Introduction
Forest Hill Paper Company (FHPC) is a small, closely-held paperboard manufacturer that produces a broad line of paperboard in large reels, termed parent rolls. These parent rolls are sold to converters who further process them into containers used for a diverse line of consumer products, such as packaging for microwavable meals. The owners of FHPC have long pursued the strategy of producing a full range of products. As a small company competing against large companies in a commodity market, management believes Forest Hill must offer a full range of both products and services. Thus, Forest Hill’s strategy is to create a niche based on service and rapid response to customer needs.
While product diversity within a paperboard plant would not be apparent to a casual observer, subtle differences exist. For example, paperboard differs by basis weight (thickness determined by caliper measurements) for a specified length of product. Additionally, paperboard may be uncoated or coated with an opaque, white clay-based material that masks cosmetic flaws and smooths surface variability. Customers are increasingly concerned with surface variability because an extremely smooth finish is required to accommodate complex printed designs on the completed paperboard container or carton.
FHPC produces 20 different grades of paperboard. Some grades are produced in large quantities requiring production runs of several days, while others are produced in smaller quantities requiring runs of only a few hours. Consistent with lean manufacturing principles, the company maintains minimal inventories. Production schedules are driven by two factors: market demand and the theoretically optimal production schedule. The optimal production schedule is designed to reduce waste associated with grade changes by producing successive batches with minor differences in
basis weight.
Competitive Environment
Paper and paperboard producers operate in a cyclical economic environment, with upswings every three to four years. In response to limited supply during an economic boom, customers often double or triple the quantities ordered. Then, they begin receiving their large orders as the economy, once again, begins to slow. As a result, many customers find their paper inventories exceed current needs and temporarily stop placing orders. To further confound the paperboard producers’ headaches, market share for domestic paperboard has been declining. The most significant contributors to the loss of market share are the trend toward plastic and to more environmentally friendly grades of recycled paperboard.
Throughout the industry, companies have made very limited investments to expand capacity. When a surge in demand for paper products occurs, demand will exceed capacity. In boom times the industry experiences steep price hikes resulting in record selling prices for most grades.

The Manufacturing Process
Pulp manufacturing begins with hardwood or softwood
timber in the form of logs or wood chips. If raw materials are
received in the form of logs, the first step in the process is
debarking. A rotating debarking drum that measures 16 feet
in diameter by 100 feet in length tumbles the logs to remove
the bark. After debarking, chippers reduce the logs into oneinch cubes.
The second step in the process is termed “digesting.”
Wood chips are cooked at 325 degrees Fahrenheit to break
down the glue-like material bonding the wood fibers.
Chemicals used in the digestor are reclaimed and reused in
future pulp production. Following the digesting process,
the naturally brown fibers are washed and screened. A
bleaching process converts brown pulp into white pulp.
The paperboard manufacturing process begins by
mixing pulp with water and chemicals in the first stage,
or headbox, of a paper machine. The mixture is applied
to a porous wire mesh; formation of paper actually occurs
within this step. The wire mesh travels through a press
that forces the pulp mixture against the wire to eliminate
water within the mixture and to form the desired paper
thickness. The material then proceeds to a drying section
where it travels across numerous cylindrical dryers that are
heated with steam. In the final section of the paper machine,
long sections of paperboard (approximately five miles long
and weighing ten tons) are rolled up into parent rolls and
are removed from the machine. The parent roll is further
processed by FHPC’s customers to make various types of paperboard containers.
Sometimes customers require additional processing on
parent rolls. For example, food processors often require
widths of 18 inches, rather than the standard width of a
reel (approximately 12 feet). Thus, reels are loaded onto
a rewinder slitter to produce eight reels 18 inches wide
from one 12-foot-wide reel. For convenience, Forest
Hill had always combined labor and machine costs of
the rewinder slitter with those of the paper machine for
allocation purposes. Thus, all grades of paperboard shared
in the costs of slitting even though most grades were not
slit. Engineering studies suggest slitting may be more
expensive than previously thought. In addition to the costs
of specialized equipment and extra labor, knives used in
the slitting process often damage the paperboard’s edges.
Thus, more quality inspection and testing are required when
producing slit reels.
Continuous processors, such as chemical and paper producers,
historically have used volume-related drivers to attach
overhead to products. Forest Hill traditionally applied
overhead to its products as a function of material costs.
Management believed using “material costs” as an allocation
base made sense because thicker products (containing more
material per lineal foot than thinner products) required more
machine time to process as they demanded slower machine
speeds. Additionally, drying time and energy consumption
increase with thicker basis weights. (See Exhibit 1 for material
costs associated with each product, or grade.) Thus, unit level
(or volume-related) drivers made sense for applying certain
types of overhead to products. However, other important costs
were incurred without respect to volume. For example, grade
changes induce instabilities in the manufacturing process
that result in scrap until the process resumes stability. On
average, production engineers estimate that approximately
one-half reel is lost to scrap each time a grade change is made.
Just as discrete-part manufacturers incur machine setup costs
between production runs of two different products, scrap
produced following grade changes is a predictable cost of
production. Some of the pulp can be recovered by recycling
the scrapped paper, termed “broke” paper. Thus, the grade
change cost figures presented in Exhibit 2 include only
depreciation, labor, energy, and lost chemicals associated with
grade changes.
Recently, some managers at the company began
questioning the long-standing strategic policy of producing
a full product line. Because selling prices and profit margins
significantly varied across the product mix, some managers
questioned whether the company’s assets were being
used to the greatest advantage. Currently Forest Hill was
experiencing demand in excess of its production capacity.
A sample representing significant categories of grades is
presented in Exhibit 1. The sample contains thin paperboard
grades (caliper .013) as well as heavier grades (caliper .020).
In addition, Exhibit 1 identifies whether a grade is coated or
uncoated, or slit. The sample is representative of the variation
in batch quantities. Some grades are produced and sold in
small quantities, while the market demands significantly more
production of other grades. Material cost per reel includes
pulp and chemical costs, while the selling price reflects recent
spot market prices.
Pulp and paperboard is a capital-intensive industry
requiring expensive processing equipment. Forest Hill’s
accountants estimated that manufacturing overhead,
including labor, energy, and depreciation on capital equipment, approximate 105% of material costs.

