BKAL 3063 Group I (2)

Contents INTRODUCTION ...................................................................................................................... 2 SUMMARY ............................................................................................................................... 2 ISSUE ......................................................................................................................................... 3 VARIANCE ANALYSIS .......................................................................................................... 5 1.Quantity variance ................................................................................................................. 5 2.Price variance ...................................................................................................................... 6 3.Fuel efficiency variance....................................................................................................... 6 4.Fuel cost variance ................................................................................................................ 7 INCOME STATEMENT ANALYSIS ....................................................................................... 9 Income statement variance for year 2011 ............................................................................... 9 Income statement variance for 2010 and 2011 explanations ............................................ 11 The trend of income statement from year 2010 to 2011....................................................... 12 The explanation for the trend of income statement from year 2010 to 2011 .................... 13 RECOMMENDATION ........................................................................................................... 14 CONCLUSION ........................................................................................................................ 16

BKAL 3063 Group I (2)

INTRODUCTION
Through this case of Luotang Power: Variances Explained, we will study about the variances that will show the changes in performance and about the external environment that beyond the plants power of control. This will affectthe financial performance. Luotang Power Company (Luotang) is established by American company to run the project that were contracted on a Build Operate Transfer (BOT) basis. Luotang is a 600 Mega Watt (MW) coal-fired power plant that located in Hubei Province, China. Its parent company is China Hua Tong Power (HT Power), main supplier is Pindingshan Coal Company (Pingdingshan) and its primary customer is Hubei Provincial Power Company (HPPC).HPPC is a state-owned electric power company and was the only power transmission and distribution company in Hubei Province. The general manager of Luotang since 2002 is Tan Min Yi.

SUMMARY
To begin with, Tan was scheduled to make a presentation to the Board of Directors (BOD)of HT Power the following week about the most recent results and was concerned about their reaction to the disappointing results. Tan knew that his company had performed well during the year. Therefore, he have to make sure that the BOD will be satisfied with the presentation made by him the following week. This is because HT Power was considering a 2,000 MW expansion at Luotang and he hoped that he will be promoted for the companys Executive Vice President position. Luotang facing a falling in revenues due to several reasons. First, HPPC has decrease their demands dramatically over the previous 12 months and stopped purchasing the Excess Energy because they also had many of its own electricity generating units across Hubei Province. Next, there is a deterioration of coal quality by 3% and Luotang still pays at a fixed price. Each year, the plant power will buy RMB300million and this was potentially a large number especially if the mining company was able to consistently provide coal close to the low end of the intended quality range. To find out about how well their companys performance is, there will be several issue that will be analyzed in the next section.

BKAL 3063 Group I (2)

ISSUE
The main issue of the case is that, the plant performance, Luotang Power is not good due to the external factors and this has affect their financial performance. Their improved performance in both plant availability and fuel economy does not reflect their companys performance during the year. The external factors including variance, supplier and environment factor. These external factors will be analyzed using Porters five forces. In terms of bargaining power of supplier, their main coal supplier, the newly listed Pindingshan Coal Company (Pingdingshan), Luotang paid a fixed price per tonne of delivered coal regardless whatever quality of coal they received. The coal quality had deteriorated about 3% from the expected quality and Luotang bought RMB300million of coal each year. From Exhibit 2, low quality coal is the coal that have low heat value and high moisture content coal, while high quality coal is the coal that have high heat value and low moisture content coal. The deterioration of coal quality by 3% from the expected quality is considered as the low quality, plus buying a large amount of coal will make the small changes becomes a large changes and have impact on the production of electricity. Low quality coal is the wet coal that neededto be dried before being burned. Burning of wet coal will consume energy which might otherwise have been used to produce electricity. Receiving low quality of coal from supplier has decreased the plants financial performance in terms of quality of coal because Luotang will need more coal to produce more heat with a low quality coal and this has leads to the poor performance of Luotang. The bargaining power of supplier is very high because Pingdingshan is their main supplier and Luotang depends with Pingdingshan to supply coal. Next, in terms of environment factor, in which the subtitutes product analysis and the bargaining power of customer. Luotangs primary customer, the Hubei Provincial Power Company (HPPC) and the only entity legally allowed to purchase electricity generated by Luotang has decreased their demand for electricity dramatically over the previous 12 months with respect to the Excess Energy sales. Then HPPC was only committed to purchase 3,000,000MWh of electricity annually. This is because HPPC also had many of its own electricity generating across Hubei Province and electricity that they purchased from the Luotang plant effectively substituted for electricity it could have produced itself. Thats why it is harder for Luotang to negotiate with HPPC than in previous years regarding the Excess Energy sales. They can produce their own electricity, so why should they bother to buy the Excess Energy from Luotang Power. The substitutes product analysis came out very high
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BKAL 3063 Group I (2) because HPPC can produce their own electricity. The bargaining power of customer is also high because HPPC is the only customer and the only entity legally allowed to purchase electricity generated by Luotang.The decrease of sales in Excess Energy has made Luotangs performances poor and decrease the revenue. Next, there is no threats of new entrants and no threats of existing competitors. Then, the financial performance is affected by falling revenues due to the high debt burden that the project carried. It is approximately 80% of the initial construction costs being financed by debt. Other than that, Luotang have to adjust with the account for inflation and changes in transportation costs.

