During the recession in 1990, Mercedes -Benz struggled to adapt to changing markets. The luxury car market lost money for the first time in history in the 90’s. In 1993, there was a big sales slump in Mercedes-Benz sales. In its search for additional market share, new segments, and new niches Mercedes started developing a range of new products. One of the most radical and largest of the new range of products is AAV (all activity vehicles). In order to be competitive in the market, Mercedes-Benz needs to control costs and also meet the customer requirements at the same time.
To achieve this goal, Mercedes-Benz adapted target costing. Is Mercedes-Benz heading in a right direction with target costing? Should they continue to use it? If target costing is not appropriate what is the best alternative? Mercedes-Benz is a world renowned company which primarily operated in the luxury market segment before the 1990 recession. Because of the recession in 1990, the luxury market took a hit and Mercedes-Benz struggled with cost efficiency, product development, material purchasing, and problem in adapting changes. A modular construction process was used to produce the AAV.
Functional groups with representatives from different areas like marketing, development, engineering, purchasing, production, and controlling were used to design the vehicle and production system. From the concept development to production commencement, it only took 5 years. After comparing existing production lines with various market segments for opportunities, the management discovered the sports utility vehicle market is rapidly expanding. During the project realization phase, engineers designed a prototype which was viewed by customers to let engineers know how they received it.
The customers were also asked to rank the importance of various features such as safety, comfort, economy, and styling. During the production phase, the accounting system served as a controlling mechanism to ensure actual production costs confirmed to target costs. The target selling price was set based on positioning of the product and the industry average in profits. The required margin was set based on internal benchmark and prices of competitors. The target cost was calculated as selling price- desired profit. The design of the vehicle should be done to meet the target cost.
Target costing for AAV: The process of achieving target costing began with estimating cost for each function group. A function group for AAV is any major part or component that contributes to significant cost of the product such as chassis, transmission, and electric system etc. Cost reduction targets were set for each of the function groups. The manufacturing relied on high value added system suppliers by making the supplier’s part of costing system by involving them in initial discussions. Mercedes expected suppliers to be part of cost targets. The target costing process was led by engineers with manufacturing and design experience.
Index development: During the concept development phase various indexes were developed to determine critical performance, design, and cost relationships for AAV. To start with, a table was developed to know the customer responses to importance to each category such as safety, comfort, styling, and economy, etc. For example, safety was listed as one of the important categories by customers, the importance is 32 which is 41% relative to the total percentage, comfort- importance is 25 and relative percentage 32%, economy- importance 15 and relative percentage is 18%, styling- importance 7 and relative percentage 9% etc.
A second table was developed to better understand various sources of costs for each of the function groups. For example, function group chassis target cost is $x,xxx and percentage of total cost is estimated as 20%. Based on functional groups developed by engineers and customer requirements, a third table was developed. This table summarizes how each function group contributes to the customer requirements by taking information from table 1. For example, Chassis function group contributes 50% to safety, 30% to comfort, 10% to economy and 10% to styling.
From this, engineers determined that chassis quality was important. A fourth table was created to know the importance index of various function groups by using information from table1 and table 3. For example, the importance index for chassis is calculated by multiplying each row in table 3 with the relative percentage of each column of table1 that is (. 50 x . 41) + (. 30 x . 32) + (. 10 x . 18) + (. 10 x . 09) = . 33. A final table was developed to calculate the target cost index for each functional group.
The target cost index was calculated by dividing each important index (from table 4) with target cost (from table 2). For example, the importance index for Chassis is . 33 and the target cost is 20% so the target cost index is 1. 65. A function group with target cost index ration less than 1 indicates that it is a candidate for possible cost reduction. That is the ratio of cost to benefit is low. Options available are: Re evaluating assumptions or importance, reduce cost of existing design by working with supply partners.
In general, 80% of the components and systems are provided by suppliers. So working with the suppliers for cost reduction is very critical for target costing. Through an iterative process, either the importance index or the target cost is adjusted to bring the target cost index to the desired level. By using target costing, Mercedes controlled costs at the concept development phase. In general, target costing is well suited for high parts complexity products with long development cycles, large investments, and horizontal integration.
In the case of AAV, target costing was successfully used to reduce the purchase price by iteratively adjusting the importance index and target cost to get a desired target cost index. This was also made possible by making suppliers as part of production process (entire cockpit was purchased as a unit from suppliers), and by the high investment with an expected production estimates of 65,000 vehicles a year. Mercedes approached cost reduction to target costing without compromising on safety and quality. Alternatives: 1.
Continue to use the existing system where the company builds products with emphasis on what they can do (more emphasis on luxury with function, safety, and engineering excellence) rather than what customers want. 2. Use target costing to reflect market trends and involve all parties from the beginning to end to come up with the cost. 3. Other alternative such as profit maximizing pricing, cost plus pricing, and cost plus pricing could be used. Alternative 1 results in expensive vehicles and might not include what customers want. Alternative 3 will not address competition from other brands.
Alternative 2 should be chosen because Mercedes wants to move to value market and is trying to adapt to new markets to ensure that the costs are addressing customer requirement and reflect the market competition. Mercedes should continue to use target costing as it is a systematic process of enterprise-wide cost management and profit planning. Target costing is consumer driven. By using target costing Mercedes can reconcile what customer want with what company believes in. By adopting target costing, Mercedes- Benz can achieve the following: customer requirements for cost, time and quality can be simultaneously incorporated.
Cost control is emphasized at the product and process development stage which will give them a chance to revise the cost several times before production begins. Different departments can be involved in all stages of product development from beginning to the end. All members of the value chain such as suppliers etc can be included in the costing system and total life cycle costs are minimized for both producer and customer. Life cycle costs include purchase price, operating cost, maintenance, and distribution costs.