Prove overhead rate is 105% of the material cost.

Introduction Woodhill Paper Company (WPC), 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. WPC's owners have long produced a full range of products. As a small company competing against large companies in a commodity market, management believes WPC must offer a full range of both products and services. Thus, WPC'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. WPC produces 20 different grades of paperboard-produced in large quantities requiring production runs of several days, or 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 usual cyclical economic environment of three to four year upswings. In response to limited supply during an economic boom, customers often double or triple the quantities ordered. They then begin receiving their large orders as the economy, again, begins to slow. Thus, 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 to wash away and screen the naturally brown fibers. A bleaching process converts brown pulp into white pulp. The paperboard manufacturing process mixes 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 WPC's customers to make various types of paperboard containers. Some customers require further processing on parent rolls. E.g., food processors often require widths of 18 inches, rather than the standard width of a reel (about 12 feet). Reels are loaded onto a rewinder slitter to produce eight reels 18 inches wide from one 12 -foot-wide reel. For convenience, WPC always combines 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. WPC 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 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 WPC managers 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 WPC was experiencing demand in excess of its production capacity. A sample representing key categories of grades appears n Exhibit 1 , containing thin paperboard grades (caliper .013 ) as well as heavier grades (caliper.020). Exhibit 1 also identifies whether a grade is coated or uncoated or slit and other variations 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. WPC's accountants estimated that manufacturing overhead, including labor, energy, and depreciation on capital equipment, approximates 105% of material costs. Historically, product costs at WPC 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, WPC managers 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. Exhibit 1 Selected Product Grades with Production and Financial Data \begin{tabular}{cllllll} Product(grade) & Caliper & Coated/Uncoated & Slit & AverageReelsperBatch & MaterialCostperreel & SellingPricePerReel \\ \hline 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 \\ \hline \end{tabular} Introduction Woodhill Paper Company (WPC), 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. WPC's owners have long produced a full range of products. As a small company competing against large companies in a commodity market, management believes WPC must offer a full range of both products and services. Thus, WPC'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. WPC produces 20 different grades of paperboard-produced in large quantities requiring production runs of several days, or 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 usual cyclical economic environment of three to four year upswings. In response to limited supply during an economic boom, customers often double or triple the quantities ordered. They then begin receiving their large orders as the economy, again, begins to slow. Thus, 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 to wash away and screen the naturally brown fibers. A bleaching process converts brown pulp into white pulp. The paperboard manufacturing process mixes 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 WPC's customers to make various types of paperboard containers. Some customers require further processing on parent rolls. E.g., food processors often require widths of 18 inches, rather than the standard width of a reel (about 12 feet). Reels are loaded onto a rewinder slitter to produce eight reels 18 inches wide from one 12 -foot-wide reel. For convenience, WPC always combines 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. WPC 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 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 WPC managers 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 WPC was experiencing demand in excess of its production capacity. A sample representing key categories of grades appears n Exhibit 1 , containing thin paperboard grades (caliper .013 ) as well as heavier grades (caliper.020). Exhibit 1 also identifies whether a grade is coated or uncoated or slit and other variations 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. WPC's accountants estimated that manufacturing overhead, including labor, energy, and depreciation on capital equipment, approximates 105% of material costs. Historically, product costs at WPC 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, WPC managers 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. Exhibit 1 Selected Product Grades with Production and Financial Data \begin{tabular}{cllllll} Product(grade) & Caliper & Coated/Uncoated & Slit & AverageReelsperBatch & MaterialCostperreel & SellingPricePerReel \\ \hline 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 \\ \hline \end{tabular}