Control, Performance Evaluation and Incentive Systems

Thomas W. Lin
Leventhal School of Accounting
University of Southern California
Los Angeles, CA 90089-0441
Tel: (213) 740-4851
Fax: (213) 747-2815
E-mail: [email protected]

Kenneth A. Merchant
Leventhal School of Accounting
University of Southern California
Los Angeles, CA 90089-0441
Tel: (213) 740-4851
Fax: (213) 747-2815
E-mail: [email protected]

Case presented at the AAA Management Accounting Section Conference at Savannah, Georgia,
January 20, 2001

Third Revision, March 2001

____________________________
We gratefully acknowledge the help from Professors Xiayue Chen and Shengli Du of Tsinghua
University, and Wenxin Jia, Huanliang Wang, and Yueguo Liu of China Huaneng Group, and
helpful comments from Professor V.G. Narayanan as well as the funding support provided by the
Center for International Business Education and Research at the Marshall School of Business,
University of Southern California.
 Control, Performance Evaluation and Incentive Systems

Abstract

During the past five years, China has focused considerable attention to the reform of its state-
owned enterprises. Chinese firms started to realize that they need modern management
accounting techniques to provide management with relevant, timely, and accurate information to
improve enterprise performance. However, few such findings have been published on the
progress Chinese firms have made toward this goal. The purpose of this case is to describe the
efforts of one of China's 100 key state-owned enterprises’ reforms on its subsidiary company
control, performance evaluation and incentive systems, China Huaneng (power-generation)
Group.

Introduction

In July of 1999, Ms. Wenxin Jia, Vice Manager of China Huaneng Group’s (CHNG) Finance
Department, described her company’s operating philosophy and systems by the following four
principles:

(1) High quality and scale of projects – new project or subsidiary selection or development must be
based on the economy of scale and the adoption of the advanced technology.
(2) High speeds in construction – to shorten the construction period while guaranteeing the quality
standard.
(3) High level of management – to keep pace with the world’s advanced management level.
(4) High efficiency in operation – the overall evaluation criterion for developments and operations.

According to Jia, CHNG’s strategy is “Maintaining to make diversified development, with power
business as CHNG’s core industry.”

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 Industry Information

In the early 1970s, the long-lasting shortage of electric power in China became an important factor
that affected and limited the development of the Chinese economy. During the past 20 years, China
has experienced a structure reform in its economy as it began to open up to the outside world.
During this time, China's power industry has engaged in developmental twists and turns that
eventually led to brilliant achievements attracting worldwide attention.

In 1978, China’s total installed generating capacity stood at 57.12 million kwh and the electric
power output was 256.6 billion kwh, ranking 8th and 7th in the world, respectively. Over the
past 20 years, China's power industry has advanced tremendously with an average annual
increase of installed capacity of 10 million kwh. By the end of 1997, China's total installed
generating capacity and total power output had reached 250 million kwh and 1,105.4 billion
kwh respectively, both ranking second in the world, making China one of the nations with the
fastest growing power industries.

With the rapid development of China's power industry, Chinese power enterprises began
developing in the directions of industrialization, big company groups, and large-scale plants
while speeding up the shifting of operational mechanisms. Especially since 1997, the growth rate
of China’s power industry has been enormous, with the industry's fixed assets and output value
growing steadily. According to China’s statistics yearbook, 1997 year-end total assets of the
industry was RMB 682.24 billion yuan, 31.82% more than the previous year. (Note: U.S. 1$ =
RMB 8.27 Yuan)

In output value, statistics show that the industry gained a total of RMB 203.03 billion yuan in 1997,
19.57% more than the previous year; the industrial added value was RMB103.89 billion yuan, up
19.26%; and the sales value was RMB197.58 billion yuan, up15.86%.

Overall, the power industry’s major economic growths in China have maintained a steadily growing
momentum. In the five years from 1993 to 1997, the industry made RMB116.5 billion yuan in total
profits and taxes, of which profits were RMB 36.2 billion yuan and taxes were RMB 80.3 billion
yuan.

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 Exhibit 1 presents China power industry’s financial data during 1995-1998.

