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.

10.

In memo form, summarize to Mr. Watson why he experienced such volatility in

profit under absorption costing when sales levels were relatively constant. Be

sure to include the advantages and disadvantages of using variable costing for

internal reporting purposes and how it applies to him.

Answer 1

The main reason for volatility in profit under absorbtion costing is due to the use of fixed overheads based on the number of units produced. Say in the question below:

Particulars	Q2	Q3
Variable manufacturing cost	10	10
Fixed manufacturing overhead	300,000	300,000
Actual production	12,000	15,000
Fixed manufacturing overhead per unit	25	20
Total cost per unit	35	30

It shows that the cost per unit sold decreased from $35 to $30. The reason for decrease is only the increase in production from 12,000 to 15,000 units. This does not happen in variable cost accounting. so, it has more stable cost per unit and the income moves in the same direction as the sales.

How to apply variable costing for Mr. Watson for Q2,Q3 and Q4 - Below table show the Income statement using Variable cost accounting method:

Particulars	Q2	Q3	Q4
Actual production	12000	15000	1000
Sales volume	10,000	8,000	10,000
Reveue	520,000	416,000	520,000
Opening stock	0	20,000	90,000
Variable manufacturing cost	120,000	150,000	10,000
Fixed manufacturing cost	300,000	300,000	300,000
Closing stock	-20,000	-90,000	0
(-)Cost of goods sold	400,000	380,000	400,000
Gross Profit	120,000	36,000	120,000
Variable selling & administration cost	60,000	48,000	60,000
Fixed selling & administration cost	50,000	50,000	50,000
Net Profit	10,000	-62,000	10,000

The comparison of profit is shown below:

Net Profit under	Q2	Q3	Q4	Total
Variable Costing	10,000	-62,000	10,000	-42,000
Absorbtion Costing	60,000	78,000	-180,000	-42,000

Although, the total loss for three quarters is same using both methods, the variable costing method seems more consistent and absorbtion costing is volatile as explained earlier.

Advantages of using variable costing:

- In variable cost accounting, contribution margin method is used which serves as a basis for CVP (Cost volume profit) analysis and calculation of break even units.

- Net operating income is close to the cash flow.

- It clearly separates the costs related to the unit production with that of the fixed costs which not dependant on the production of units. As fixed costs relates to time rather than unit cost, and hence should not be regarded as production cost.

- There is no change in per unit variable cost due to change in the level of production.

- Under variable costing, income and sales have a direct relationship i.e. they generally move in same direction as shown above. Decrease in sales in Q3 reduced profit leves and increase in sales again increased the level of profit. Sales units are same for Q2 and Q4. Under variable costing, profit is also same as $10,000 as shown in the table above. Under absorbtion costing, the income increases even when the sales decreased in Q3 and income decreased bu the units sales increased in Q4 from Q3.

Disadvantages of using variable costing:

- GAAP (Generally accepted accounting principles) accept absorption costing method and not variable costing.

- Tax authorities also require the use of absorbtion costing.

- It does not follow Matching accounting principle. Production cost does not match with the revenue as fixed cost is not added to the unit cost of production.

- Since total cost is not used in variable costing, it can't be used to measure management performance and efficiency levels.

- Total fixed cost is deducted in the accounting year rather than unit based. So, this tends to reduce the net income and hence income tax payments (from government perspective).