BKAL 3063 Group I (2)

VARIANCE ANALYSIS
Assumption / input variables Installed capacity (MW) Average utilization (hours at full capacity) Gross electricity generation (MWh) Less internal electricity used Net electricity generation (MWh) [amount sold] Coal consumed (tonne/1000 MWh of net electricity generation Price for normal take (RMB/kWh) Average price for all electricity sold 342 0.42 0.4186 347 0.4219 0.3817 346 0.4238 0.3974 2009 600 5,303 3,181,650 4.81% 3,028,690 2010 600 6,913 4,147,888 5.08% 3,937,377 2011 600 6,023 3,613,686 5.16% 3,427,351

1.Quantity variance
(NET GENERATION MWH IN CURRENT YEAR - NET GENERATION IN MWH IN PRIOR YEAR)*PRICE PER MWH IN PRIOR YEAR 2010 =(3,937,377-3,028,690)*420 =381,648,540 Favourable **KWh->MWh: KWhx1000 2011 =(3,427,351-3,937,377)*421.9 =215,179,969.4 Unfavourable

Quantity variance is based upon the quantity of electricity sold to HPPC. This can show the effect on contractual minimum take as well as the Excess Energy if desired. In year 2010, the quantity variance is 381,648,540 favourable. But in 2011, the quantity electricity sold to HPPC being reduced compare with last year, which the amount is 215,179,969.4. The quantity variance had decrease may due to the demand of Excess Energy from HPPC is reduced. Furthermore, the quantity is unfavourable because its been harder for general manager of Luotang Power to ne gotiate with HPPC. These problems due to HPPC also had many of its own electricity generating unit across of the Hubei province. Since HPPC is their primary and only customer, so reduces in sales will affect the revenue receive in Luotang.

BKAL 3063 Group I (2)

2.Price variance
(PRICE PER MWH IN CURRENT YEAR-PRICE PER MWH IN PRIOR YEAR)*NET GENERATION IN CURRENT YEAR 2010 =(381.7-418.6)*3,937,377 =145,289,211.3 2011 =(397.4-381.7)*3,427,351 =53,809,410.7

Based upon the average price that electricity sold to HPPC, in 2010, the price variance is 145,289,211.3 than in 2011 which are 53,809,410.7. The differences between these two years price because the reducing of electricity sold to HPPC. HPPCs power purchase contract with Luotang which Luotang will provide a minimum annual purchase of electricity based on 5,000 hours generation of the 600MW plant capacity for a total 3,000,000MWh per annum (the normal take). The contracts also required Luotang sell amounts in excess of the minimum annual purchase quantity (excess energy) at approximately 65% of regular price. Since HPPC purchase below the contract, the price of electricity sold is higher in 2011 than 2010. HPPC only can negotiate the price if they request excess energy and was the only entity legally allowed to purchase electricity generated by the plant which HPPC could renegotiate the price annually based on its expected need for electricity.

3.Fuel efficiency variance

(MASS OF COAL USED PER NET MWH SOLD THIS YEAR MASS OF COAL USED PER NET MWH SOLD LAST YEAR)*MWH SOLD THIS YEAR * PRICE OF COAL LAST YEAR 2010 =(347-342)/1000*3,937,377*260RMB =5,118,590.1 Unfavourable 2011 =(346-347)/1000*3,427,351*265RMB =908,248.015 Favourable

BKAL 3063 Group I (2) Price of coal (Coal cost = Price of coal*Coal consumed Tone/1MWh of net electricity generation*Net electricity generation MWh) 2009: 269,311,000 / (342/1000 x 3,028,690) = 260 2010: 352,062,000 / (347/1000 x 3,937,377) = 265 2011: 320,183,000 / (346/1000 x 3,427,351) = 270 Fuel efficiency variance is based upon the quantity of coal used to generate each MWh of electricity sold to HPPC. However some of electricity cannot be store once it was generated at the internally plant. The fuel efficiency variance in 2010 is unfavorable but the variance in 2011 shows favorable. This shows that the efficiency of usage for the coal is improved. In year 2011, the fuel efficiency variance shown favorable, this may due to the usage of coal to generate each MWh of electricity in year 2011 is less than year 2010. Furthermore, the percentage of internal electricity used in year 2011 is higher than last year, so it proved that the fuel efficiency variance is improved.

