Mercedes Benz AAV’s Target Costing and Cost Analysis Strategies
In the early 1990s, Mercedes Benz was experiencing declining profit margins as a result of the increasing value of the German Deutschmark (BMW, 2007). The competitive environment for MB at the time was characterized by other leading European automobile manufacturers undergoing the same effects of high labor costs and weakening monetary exchange rates (BMW, 2007).The sales stats for 1993 proved to be the only year that Mercedes Benz has ever showed negative profits. The monetary exchange rate and high production costs for materials and labor were decisive factors in the directive to implement foreign production facilities (Mercedes, 2007). German automakers were the highest paid on the Earth at that time. In 1992 Mercedes Benz made the decision, following the lead of BMW the previous year, to build a production facility in the United States – specifically in Alabama.
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Corporate management was convinced that international market conditions would remain consistent for a sufficient time period necessary to recoup the investment costs required for these facilities (BMW, 2007). MB conducted research that exposed American demand for luxury sports utility vehicles. This was the beginning of an effort to develop the exploding market for sport utility vehicles in the US, although Mercedes named theirs AAVs; All Activity Vehicles offered in the A-class or the M-class models (Albright Case Study). Non-standard techniques of cost targeting were engaged and the analysis of benefits compared to costs proved feasible. Globalization schemes and atypical production strategies coupled with the superior quality and perceived value of products offered ensured no repetition of profit loss for the corporation (Mercedes, 2007). This document explores the target costs and cost analysis strategies utilized to turn the automaker back to good and solidify its position as a world leader in the production of luxury vehicles.
To gain an understanding of the steps taken by Mercedes’ management to rectify their grave situation, it is necessary to explore some key issues of the case. The accounting department at MB modeled possible future economic situations that could affect the long-term success of such a project. After sufficient research and modeled scenarios concerning ten years of future net present values (NPV) was completed with profit-assuring feasibility assumed, production efforts ensued. Firstly, a modular-based construction process utilizing groups representing all company areas was used to design the initial AAVs. First-tier suppliers provided whole systems rather than individual parts (Albright case study). Mercedes undertook meticulous efforts to gain an understanding of the competition in part by purchasing and dissecting their vehicles. They taught themselves how to provide superior engineering by exposing the weaknesses of that of other manufacturers. The accounting department consistently computed and recomputed actual and modeled scenarios to provide fresh and relevant data concerning the project and its success (Mercedes, 2007).
MB also knew the importance of developing a component importance indexing system. They again conducted research to ascertain which features were the most important to potential consumers concerning the design and engineering the AAVs. Individual components such as safety, comfort, economy and styling were ranked in importance by the research contributors. Resource allocation was dictated by these results and a project budget was developed accordingly. This was another important step along the road to effective and accurate target costing procedures (Albright case study). By considering different function groups within each determined area of importance, MB was better able to dictate the amount of resources that could feasibly be dedicated to each area. This in turn allowed them to determine areas that could be focused upon to reduce costs of production as compared to areas that needed more resources allocated. In this way they were able to control costs by not expending any resources to any area of development/production that was not an integral component for the final product.
In an effort to expedite communication, management placed members from both design and testing teams in close physical proximity. Engineers from MB worked directly with parts suppliers from early stages to help eliminate confusion and capacitate more rapid communications. Parts suppliers became system suppliers. Instead of having various manufacturers provide individual components necessary for a system, the manufacturer produced the entire system, again further reducing confusion, improper design, and human error increased through the involvement of more people (Mercedes, 2007). Examples of such systems include the dashboard, doors, and every other multi-componential entity. Regular meetings were held to ensure a constant understanding of the balance being kept between target costs and cost analysis.
