Question

M5: Watson Activity

Watson, Inc. is a manufacturing firm. Its owner, Tom Watson, was worried about

the firm’s third quarter results because demand for its product has been

decreasing. However, he was pleasantly surprised to see that profit had actually

increased in the third quarter. Still, he has a nagging feeling that he’s missing

something important.

Watson, Inc.

Income Statements

2017

Q2

Q3

Q4

Sales volume

10,000

8,000

10,000

Sales revenue

$520,000

$416,000

$520,000

Cost of goods sold

350,000

240,000

590,000

Gross margin

170,000

176,000

(70,000)

Selling and administrative expenses

110,000

98,000

110,000

Net operating income

$60,000

$78,000

(180,000)

Production Levels

Q2

Q3

Q4

Actual production (units)

12,000

15,000

1,000

Cost information

Variable manufacturing cost

$10.00

per unit

Variable selling and administrative cost

$6.00

per unit

Fixed manufacturing overhead

$300,000

per qtr

Fixed selling and administrative cost

$50,000

per qrt

Other Information:



    The company's selling price and cost structure have been stable for the last year



    The company applies overhead based on actual production



    The company uses LIFO for inventory costing



    Beginning Inventory at the start of Q2—0 Units / $0



    The company introduced Lean Production at the beginning of the fourth quarter,

resulting in zero ending inventory. The results for Q4 using absorption costing

are shown above.

7. Reconcile net operating income from variable costing to absorption costing for

Quarter’s 2 and 3.

8. Sales volume is the same in Q4 as it was in Q2. Nothing has changed about the

firm’s selling price or cost structure.

a. Why does the reported profit differ between Q2 and Q4 when absorption

costing is used?

b. If variable costing were used, what profit or loss would be reported for the

fourth quarter?

c.   Reconcile the absorption costing net income and variable costing net income

for Q4.

9. Starting with the first quarter of the next year, would you expect any differences

between the net operating income reported under absorption costing and

variable costing?

Answer 1

As per policy, only four parts of a question is allowed to answer, so answering four parts :

1 a) Income statement as per Absorption and Variable costing :

AS PER ABSORPTION COSTING :
	Q2	Q3	Q4
PRODUCED	12000	15000	1000
SOLD	10000	8000	10000
REVENUE	520000	416000	520000
LESS:
V MANUF EXP	-100000	-80000	-100000
F MANUF EXP	-250000	-160000	-300000
(300000 * 10/12)
OPENING STOCK			-190000
TOTAL COGS	350000	240000	590000
GM	170000	176000	-70000
S & AD EXP	110000	98000	110000
NOI	60000	78000	-180000
1 b)
AS PER VARIABLE COSTING :
	Q2	Q3	Q4
PRODUCED	12000	15000	1000
SOLD	10000	8000	10000
REVENUE	520000	416000	520000
LESS: VARIABLE EXP:
V MANUF EXP	-100000	-80000	-100000
S & AD EXP	-60000	-48000	-60000
TOTAL VARI EXP	-160000	-128000	-160000
CONTRIBUTION	360000	288000	360000
Less: FIXED EXPENSES:
FIXED MANUF EXP	300000	300000	300000
S & AD EXP	50000	50000	50000
TOTAL FIXED EXP	350000	350000	350000
NOI	10000	-62000	10000

c) Reconciliation of Q2 & Q3 :

	q2	q3
absorption costing NOI	78000	-180000
less: Fixed Manuf. exp. trasferred forward with closing stock	-140000	+190000
variable costing NOI	-62000	10000

b)

If variable costing were used, the profit or loss that would be reported for the

fourth quarter is $10000