Exhibit 1

Financial Data of China’s Power Industry in 1995-1998

1995 1996 1997 1998

Output (1 billion kwh) 1,007.0 1,081.3 1,105.4 1,125.2

Sales (1 billion kwh) 662.8 716.3 752.5 760.0
Revenues (RMB 1 billion) 154.4 185.9 249.9 258.2
Taxes (RMB 1 billion) 15.3 17.5 22.3 22.7
Net Income (RMB 1 billion) 7.7 8.0 8.2 8.6

Company Background

China Huaneng Group (CHNG) was established in August 1988. “Hua” means China, while “neng”
means energy. It is a large-scale state-owned enterprise with 20,000 employees and headquarters in
Beijing. The company’s core business is power generation.

In 1991 CHNG was listed among the first batch of experimental large-size groups in China. In 1996,
CHNG merged with the State Power Corporation of China. It is a holding company of many power
companies; it also has many peripheral businesses in telecommunications, real estate, finance, cement,
and electrical appliances. Most are vertically integrated. CHNG reports to the State Power Corporation of
China, which is a part of the government. Consequently, this is a true state-owned enterprise.

At present, CHNG consists of its core enterprise (China Huaneng Group Corporation), and nine other
member corporations (Huaneng International Power Development Corporation, Huaneng Raw Materials
Corporation, China Huaneng Finance Corporation, China Huaneng Technology Development Corporation,
Huaneng Comprehensive Utilization Development Corporation, Huaneng Real Estate Development
Corporation, Huaneng Industrial Development & Service Corporation, China Huaneng International
Trade-Economics Corporation, and Huaneng South Development Corporation) and about 400 subsidiary
companies throughout China. In addition, it directly controls about 30 overseas branches and companies.

Only two subsidiaries are publicly held: Huaneng International Power Development Corporation and
Shangdong Huaneng Power Development Corporation. Both had their stocks issued on the New York
Stock Exchange during the second half of 1994.

CHNG’s mission in 1985 was to address the national shortage of power. Now the mission is to increase
profits. The government primarily appoints its board of directors. The goal is “slow steady growth in

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profits.” The Chinese government is not very strict; it doesn’t look at how much profits have improved
each year. Hence, there are no sanctions by the government if no increase in profit is reported.

Exhibit 2 presents CHNG’s Annual Power Generation/Production during 1989-1996. Exhibit 3 shows
CHNG’s financial statement information for 1995 and 1996. Exhibit 4 displays CHNG’s major financial
data during 1989-1996.

Exhibit 2

CHNG’s Annual Power Generation/Production during 1989-1996

(Unit: 1 billion KWH)

Power Generation Percentage of the Country

1989 18.30 3.13%
1990 25.60 4.20
1991 39.38 5.81
1992 52.70 6.99
1993 69.77 8.34
1994 81.60 8.80
1995 93.81 9.32
1996 97.70 9.70

Exhibit 3

CHNG’s Recent Two Year Financial Statement Information (Unit: RMB 1,000 yuan)

1996 1995

Sales Revenues 20,705,540 18,183,350

Cost of Goods Sold 15,740,050 13,591,050
Operation Expenses 130,480 39,960
Administrative Expenses 538,330 488,690
Operating Income 2,293,400 2,028,360
Income Tax 729,470 599,270
Profit before Tax 3,497,700 3,249,850
Total Assets 112,761,330 90,910,650
Current Assets 33,416,340 26,312,540
Accounts Receivable 10,565,720 8,076,000
Inventories 2,932,510 1,865,470
Long-term Investment 5,095,010 5,627,810
Fixed Assets 34,742,330 32,407,040
Projects in Construction 27,974,070 19,044,040
Total Liabilities 82,707,660 63,290,520
Current Liabilities 26,040,720 18,380,360
Long-term Liabilities 56,666,940 44,910,160
Minority Interest 17,269,390 15,761,220
Capital Stock 4,026,810 4,026,810
Stockholders’ Equity 30,053,670 27,620,130

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 Exhibit 4

CHNG’s Major Financial Data During 1989-1996

(Unit: RMB 1 billion yuan)

Total Assets Stockholders’ Equity Profit before Tax

1989 11.79 1.99 0.27

1990 27.61 2.72 0.35
1991 34.13 3.77 0.66
1992 39.91 4.91 1.03
1993 46.07 6.75 1.83
1994 80.13 24.16 2.17
1995 90.91 27.62 3.24
1996 112.76 30.05 3.49

Control of Subsidiaries

CHNG has adopted a decentralization philosophy since its establishment. Through its decentralized
subsidiary company operations, CHNG enhanced its Performance Evaluation System by continuously
adding value to state assets.