4.Fuel cost variance

(PRICE OF COAL SOLD THIS YEAR PRICE OF COAL LAST YEAR )*MASS OF COAL USED PER NET MWH SOLD THIS YEAR *MWH SOLD THIS YEAR 2010 =(265-260)0.347*3,937,377 =6,831,349.095 Favourable 2011 =(270-265)0.346*3,427,351 =5,929,317.23 Unfavourable

The fuel cost variance is based upon the price of coal purchased but also taking changes in market price for coal and the quality of the coal delivered into account. Luotong paid a fixed price tone of delivered coal, adjusted to account for inflation, changes in transportation costs and for the energy water content of the coal if either fell outside a specified range to Pingdingshan. In 2010, the price of coal is 265RMB. Although the prices for coal had been fluctuated from the previous years, which the price are from 260RMB to 265RMB, but the average price of standard quality of coal in the market is remain stable at around 265RMB/Tone since 2009. Since the actual price do not exceed to market price, so it
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BKAL 3063 Group I (2) is favourable. However, in year 2011, the actual price for the coal is RMB270 and the coal is poor in quality, it is higher than the market price. So the fuel cost variance for year 2011 is unfavourable.

BKAL 3063 Group I (2)

INCOME STATEMENT ANALYSIS

Income statement variance for year 2011
2011 RMB 000 Revenue Normal Take (contractual Min) Excess Energy Total Revenue (Actual) 1,271, 538 90,566 1,362,104 2011 RMB 000 (Standard Cost) Variance RMB 000

Operating Costs Coal costs Fixed Operating and Maintenance Depreciation Expense Variable Maintenance Insurance Costs Total Operating Costs 578,751 Net Profit from Operations Operating and 320,183 39,068 348,549 51,886 23,666 783, 353 315,162 33,178 304,090 5,021 U 5,890 U 44,459 U

BKAL 3063 Group I (2) Income statement variance for year 2011

2010 RMB 000 Revenue Normal Take (contractual Min) Excess Energy Total Revenue (Actual) 1,265,769 237,301 1,503,070

2011 RMB 000 (Standard Cost)

Variance RMB 000

Operating Costs Coal costs Fixed Operating and Maintenance Depreciation Expense Variable Maintenance Insurance Costs Total Operating Costs 670,061 Net Profit from Operations Operating and 362,062 38,115 349,342 60,058 23,432 833,009 315,162 33,178 304,090 46,900 U 4,937 U 45, 252 U

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BKAL 3063 Group I (2)

Income statement variance for 2010 and 2011 explanations

The table compares the actual cost for 2011 and 2010 with standard cost for several operating cost. According to 2011 income statement, there are unfavorable results for the operating cost variance. It showed that the actual cost is higher than standard cost. For example, the coal cost showed unfavorable amount of RMB 5021,000 higher than standard cost. Besides that, the income statement shows that the company is having unfavorable value of fixed operating and maintenance cost and depreciation expense in which it shows the actual cost is higher than the actual cost. The variance is RMB 5890,000 for fixed operating and maintenance while RMB 44,459,000 is the variance for depreciation expense. The unfavorable result is occurred because of some reasons. First, the quality of coal that Luotang received is a low level quality than the expected quality in which the quality of coal is deteriorated about 3%. As we know, the good quality of coal can generate more electricity. Besides, the demand for electricity had fallen dramatically over the previous 12 months as the main power purchaser; HPPC could produce electricity by its own. Moreover, Luotang is facing difficulties in selling the excess energy which they are required to sell at approximately 65% of the regular price. In 2010 also showed unfavorable result for the operating cost by using standard cost for 2011 as a comparison amount with the actual cost of 2011. So, the company may compare the variance analysis of income statement for 2011 with 2010. For the coal cost and depreciation expense, the unfavorable value is higher for year 2011 compares to year 2010 because the actual cost for 2011 used is closed with the standard cost. For variable operating and maintenance cost showed that the unfavorable amount in year 2010 higher than year 2011.

