Principles Managerial Solutions 1
Chapter 1
E1-4.
The Role and Environment of Managerial Finance
11
Agency Costs
Answer: Agency costs are the costs borne by stockholders to maintain a governance structure that ensures against dishonest acts of management, and gives managers the financial incentive to maximize share price. One example of agency costs is stock options, which are used to provide an incentive for managers to work diligently for the benefit of the firm. Tips are similar to stock options in that they are offered as rewards for good service much as stock options are used to reward managers, presumably based on their good performance—which subsequently leads to a higher stock price. The Donut Shop, Inc. example does not represent a clear case of agency costs because it is the management itself that has instituted the “No tips” policy and the employees have responded with reduced performance. By banning tips, the management has created a situation where an agency cost may be necessary to provide an incentive for employees to resume their former level of performance.
One solution that may work for Donut Shop, Inc. is to institute a profit-sharing plan that reaches down to the employee level where the slowdown and inefficiency are occurring. A profit-sharing plan is designed to motivate the employees and could alleviate the aggravation caused by the no-tip policy, but must be clearly identified as the replacement to tipping in order to be effective. A profit sharing plan is usually viewed by the employees as a reward for good performance, but does not have the immediacy of the positive effect that an employee gets from a tip.
It is unclear from the case whether the new no-tip policy is a company-wide policy or simply the actions of a few branch managers. However, the real solution here is to recognize that the no-tip policy has created an unnecessary backlash that can be alleviated by reversing management’s position without incurring the additional costs of
E1-4.
The Role and Environment of Managerial Finance
11
Agency Costs
Answer: Agency costs are the costs borne by stockholders to maintain a governance structure that ensures against dishonest acts of management, and gives managers the financial incentive to maximize share price. One example of agency costs is stock options, which are used to provide an incentive for managers to work diligently for the benefit of the firm. Tips are similar to stock options in that they are offered as rewards for good service much as stock options are used to reward managers, presumably based on their good performance—which subsequently leads to a higher stock price. The Donut Shop, Inc. example does not represent a clear case of agency costs because it is the management itself that has instituted the “No tips” policy and the employees have responded with reduced performance. By banning tips, the management has created a situation where an agency cost may be necessary to provide an incentive for employees to resume their former level of performance.
One solution that may work for Donut Shop, Inc. is to institute a profit-sharing plan that reaches down to the employee level where the slowdown and inefficiency are occurring. A profit-sharing plan is designed to motivate the employees and could alleviate the aggravation caused by the no-tip policy, but must be clearly identified as the replacement to tipping in order to be effective. A profit sharing plan is usually viewed by the employees as a reward for good performance, but does not have the immediacy of the positive effect that an employee gets from a tip.
It is unclear from the case whether the new no-tip policy is a company-wide policy or simply the actions of a few branch managers. However, the real solution here is to recognize that the no-tip policy has created an unnecessary backlash that can be alleviated by reversing management’s position without incurring the additional costs of