Agency Theory

Agency Theory– Agency theory focuses on the diverse interests and goals of the stakeholders in an organization on how employee compensation can be used to align these interests and goals. Unlike the earlier days when the owner and the manager were mostly the same people in the modern organizations the ownership and management are separate. Nowadays the stakeholders are far removed from the day-to-day operations of the company. So agency costs are created. These are the costs created from the interests of the owners and managers not converging.

What is considered best by the manager may not be considered a bet to the owner’s interest? Agency costs might include money spent by management on perquisites or empire building rather than trying to maximize the stakeholder wealth. In fact, the difference between the attitudes of the management and the stakeholders also gives rise to agency costs. It is easier for the shareholders to diversify their investments than for the management to diversify risks in their pay. Therefore managers may prefer lesser risk in their pay by emphasizing more on base salary and less on incentives and uncertain bonuses. Agency theory is also taken into consideration for non – manager’s compensation. In this case a divergence of interests may occur between the managers and their employees. Agency theory says that the management must introduce a contracting scheme that helps to align the management’s interest with the employee’s interest. These contracts help in reducing the agency costs. Such contracts are classified as:

• Outcome Oriented Contracts: In this the interest of the firm and the employees are aligned. If profits are high compensation goes up and vice versa. But the drawback of such a contract is that these contracts increase the amount of risks borne by the firm.
• Behavior Based Contracts: In this the risks are not transferred to the employees but the firm needs to monitor what the employee is doing.

Pay practices vary significantly across organizations and across jobs.

• Form of Pay: Pay can be in the form of cash or benefits like health care, retirement, paid vacations etc. Health care has been the fastest growing benefit over the years and most employees find it highly challenging to control these costs.
• Level of Benefits: Benefits and cash compensation can be defined in terms of their level i.e. how much should be paid. Most of the organizations take help of market surveys to analyze what the other organizations are paying for similar jobs before deciding on their pay levels. Broadly put, labor costs are a function of both compensations cost per employee and total employee headcount. Therefore, to assess competitiveness in the product market, organizations should not focus only on pay levels. They should compare total labor costs as well as compare with other organizations the sort of return they receive in terms of profits, sales, and so forth for each dollar spent on labor costs.
• Pay Structure: The structure refers to the nature of pay deferential within an employee unit i.e.

1. Number of steps or grades in the structure
2. Size of Pay differentials between different grades
3. Similarity in pay of employees on the same grade in different organizations
4. Timing of payment over employees’ career i.e. pay growth.

• Mix: Payment systems also differ in their mix i.e. how and when cash compensation is disbursed. Virtually some organizations pay a base salary to all the employees which are reviewed approximately once a year on the basis of a traditional merit increase system. Merit increases become a part of the base salary and depend on the performance of the employee. Other than this most of the organizations offer variable pay or pay at risk which means that some portion of the employee’s salary is uncertain and depends upon some combination of organization performance, group performance, and individual performance.
• Administration: In different organizations, pay is administered differently. The design of pay policies differ in terms of who is involved in the process. The roles of human resource departments, line managers, and rank and file employees differ across various firms. In some organizations, line managers may design plans, often with assistance from the human resources department. Alternatively, human resources take the lead in other cases. Employees to be covered by a payment system are sometimes involved, and in some cases may actually design plans for themselves. Communication is another aspect of administration. The most methodically planned pay plan sometimes could have a positive effect and sometimes could backfire. So it is important that rationale for the payment plan is understood and accepted. Also, it should be kept in mind that the employee’s perceptions and expectations are kept in mind while devising the payment plan.

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