M5: Watson Activity

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

the firms 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 hes 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 Q20 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

Quarters 2 and 3.

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

firms 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?