CHNG's investments in subsidiary companies are usually in the form of joint ventures with local
enterprises. According to the capital structure relationship, CHNG is divided into three levels: core
enterprise, member companies, and operating units. Recently, CHNG became the wholly owned
subsidiary of State Power Corporation of China, which was established in 1997. The specialized
member corporations in different areas are 100% subsidiaries of CHNG. Some of CHNG's core
enterprise and member companies also invested in some operating units. The first level of CHNG's
core enterprise is its decision-making and management center (i.e., the parent company). Member
companies (i.e., one type of subsidiary companies) comprise the second level, and are in charge of
the management of operating units as well as making investment decisions. Operating units (i.e.,
another type of subsidiary companies) constitute the third level. They solely concentrate on business
operations instead of making investments.

In periods of a heated economy in the 1980s, CHNG had a fourth level and a fifth level. However,
after years of reorganization and improvement, it now has three levels. CHNG uses the equity method
to record its investments; it also prepares consolidated financial statements. Member companies
manage their investments and have the right to make decisions according to the shareholder’s
structure. They also implement the management principles of the core enterprise. Previously, the core
enterprise considered giving up its close control of its subsidiaries to control through two financial
statements (Balance Sheet and Income Statement) and one person (the general manager). Later, they
found that this kind of "after the fact" control was highly risky because of the irreversible loss
incurred by incorrect decisions. Presently, CHNG maintains both flexibility and necessary control
over its subsidiaries.

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The parent company and subsidiaries in CHNG are connected by the capital relationship between
them. Subsidiary companies are highly autonomous. Meanwhile, the parent company maintains
control in three areas:

1. Personnel Control

- hiring of managers.

- total annual compensation (salaries plus bonuses).

- number of positions in each function in each company.

2. Investment Money Control (fixed assets and cash)

- Investment. Any new investment (> RMB 30 million yuan in large company; > RMB 5
million yuan in small company) must be approved by the parent company.

- Financing. The government (State Planning Commission) will fund large projects. The
parent company also acts as the guarantor of other loans, but sets upper limits. It’s difficult
to borrow money without the parent company guarantee. China lacks a good credit rating
system.

3. Financial Performance Control

Each year financial performance targets are set as last year’s actual results. Three areas of
financial performances are: (a) profit, (b) net worth, and (c) cash flow from operations (after
capital charge on capital invested).

In general, it is very rare for a company to fail to achieve its financial targets. Typically, a desired
ROE is 15%. However, it is lower (10%) for power generation businesses because the Chinese
government often sets the price of electricity. Some businesses desired ROE is much higher than
15% (e.g., financial services, trading companies), even as high as 100%.

CHNG uses the same planning forms across all of its subsidiary companies. However, some
of its accounting systems are different because its subsidiaries are in different businesses.

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 Performance Evaluation System of CHNG

History of CHNG's Performance Evaluation System

CHNG's Performance Evaluation System underwent three stages:

Stage One: Objective System (1989-1991).

In this stage, most of the projects are still in the construction period. Material working units and
some other absolute indicators are evaluated under this system. These indicators include Major
Product Production Units, Percentage of Completion, Profit, Loans Repayment and Administration
Expenses. The major weakness of this system is the rush investment made without evaluating the
outcome, and all the subsidiaries were keen on making investments.

Stage Two: Contracting-Based Managerial Responsibility System (1992-1996).

Since 1992, CHNG entered into a contract with the State Finance Department that it would increase
the remitted profit 10% every year. The State would compensate CHNG the shortage of profit if not
enough, and CHNG could keep part of any extra profit if the actual profit was greater than the
contracted profit. CHNG also tied employee compensation to its performance evaluation system.
Under this system, CHNG began to focus on profit and divided the authority and responsibility
between different units. However, this focus on profit caused harmful battles among units for
projects, loans, and scales. Meanwhile, there turned out to be huge differences in the subsidiary
companies' increases in assets, debts, or profits. This sparked CHNG's top management to consider
how to thoroughly evaluate the efficiency of its management and units instead of only focusing on its
short-term profit. As a result, the concept of a Contract-Based Managerial Responsibility System was
introduced in 1994. Relative figures reflecting efficiency such as Return on Equity and Increase in
Equity were added. In addition, Repayment of Core Enterprise Loans and Profits Remitted were
added to the system since they were relevant to the overall profit of CHNG. Later, the top
management found the following problems: First, the uniform standards or criteria were not adequate
due to the different levels of profitability between different industries. Second, the contracting system
did not consider the control and supervision over the process.

