Photoshop files in DVDSP-best practices...

I am teaching a class and a discussion point cam about regarding Photoshop and layers. At issue is a menu design where the designer used multiple layers (10-13)for text, objects, etc. This is not a layered menu but there is one overlay file.
Question:
Apart from the overlay layer should one be merging or flattening (not sure I know which is preferred) the file before doing a build?
Comment:
In the build process we are converting still assets to JPEG's and video assets to MPEG2 so this very process does a "flattening." Therefore the extra time/work in Photoshop is not needed.

You can certainly use a layered file to create a standard menu. It's a DVDSP feature, not something that all authoring apps let you do. Some may, but not all.
You can import 10-13 layers in a single file, no need to flatten or merge. When you add this to a menu be sure to create the right kind of menu first! You are making a standard menu, not a layered menu. When you add the photoshop file the layers are preserved and you can then see how it looks. If you need to edit the file you can do so, and of course you get to specify which layer is the overlay. This last bit is in a different tab, but all in the property inspector for the menu. Also, if you sue coloured shapes for the overlay layer (and why not?) remember that your colour mapping will need to be set correctly in the 'Colors' tab for them to show as you expect. Generally speaking, using a color in the overlay file means you'll need to set the menu up with Chroma rather than grayscale settings.
When complete, you build and format your disc, and DVDSP flattens all of the layers into a background image (apart from the specified overlay layer) before it converts them to MPEG2 format.
This functionality is a feature that is intended to make authoring menus a little easier for people. Personally, I don't use it, preferring to manage the menu creation in photoshop entirely, but I do see how you could play around with various layer combinations from inside DVDSP to decide what the final look should be before committing it to the disc.

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