An agency cost view is the result of two or more businesses that engage in a fiduciary relationship. One company typically acts as an agent in the relationship, making decisions for the other firms and/or clients. Through the complex relationship of companies, costs may be minimized through the maximization of resources. The costs are also lower than the debt used to finance the agency’s operations. This results in a boon for all firms as each company benefits from the operations and experiences lower costs.
Agency cost view relationships can begin with one of three actions. First, an express written or oral agreement among each company within the agency starts the relationship. The second consists of implications that come from operating in a particular practice, custom, or trade. The third accompanies acting under a certain conduct of principal. One of these must be in place to create a legal agency that operates under the standard procedures associated with this cost view.
The incremental or marginal cost view theory is at the heart of an agency. This theory states that the agency will experience a small increase per unit for each additional product run added to the manufacturing process. Fixed costs do not play a role in marginal cost. Variable cost analysis is more important as these costs increase under marginal cost theory. The purpose of marginal cost analysis helps a company determine its breakeven point, which is marginal cost equals marginal revenue.
Through an agency relationship, companies can experience an improved resource allocation. This can optimize the production process of each firm, allowing them to reach both an internal breakeven point and breakeven through the agency cost view. For example, companies engage in this business relationship when one firm has vast resources and the other has specific knowledge on producing products. Alone, the marginal costs for each may not reach equilibrium. Together, the combined practices can achieve each company’s goals.
It is possible to experience diminishing marginal returns. This economic theory states that, at some point in the production process, each company or the agency will increase marginal costs with no increase in marginal revenue. No matter how much the agency increases its production, no increases in marginal revenue will occur. The only way to reduce the possibility of this occurring is to stop production when marginal cost equals marginal revenue. While an agency may believe that more production will increase revenues, it is not possible under the theory of diminishing marginal returns.