Stage Three: Performance Evaluation System (Since 1997).

In order to focus on the efficiency of investments and consider the differences among different
industries, CHNG changed the Contracting-Based System to the Performance Evaluation System in
1997. It also adjusted the evaluating indicators to reflect both efficiency and process controls. In this
system, Return on Equity, Increase in Equity, and other ratios are used. Meanwhile, in order to
reflect the risks of debts and the ability to pay back its debts as well as to change the existing high
Debt Ratio in CHNG, it replaced the Increase in Equity with the Return on Total Assets. With the
deepening reform, CHNG’s power generation subsidiaries became independent and autonomous. The
new system also pays attention to the production process. Indicators such as Output, Profit, Loans
Repayment, and Securities are used to evaluate the performance in accordance with the character of
its operation. For those branches majoring in the management of power corporations, indicators such
as Output and Return on Capital are used. In other words, evaluation is conducted separately between
power generation subsidiaries, non-power generation subsidiaries, and branches.

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In summary, CHNG has three major developing stages of its Control and Performance Evaluation
System: First, it transferred from focusing on absolute values to focusing on relative values in order to
compare the efficiency levels among subsidiary companies. Second, evaluation standards were changed
from the planned figures for each subsidiary company to the average figure of all subsidiary companies in
order to minimize the negotiation between both sides of evaluating institutions. Third, it changed the
focus from the evaluation of business operations to the evaluation of investors’ managerial controls over
investments.

Performance evaluation criteria for power generation subsidiary companies (factories):

Starting from 1997, CHNG's parent company has used the following four criteria to evaluate
the annual performance of power generation companies: (1) actual vs. planned power
production units (in KWH), (2) actual vs. budget profit, (3) actual vs. planned monthly loan
repayment and interest payment amount, and (4) factory security.

The power production criterion has a basic score of 40 points. For any 1% deviation between
the actual and the planned production, it adds or deducts 1 point up to a maximum of 20
additional or deductible points.

The profit criterion has a basic score of 10 points. For any 1% deviation between the actual
and the budget profit, it adds or deducts 0.5 points up to a maximum of 10 additional or
deductible points.

The financing criterion has a basic score of 50 points. For any 1% late payment, it deducts 1
point up to a maximum of 20 deductible points.

There are no points assigned to the factory security criterion. However, CHNG will deduct
from the subsidiary company’s total wages and salaries: (1) RMB 500,000 yuan if an enormous
accident occurs; (2) RMB 100,000 yuan if a major accident occurs; and (3) RMB 50,000 yuan
for any employee death during working hours.

The maximum, standard, and minimum scores for meeting all four criteria are 150, 100, and 50
points, respectively.

Exhibit 5 shows CHNG’s Performance Indicators for its power generation subsidiary
companies.

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 Exhibit 5

Performance Indicators for Power Generation Companies

Company Name: Unit: 1,000RMB

Performance
1998 Planned 1998 Actual 1999 Forecast Comments
Indicator
Profit xxxxx xxxx xxxxx

xxxxx xxxxx xxxxx

Output

Loan Repayment xxxx xxxx xxxx

xx xx xx
Cost per Unit

Note: Cost per Unit was not evaluated in 1998.

Performance evaluation criteria for non-power generation subsidiary companies:

Since 1997, CHNG's parent company has used the following four criteria to evaluate the annual
performance of non-power generation subsidiary companies: (1) actual vs. planned return on
stockholders’ equity, (2) actual vs. standard return on total assets, (3) actual vs. planned
monthly loan repayment and interest payment amount, and (4) actual vs. planned capital charge
payment amount.