Exhibit 1
Selected product grades with production and financial data

Product( Grade)/ Caliper Coated/Uncoated /Slit /Average Reels per Batch / Material Cost per Reel / Selling Price per Reel
A /.013 /Coated/ yes /50/ $4,800/ $12,600
B /.014 /Uncoated /no /2 /$5,200 $13,500
C /.015 /Coated /yes /35 /$5,600 /$14,200
D/ .020 /Coated/ no /175/ $7,400/ $19,500

Exhibit 2
Overhead Structure
......................Total /GradeChange/ Slitting /Net
Depreciation $800,000 /$8,00 $70,000 $722,000
Labor ...........300,000/ 3,000 /25,000 272,000
Energy .........500,000/ 5,000/ 80,000/ 415,000
Other ...........98,470 /1,000 /20,000 /177,470
Unrecoverable Clay and Chemicals
from Grade Changeovers 30,000/ 30,000/ -0-/ -0-
Total ...........$1,828,470 /$47,000 /$195,000/ $1,586,470

Historically, product costs at Forest Hill were calculated
by multiplying the overhead rate by material costs. However,
brand managers had begun to suspect that some grades were
subsidizing others with respect to costs. Two significant
activities, grade changes and slitting, were identified to
help reduce cross-subsidy and provide more accurate cost
estimates. Exhibit 2 identifies total overhead costs with
respect to the four grades shown in Exhibit 1, estimated
grade change costs, and slitting costs. These costs are based
on one run of each grade.
The capital intensive structure of a paper company
coupled with the cyclical nature of the industry makes
accurate cost information an important strategic tool. Though
current demand exceeds existing capacity, managers at
Forest Hill know that a downturn is inevitable. Gaining an
understanding of the costs associated with grade changes
and slitting is a first step that will enable managers to more
effectively manage their business in good times and in bad.
requirements
1. How would you classify Forest Hill Paper Company in
terms of size and ownership?
2. What is the nature of the industry in which Forest Hill
competes?
3. Identify and discuss the strategy used by Forest Hill to
compete in a commodity market.
4. What are some examples of complexity that drive
overhead costs for Forest Hill?
5. How does the current system capture manufacturing
costs and assign them to products? (Prove the overhead
rate is 105% of material cost.)
6. Calculate the volume-based (traditional) cost per reel for
grades A-D identified in Exhibit 1.
7. What is the cost for Forest Hill to conduct a grade change?
8. What is the cost for Forest Hill to slit a reel of
paperboard? As shown in Exhibit 1, only products A and
C are routinely slit. For purposes of your analysis, assume
the slitting equipment must be set up and adjusted
between each reel slit.
9. Calculate the new volume-based overhead rate after
removing grade change and slitting costs.
10. Determine the activity-based costs for grades A-D
11. Prepare a table that illustrates the percentage change in
costs between the volume-based system and the strategic
activity-based system.
12. What conclusions can you draw from your analysis?
As a consultant to Forest Hill, what actions would you
recommend?

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