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BKAL 3063 Group I (2)

The trend of income statement from year 2010 to 2011

2010 RMB 000 Revenue Normal Take (contractual Min) Excess Energy Total Revenue 1,265,769 237,301 1,503,070 1,271, 538 90,566 1,362,104 5,769 146,735 140,966 2011 RMB 000 Difference RMB 000

Operating Costs Coal costs Fixed Operating and Maintenance Depreciation Expense Variable Maintenance Insurance Costs Total Operating Costs 670,061 Net Profit from Operations 578,751 91,310 Operating and 362,062 38,115 349,342 60,058 23,432 833,009 320,183 39,068 348,549 51,886 23,666 783, 353 41,879 953 793 8,172 234 49,656

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BKAL 3063 Group I (2)

The explanation for the trend of income statement from year 2010 to 2011

The trend of income statement analysis will help company to analyze their performance whether they are doing good or not. In terms of total revenue, year 2010 showed better performance than year 2011 which have higher amount of total revenue compared to 2011. Even though, the total amount of normal takes of energy in 2011 is more than year 2010, in year 2011 showed significant reduction for the amount of excess energy in which the difference in amount is RMB 146,735,000. Other than that, the difference amount of variable operating and maintenance cost showed that year 2010 used more cost compared to year 2011. It is because the variable cost is subject to the unit used by company in which the more used coal to generate electricity, the more variable cost used. The insurance costs have increasing in small amount from year 2010 to year 2011 which it can be considered as a fixed costs. Overall, the company showed a better performance in year 2011 in terms of the operating cost in year 2011 because it is lower than year 2010, but the total revenue showed that 2010 is better compared to 2011. It can be said that, when the company have to sell more electricity to HPPC it will cause the increasing of the operating cost. In year 2010 also showed more net profit compared to year 2011.

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BKAL 3063 Group I (2)

RECOMMENDATION
1. Establish a financial report with favourable result for presentation to the Board. Most importantly, to have a good financial result in Luotang Power Company and show their actual good performance in scheduled to make a presentation to the Board of Directors of parent company (HT Power). Mr. Tan can refer to Mr. Michael Abrahams in this area. Mr. Michael holds a Bachelor of Arts Degree and a Masters degree in business administration, h e can take a good financial approach in help the financial result more favourable. 2. Establish new purchase contract with HPPC HPPC might be another issue have to solve by Luotang Power Company. HPPC is the only major customer for Luotang Power Company. 3,000,000 MWh per annum for normal take. The contract required further that Luotang sell amounts in excess of this minimum annual purchase quantity (Excess Energy) at approximately 65% of the regular price. HPPC have the power to request or seek to renegotiate this price annually to lower and lower. This is a bad news for Luotang Company in long term. Their revenue will only drop and no benefits to Luotang due to high coal costs. Luotang should amend the term and condition in the old contract with HPPC such as increase the sales quantity from 3,000,000MWh to 3,600,000MWh per annum. Second, they can negotiate with HPPC to increase the excess energy price to higher price that at least Luotang can cover the variable costs. Due to the reputation and capacity of Luotang, they are able to supply enough energy to meets customers needs, but just lacks of the opportunity. 3. Adjust the coal price with Pingdingshan A fixed price is paid by Luotang to Pingdingshan per tonne of delivered coal. But coal quality had deteriorated about 3% from the expected quality. This affects huge amount of coal each year. Whatever the fixed price is included the adjustment to account for inflation, changes in transportation costs and others, but still cant equal to the loss of coal quality that might affect their coal-fired power plant. When the coal price get lower adjustment, as well as the financial reporting will show the better financial result.

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BKAL 3063 Group I (2) 4. Overcome debt burden Luotang is the powerplant company which is a huge and good future company. Mr. Tan and his team can find more investor for their company. They may doing some earning management on income statement and show the good financial result. Its can attract the investor make an investment on their company.

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BKAL 3063 Group I (2)

CONCLUSION
As conclusion, several actions must be implementing by Mr. Tan to have a good financial result in Luotang Power Company in parallel with good performance from his team. Mr. Tan and partners may discuss and search for other alternatives for coal supplier instead of the Pingdingshan. This can create the healthy competition among suppliers and get benefits in term of cost and quality. Besides that, the company had limited opportunity to sell energy above contractual minimum, so Mr. Tan should negotiate with HPPC to increase the minimum energy sales amount in new contract. However, recently HPPC had reduce their energy demand, so Mr. Tan and his team should find other small customers to buy the excess energy. Besides that, company should find potential investor to invest in the power plant to get more capital to support their business. With all of these recommendation apply, the revenue of Luotang will increase and expense decrease, so Luotang Power Company will get better financial result. This is good for the presentation to the Board of Directors of his parent company (HT Power) and there is a big opportunity for Mr. Tan to get the promotion from parent company and consider him as Executive Vice President position.

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