For the return on stockholders’ equity (ROE) criterion, the numerator is the net income after
taxes while the denominator is the average stockholders’ equity. The basic score of this
criterion is 60 points. If the actual ROE is greater than the planned ROE, it adds 1 point for
every 0.5% increase up to a maximum of 20 additional points. If the actual ROE is smaller
than the planned ROE, it deducts 1.5 points for every 0.5% decrease up to a maximum of 20
deductible points.

For the return on total assets (ROA) criterion, the numerator is the income earnings before
interest and taxes (EBIT) while the denominator is the average total assets. The basic score of
this criterion is 40 points. The standard ROA considers the bank loan interest rate and CHNG’s
financial condition. If the actual ROA is greater than the standard ROA, it adds 1 point for
every 0.5% increase up to a maximum of 10 addition points. If the actual ROA is smaller than
the standard ROA, it deducts 1 point for every 0.5% decrease up to a maximum of 10
deductible points.

The financing criterion has no basic points. Instead, it depends on CHNG's internal loan
contracts. For any late payment amount less than 20%, it deducts 5 points; if the late payment

10
amount is greater than 20%, it deducts an additional 1-point for any 20% amount, up to a
maximum of 10 deductible points.

For the capital charge payment criterion, every subsidiary company has to pay 8% of the
capital amount invested in the parent company by July 1. For any late payment amount less
than 20%, it deducts 5 points; if the late payment amount is greater than 20%, it deducts an
additional 1-point for any 20% amount, up to a maximum of 10 deductible points.

The maximum, standard, and minimum scores for meeting all four criteria are 130, 100, and 50
points, respectively.

Exhibit 6 presents CHNG’s Performance Indicators for its non-power generation subsidiary
companies.

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 Exhibit 6

Performance Indicators for Non-power Companies

Company Name: Unit: 1,000 RMB

Performance Indicator 1998 Planned 1998 Actual 1999 Estimated Comments

Profit and Taxes
Net Profit
Beginning Net Equity
Ending Net Equity
Return on Net Equity
Beginning Total Assets
Ending Total Assets
Interest Expense
Return on Total Assets
Loan Repayment to core enterprise
Including: Capital
Interest
Balance of Loan
Profit Remitted
Including: Last Year Remitted
This first half year

Additional Information:
1. Deferred Assets RMB
including: Pre-operation costs RMB
2. Accounts Receivables with more than three years history RMB
3. Prepaid Expenses RMB
4. Unrecognized Loss in Assets RMB
5. Long term investments RMB
Including those has no return for three consecutive years RMB
6. Return on Investments RMB

Notes:
1. Numbers are from the Headquarter's Financial Statement.
2. Unrecognized Losses in Assets include both Current Assets and Fixed Assets.
3. Return from Investments refers to dividend income and the share of earnings recorded under Equity
Method.
4. Interest Expense refers to Interest Payable minus Interest Income.

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 Incentive Systems

CHNG's total annual subsidiary company bonus amount ties directly to the performance evaluation of the
four criteria described in the above section. If a company obtains a performance score of 100 points, the
total company bonus amount will be 50% of the total company’s wages and salaries. For every
performance point over 100 points, it adds 0.5% of the total company’s wages and salaries to the bonus
amount. On the other hand, for every performance point less than 100 points, it deducts 0.5% of the total
company’s wages and salaries from the bonus amount. According to the current formula, the maximum
bonus amount for a subsidiary company is 65% of the total company’s wages and salaries.

The calculation above creates a company-wide bonus pool. The allocation of this bonus pool to
individuals depends on the individuals’ organization level and their performance ratings. Each organization
level is given a number of points. Some examples are 4 points for the high-level managers, 3 points for
the middle managers, and 2.3 points for supervisors. Dividing the bonus pool by the points of all the
people eligible for bonuses gives a bonus potential per point.

In addition, superiors, peers, and subordinates give performance ratings of their department employees in
four performance areas (with weightings shown in parentheses):

Ethics (20%)
Effort (20%)
Capability (20%)
Performance (40%)

The superior’s ratings are given the highest weight (50%); peers are given 30% weight; subordinates'
ratings are worth 20%.

