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 Hills 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 FHPCs 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 paperboards 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 companys 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 Hills 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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