers may shift to those companies that offer long credit period resulting in the decline of customer base. The management may neglect the social responsibility of the company towards other stakeholders like employees, government, society and environment. The employees may be paid less wages to minimise the operating cost. To further minimise the cost of running the business, the management may use cheap material and poor technology resulting in severe environmental hazards. These activities might result in high profit in initial days but in the long run, the company suffers a lot. Therefore, just motivating the management to make profit does not serve the purpose. The owner of the company should make investment in developing balanced corporate governance that specifies the vision and mission of the company. Investment is also required in developing the management control system of the company. As for example, the company may invest in developing a Balanced Scorecard (BSC) for enhancing managerial control in the organisation. Company use Balanced Scorecard for defining and communicating their corporate strategy and for setting individual targets and also for evaluating the performance of individual employee or the department or even the organisation as a whole. The four prospective of BSC are customer perspective, financial perspective, internal processes prospective and learning and growth prospective (Kaplan & Nagel, 2004, p.5-7). Critical analysis of agency theory All the above arguments clearly establish the benefit of separating the ownership and control in the organisation. This will assist in smooth functioning of the organisation and achieving sustainable growth in the long run. However, the concept of separation of ownership and control suffers with certain loopholes. It has been found that increased board control leads to decline in CEO compensation package. Later, it was revealed that the compensation package is often related to the effort applied by the CEO as well as the market variability. Some researchers found that when there is CEO duality, the market value of the firm increases. Many a time, due to separation of ownership and control, the rate of turnovers has declined. Moreover, when the concept of agency theory was used to find out the effectiveness of a firm, the result revealed that no change was noticed in large firms. Researchers like Fligstein & Choo, 2004, concluded that compensation paid to the CEO has no relation with the agency theory. Even, the performance of a firm just influences 4 percent of the CEO’s compensation (O’Reilly III & Main, 2005, p.8). Cases of a firm’s dismal performance due to poor corporate governance are not hard to find. After undertaking all these factors, Sarbanes-Oxley Act of 2002 was introduced. This was aimed to create a formal structure that would help companies in developing and implementing corporate governance in the organisation. Sarbanes-Oxley has a fixed set of guideline that ensures effective governance in the organisation. As per the guideline, the board committee should be free from CEO’s influence. Thus, the board committee should be diversified with several independent board members and the process of decision making should be made transparent. However, there are companies that suffer with poor corporate governance despite having separate ownership and incurring heavy agency cost (O’Reilly III & Main, 2005, p.9-11). Conclusion The concept of agency theory endorses that there must be a separation between ownership and control. In a small family owned organisation, majority of the capital is invested by a single person. Hence, he prefers to control almost all major activities taking place in the organisation. As a result, all the vital decisions are taken by the owner. However, in a public traded firm, all the shareholders (owners) have a claim on profitability of the company. Due to large numbers of shareholders, it becomes quite difficult to determine how the decision making process will be conducted. To minimise such confusion, the concept of separating ownership and control was introduced. This theory opined that the owner of the company will not take active part in the decision making process but the management will be responsible for decision making and running the business smoothly. Undoubtedly, separation of ownership and control minimises the confusion in decision making activities but this often results in extra cost to the agency. Therefore, the firm should take into account advantages as well as disadvantages associated with such a concept before taking the final call. The cost incurred by the agency may reduce the profitability of the company but it will assist in developing effective internal control. Moreover, it leads to effective corporate governance. Therefore, while deciding to separate ownership and control, the agency should develop a trade off between corporate governance and cost to agency. Reference Kaplan, R. S. & Nagel, M. E. 2004. Improving Corporate Governance with the Balanced Scorecard. [Pdf]. Available at: http://www.hbs.edu/research/facpubs/workingpapers/papers2/0304/04-044.pdf [Accessed on October 11, 2010]. O’Reilly III, C. A. & Main, B. G. M. September 2005. Research Paper No. 1912. Setting the CEO’s Pay: Economic and Psychological Perspectives. [Pdf]. Available at: https://gsbapps.stanford.edu/researchpapers/library/RP1912.pdf [Accessed on October 11, 2010]. Sridharan & Braendle. No date . The theoretical foundations of Corporate Governance. [Pdf]. Available at: http://www.virtusinterpress.org/additional_files/book_corp_govern/sample_chapter02.pdf [Accessed on October 11, 2010]. Read More