Financial Versus Activity Flexlble Budgeting Kelly Gray, production manager, was upset with the latest performance report, which indicated that she was $100,000 over budget. Given the efforts that she and her workers had made, she was confident that they had met or beat the budget. Now, she was not only upset but also genulnely puzzled over the resuits. Three items-direct labor, power, and setups-were over budget. The actual costs for these three items follow: Kelly knew that her operation had produced more units than originalily had been budgeted, so more pawer and labor had naturally been used. 5 he aiso knew that the uncertainty in scheduling had led to more setups than planned. When she pointed this out to John Hiang, the controllec, he assured her that the budgefed costs had beed adjusted for the increase in productive activity. Curious, Kelly questioned John about the methods used to make the adjustment. JOHN: if the actual level of activity differs from the original planied level, we adjust the budget by using budget formulas formulas that aliow us to predict what the costs will be for different levels of activity. KELLY, The approach sounds reasonable. However, I'm sure something is wrong here. Tell me exsctly how you adjusted the costs of tabor, pawer, and setupi. 304N: First, we obtain formulas for the individual items in the budget by using the method of least kquares, We atwume that cost variations can be explained by vanations in productive activity where activity is measured by direct tober hourt. Here is a list of the cost formulas for the three itents you mentioned, The varabie x is the number of direct isbor hours Laborcost=$9xPowercost=$5,180+$3.8xSetupcost=$99,100 KELLY: 1 think 1 wee the problem. Power costs don't have a lot to do with direct labor hours. They have more to do with machine hours. As arnduction increates, machine KELLY: I think I see the problem. Power costs don't have a lot to do with direct labor hours. They have more to do with machine hours. As production increases, machine hours increase more rapidly than direct labor hours. Also, JOHN: You know, you have a point. The coefficient of determination for power cost is only about 50 percent. That leaves a lot of unexplained cost variation. The coefficient for labor, however, is much better-it explains about 96 percent of the cost variation. Setup costs, of course, are fixed. KELLY: Well, as 1 was about to say, setup costs also have very little to do with direct labor hours. And I might add that they certainly are not fixed-at least not all of them. We had to do more setups than our original plan called for because of the scheduling changes. And we have to pay our people when they work extra hours. It scems as if we are always paying overtime. I wonder if we simply do not have enough people for the setup activity. Supplies are used for each setup, and these are not cheap. Did you build these extra costs of increased setup activity into your bucjet? JOHN: No, we assumed that setup costs were fixed. I see now that some of them could vary as the number of setups increases. Kelly, let me see if I can develop some cost formulas based on better explanatory variables. til get back with you in a few days. Assume that after a few days' work, John developed the following cost formulas, all with a coelficient of determination greater than 90 percent: Labor cost =59x; where x - Direct labor hours Power cost =$58,700+0.90Y; where Y= Machine hours Setup cost =$97,540+$3982; where 2= Number of setups The actual measures of each of the activity drivers are as follows: 1. Prepare a performance report for direct laboc, power, and setups using the direct-labor-based farmulas. 2. Prepare a performance report for direct labor, power, and setups using the multiple cost driver formulas that John developed. 3. Of the two approaches, which provides the most accurate picture of Kelly's performance? 4. After reviewing the approach to performance measurement, a consultant remarked that non-value-added cost trend reports would be a much better performance measurement approach than comparing actual costs with budgeted costs-even if activity flexble budgets were used. Do you agree or disagree