Target costing is the determination of the maximum allowable costs that can be incurred by a company as a result of research, design, engineering, and production (Target Costing, 2007). If these costs go beyond the projected target cost, profits begin to be forfeited. If these costs exceed their estimated projections, the company could not continue in the long run; it would deplete funding and show negative returns. This estimating technique was developed by the Japanese in the 1970’s (Target Costing, 2007). The total estimated costs of facility construction, product research and design, market research, product production, marketing and distribution are summed together with an added variable for desired profit to obtain the target costs. Mercedes Benz corporate management wanted to determine the target costs for development, construction, and implementation of an oversea production facility. Market research was conducted to ascertain whether consumer demand for a SUV-type vehicle with more expensive, Mercedes-quality features would justify these targeted costs. In fact, the market had shifted its consumption trends towards more luxurious vehicles. This fact coupled with the fact that the SUV market was booming were decisive factors to go ahead with the project (Mercedes, 2007).
The problem with target costing techniques is that they are prone to many changing variables as well as their very nature of being future-based (Target Costing, 2007). This causes inaccuracy. Models create artificial scenarios that (hopefully) mimic true market conditions of the future. Model designers recognize the risks of inaccuracy and allow variables within the models to incorporate fluctuations in such components as: differing monetary exchange rates; different sales levels; and oscillating material costs. Where there are models in use for trend detection and market simulation, there will also be error. Therefore it is necessary to possess calculating methods of real market conditions in order to ascertain the validity and accuracy of the models in use (Target Costing, 2007). In the case of Mercedes Benz, an effort was made to control such fluctuating variables. One such method involved the inclusion of systems designers in the early stages of product development (Albright case study). This increased the probability that the individual systems designers would be able to deliver the systems according to the target costs set, thus alleviating some of the potential inaccuracies presented by the model. Still, other variables were not so readily caged.
Enter the concept of cost analysis, aka: benefit-cost analysis. Cost analysis is a set of methods for appraising a project; a way to determine the effectiveness of the models employed. It is “the process of weighing the total expected costs against the total expected benefits of one or more actions in order to choose the best or most profitable option (Albright case study)”. Calculations are made to weigh initial and current expenditures against the expected return (Target Costing, 2007). Market observation and established surveying methods are utilized in the attempt to accurately represent costs and benefits simultaneously. Computational formulae exist to derive the time value of money. Costs and benefits expected in the future are converted to present value amounts through the utilization of these formulae. The specific formula employed by Mercedes for their project appraisal efforts was called net present value (NPV). It is a standard method of computation for the financial evaluation of long term projects like the introduction of AAVs by Mercedes. It yields excesses or shortcomings of cash flows in present value terms once initial expenditures and financing charges are met (Net Present Value, 2007). Constant recompiling of this data throughout the course of the Mercedes AAV project helped to keep all components and teams on track and in efficient production ratings (Albright case study). Since the first sales year for the A & M-class Mercedes Benz AAVs, 1997, there has been no further loss of profits for the manufacturer (Mercedes, 2007). On the contrary, sales are booming again this year for the auto giant. Mercedes continues its illustrious legacy of being one of the world’s top sellers of automobiles known not simply for luxury, but also for exceptional engineering and design. Consumers showed trends of considering safety of the highest priority (Albright case study). Mercedes has and continues to claim the safest, most well-designed auto on the planet. Through continued utilization of creatively modeled methods to develop and control target costs and accurately analyze them, Mercedes will probabilistically continue its success story well into the future.
Bent Flyvbjerg, Nils Bruzelius, and Werner Rothengatter, Megaprojects and Risk: An Anatomy of Ambition (Cambridge University Press, 2003
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Net present value (NPV) is a standard method for financial evaluation of long-term projects. Used for capital budgeting, and widely throughout economics, it measures the excess or shortfall of cash flows, in present value (PV) terms, once financing charges are met. Each cash inflow/outflow is discounted back to its PV. Then they are summed.
t – The time of the cash flow
n – The total time of the project
r – The discount rate
Ct – The net cash flow (the amount of cash) at that point in time.
C0 – The capital outlay at the beginning of the investment time (t = 0)