Introduction

General Paper Company (GPC) 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 GPC 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 General must offer a full range of both products and services. Thus, Generals 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.

GPC produces 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 one-inch 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 GPCs 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, General 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 cost drivers to attach overhead to products. General currently applies overhead to its products as a function of material costs (the current plant-wide pre-determined overhead rate of $1.05 used is based on material costs). Management believes using material costs as an allocation base makes 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) cost drivers appear to make 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 into 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 General 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. Generals accountants estimated that manufacturing overhead, including labor, energy, and depreciation on capital equipment, approximates 105% of material costs.

Exhibit 1

Selected product grades details

product caliper coated Slit Average reels material cost Selling price

(grade) /uncoated per Batch per reel 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 grade change Slitting Net

Depreciation $800,000 $8,000 $70,000 $722,000

Labor 300,000 3,000 25,000 272,000

Energy 500,000 5,000 80,000 415,000

Other 198,470 1,000 20,000 177,470

Unrecoverable 30,000 30,000 -0- -0-

Clay andChemicals

from Grade Changeovers

total $1,828,470 $47,000 $195,000 $1,586,47

Historically, product costs at General 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 General 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. Their goal is to have a better costing method in order to better understand markup per product line.

Case Analysis Guidelines General Paper Company

TASK:

You have been hired to provide recommendations on an improved method of estimating costs of production for General Paper Company. Currently the company applies overhead using one plant-wide overhead rate based on direct material costs. The fear by management is that this allocation method is incorrectly subsidizing manufacturing costs of the different types of products. Your task is to come up with a better overhead allocation approach that takes into consideration the significant activities described by management.

Start by understanding how the company is currently computing its overhead rate of $1.05 per direct material cost. Determine the current gross profit (or markup) on each product based on the current allocation system. Note that this capital intensive industry has relatively small labor costs, as such labor costs (direct and indirect) are simply included as part of overhead costs. Provide your client with your recommendation of a better overhead allocation method based on the activities involved in manufacturing the different types of products. Contrast how your improved allocation method changes the gross profit on each product as compared to the current allocation system. Based on your professional judgment, explain to the client why your work is so important to the survival of their business.

You will report your findings in a memorandum addressed to General Paper Companys CEO. One of your challenges is to address the issues completely yet concisely. It does not help your grade to write more than is necessary. Your ONE page memo (front side of paper only, think of it as an executive summary) must be clearly supported and cross[1]referenced with your supporting computations (e.g. tables, charts, external evidence, etc. in the appendix). Effective cross-referencing between the memo and the supporting computations is VERY important; please make sure it is clear to me where the numbers are coming from. While the written memo should not exceed ONE page, the appendix with tables, charts, external evidence, etc. does not have a limitation on length.

Keep in mind that there is no one right answer as these type of analyses require judgement and differing assumptions. Your accounting analysis will vary from everyone in class and that is OK. Your grade is mostly based on how well you make and support a persuasive argument to your client.

Sample Format

Introduction/Background

Here you may want to write

Objective and goal of this report, why you did it, why is it important.

What you are going to write (main sections). One paragraph

Methodology of Analysis You Used / Data Collection

Here you may want to write

Methodological approach you used/you created (e.g. least squares regression, standard costing, variable costing, net present value analysis, etc)

Brief justification of why the analytical method/framework is appropriate in this particular case.

What type of data are you using and how you collected data for your analysis. One paragraph

Results of Analysis

Here you may want to write

Explanation of findings (very important to reference the numbers from the Tables/Charts in the Appendix)

Overall summary of the findings One paragraph

Conclusions/Recommendations

Here you may want to write

Your conclusion or recommendation.

Limitations of the analysis if appropriate (for example, because of assumptions made).

Future analysis you think is necessary. One paragraph

References

Doe, J. and Smith, J. (2014). What is systems thinking? International Journal of LCOB, 1(1), 20-25.

Johnson, K. (2015). The definition of systems thinking. Is it good or evil for the information technology industry? Journal of FGCU, 1(1), 1-2.

Appendix

Tables, Charts, External Evidence, etc.