There is a guideline for calculating each subsidiary company general manager’s bonus: (1) For companies
doing very well on all four criteria, the general manager’s bonus will be 2.5 to 2.8 times greater than the
average company employee’s bonus amount; (2) For companies meeting all four criteria as planned or in
standard amounts, the general manager’s bonus will be 2.0 to 2.5 times greater than the average
company employee’s bonus amount; (3) For companies that have not met the four criteria but still have
profit, the general manager’s bonus will be 1.5 to 2.0 times of the average company employee’s bonus
amount; and (4) For companies with no profit, the general manager’s bonus should not be greater than
the average company employee’s bonus amount.

The annual compensation increases for each employee are paid out 65% as increases in monthly salary
and 35% as one-time bonus.

The largest bonus paid in 1997 was RMB 30,000 yuan. This is not a large bonus amount, but employees
feel comfortable with the bonus system because their jobs are stable while other industries are facing
layoffs.

According to Senior Accountant, Huanliang Wang, “The system does not motivate people significantly.
The bonus amount is so small. But the performance evaluation system is transparent and fair with the
individual employee performance evaluations.”

Positive Effects of the CHNG's Control, Performance Evaluation and Incentive System

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 CHNG's Senior Accountant, Yueguo Liu collected feedback information from top management, and
identified the following positive effects of the control system implemented:

1. Performance indicators have influenced the operating behaviors of subsidiary companies.

Especially such relative figures as Return on Assets and Return on Equity have helped subsidiary
companies to focus more on financial outcome performance and to understand the concept of risk.

2. The objective performance evaluation results showed different performance levels among
subsidiary companies. Take the evaluation results of 1997 as an example; four categories exist in
non-power generation subsidiary companies. In the first category, the highest score is 106.1. In the
last category, the lowest score was only 50. For power generation subsidiary companies, three
categories exist with the highest score of 114 and the lowest 99. Performance differences were
found although they were not very obvious. For Branches and Offices, the highest score was 121.5
and the lowest, 98.5, in three categories. These numbers help top management to objectively evaluate
the performance of different subsidiary companies.

3. The ties between the performance evaluation results and the compensation have encouraged
and motivated employees and managers. According to the system, the amount of the total annual
bonus pool, which is the resource of the annual bonus of each subsidiary company, is determined by
the evaluation criteria. The actual bonus paid to each subsidiary company is decided by the parent
company based on the results of each specific company's performance evaluation. At the same time,
employees and managers’ bonus are also determined by the evaluation results. This incentive system
motivates employees and pushes subsidiary companies' business forward. The only constraint is that
any increase in the total compensation amount should not exceed any increase in the subsidiary
company's profit.

4. The performance evaluation system provides an objective standard to evaluate subsidiary

company managers. According to the evaluating system for managers, CHNG has four categories of
ratings: Ethics, Effort, Capability, and Performance to evaluate and appoint managers. The
Performance criterion has the biggest weighting percentage. The results of a specific subsidiary
company's performance evaluation are also an important criterion for assessing the competence of its
managers.

5. The overall control, performance evaluation and incentive system improved CHNG's
managing style and system for the whole group. CHNG’s inner management system is established on
the basis of investment capital control. The evaluation results are the basis of exercising the
shareholders’ rights of making decisions, selecting managers, and enjoying the earnings. The set of
evaluating criteria is to standardize the entire companies’ behaviors. In order to make evaluating
criteria better reflect the subsidiary companies’ operating conditions, CHNG’s top management also
decided to standardize and improve all subsidiary companies’ financial management and assets
management. For example, Equity Method is used in its long-term investments; interest payable is
recorded as Financial Expenses; estimated or unrealized gains or losses should not be included in a
subsidiary company's Income Statement as realized profits or losses; and bad debt expenses must be
recognized.

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Required:

Read the China Huaneng Group (CHNG) case carefully and answer the following five questions:

1. Briefly describe the China Huaneng Group.

2. Describe and evaluate strengths and weaknesses of CHNG's Control of Subsidiaries.

3. Describe and evaluate strengths and weaknesses of CHNG's current Performance Evaluation
System.

4. Describe and evaluate strengths and weaknesses of CHNG's current Incentive System.

5. What changes, if any, would you propose with respect to CHNG's existing: (1) Control of
Subsidiaries, (2) Performance Evaluation System, and (3) Incentive System?
For each change that you propose, explain what problem it is designed to resolve.

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