Reporting Accounting Assignment

ISSN 1940-204X

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Mercedes-Benz All Activity Vehicle (AAV)

Tom Albright

The University of Alabama

INTRODUCTION

During the recession beginning in the early 1990s,

Mercedes-Benz struggled with product development, cost

efficiency, material purchasing, and problems in adapting

to changing markets. In 1993, these problems caused the

worst sales slump in decades and the luxury carmaker lost

money for the first time in its history. Since then, Mercedes

has streamlined the core business, reduced parts and system

complexity, and established simultaneous engineering

programs with suppliers.

In its search for additional market share, new segments,

and new niches, Mercedes started developing a range of new

products. New product introductions included the C-class

in 1993, the E-class in 1995, the new sportster SLK in 1996,

and the A-class and the M-class in 1997. Perhaps the largest

and most radical of Mercedes’s new projects was the All

Activity Vehicle (AAV). In April 1993 Mercedes announced

it would build its first passenger-vehicle manufacturing

facility in the United States. The decision emphasized the

company’s globalization strategy and desire to move closer to

its customers and markets.

Mercedes-Benz United States International used

function groups with representatives from every area of the

company (marketing, development, engineering, purchasing,

production, and controlling) to design the vehicle and

production systems. A modular construction process was

used to produce the AAV. First-tier suppliers provided

systems, rather than individual parts or components, for

production of approximately 65,000 vehicles annually.

ThE AAV PROJECT PhASES

The AAV moved from concept to production in a relatively

short period of time. The first phase, or concept idea phase,

was initiated in 1992. The concept phase resulted in a

feasibility study that was approved by the board. Following

board approval, the project realization phase began in 1993,

with production commencing in 1997. Key elements of the

various phases are described below.

CONCEPT PhASE: 1992 – 1993 Team members compared the existing production line with

various market segments to discover opportunities for new

vehicle introductions. The analysis revealed opportunities

in the rapidly expanding sports utility vehicle market that

was dominated by Jeep, Ford, and GM. Market research was

conducted to estimate potential worldwide sales opportunities

for a high-end AAV possessing the characteristics of a

Mercedes-Benz. A rough cost estimate was developed

that included materials, labor, overhead, and one-time

development and project costs. Projected cash flows were

analyzed over a 10-year period using Net Present Value (NPV)

analysis to acquire project approval from the board of directors.

The sensitivity of the NPV was analyzed by calculating “what-

if” scenarios involving risks and opportunities. For example,

risk factors included monetary exchange rate fluctuations,

different sales levels due to consumer substitution of the AAV

for another Mercedes product, and product and manufacturing

costs that differed from projections.

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Based on the economic feasibility study of the concept

phase, the board approved the project and initiated a search

for potential manufacturing locations. Sites located in

Germany, other European countries, and the United States

were evaluated. Consistent with the company’s globalization

strategy, the decisive factor that brought the plant to the

U.S. was the desire to be close to the major market for sports

utility vehicles.

PROJECT REALIzATION PhASE: 1993 – 1996 Regular customer clinics were held to view the prototype

and to explain the new vehicle concept. These clinics

produced important information about how the proposed

vehicle would be received by potential customers and the

press. Customers were asked to rank the importance of

various characteristics including safety, comfort, economy,

and styling. Engineers organized in function groups

designed systems to deliver these essential characteristics.

However, Mercedes would not lower its internal standards

for components, even if initial customer expectations might

have been lower than the Mercedes standard. For example,

many automotive experts believed the superior handling of

Mercedes products resulted from manufacturing the best

automobile chassis in the world. Thus, each class within the

Mercedes line met strict standards for handling, even though

these standards might have exceeded customer expectations

for some classes. Mercedes did not use target costing to

produce the lowest priced vehicle in an automotive class.

The company’s strategic objective was to deliver products

that were slightly more expensive than competitive models.

However, the additional cost had to translate into greater

perceived value on the part of their customer.

Throughout the product realization phase, the vehicle

(and vehicle target cost) remained alive because of changing

dynamics. For example, the market moved toward the luxury

end of the spectrum while the AAV was under development.

In addition, crash test results were incorporated into the

evolving AAV design. For these reasons, Mercedes found

it beneficial to place the design and testing team members

in close physical proximity to other functions within the

project to promote fast communication and decision-making.

Sometimes new technical features, such as side airbags, were

developed by Mercedes. The decision to include the new

feature on all Mercedes lines was made at the corporate level

because experience had shown that customers’ reactions to a

vehicle class could affect the entire brand.

PRODUCTION PhASE: 1997 The project was monitored by annual updates of the NPV

analysis. Additionally, a three-year plan (including income

statements) was prepared annually and reported to the

headquarters in Germany. Monthly departmental meetings

were held to discuss actual cost performance compared with

standards developed during the cost estimation process.

Thus, the accounting system served as a control mechanism

to ensure actual production costs conformed to target (or

standard) costs.

TARgET COSTINg AND ThE AAV The process of achieving target cost for the AAV began with

an estimate of the existing cost for each function group. Next,

components comprising each function group were identified

with their associated costs. Cost reduction targets were set

by comparing the estimated existing cost with the target cost

for each function group. These function groups included

the following: doors, sidewall and roof, electrical system,

bumpers, powertrain, seats, heating system, cockpit, and front

end. Next, cost reduction targets were established for each

component. As part of the competitive benchmark process,

Mercedes bought and tore down competitors’ vehicles to help

understand their costs and manufacturing processes.

The AAV manufacturing process relied on high value-

added systems suppliers. For example, the entire cockpit

was purchased as a unit from a system supplier. Thus, system

suppliers were part of the development process from the

beginning of the project. Mercedes expected suppliers to

meet established cost targets. To enhance function-group

effectiveness, suppliers were brought into the discussion

at an early stage in the process. Decisions had to be made

quickly in the early stages of development.

The target costing process was led by cost planners who

were engineers, not accountants. Because the cost planners

were engineers with manufacturing and design experience, they

could make reasonable estimates of costs that suppliers would

incur in providing various systems. Also, Mercedes owned

much of the tooling used by suppliers to produce components,

such as dies to form sheet metal. Tooling costs were a

substantial part of the one-time costs in the project phase.

INDEx DEVELOPMENT TO SUPPORT TARgET COSTINg ACTIVITIES

During the concept development phase Mercedes team

members used various indexes to help them determine

critical performance, design, and cost relationships for the

AAV. To construct the indexes, various forms of information

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were gathered from customers, suppliers, and Mercedes’

own design team. Though the actual number of categories

used by Mercedes was much greater, Table 1 illustrates the

calculations used to quantify customer responses to the AAV

concept. For example, values shown in the “Importance”

column resulted from asking a sample of potential customers

whether they considered each category extremely important

when considering the purchase of a new Mercedes product.

Individuals could respond affirmatively to all categories

that applied.

To gain a better understanding of the various sources

of costs, function groups were identified together with

target cost estimates. (Mercedes also organized teams called

function groups, whose role was to develop specifications

and cost projections.) As shown in Table 2, the relative target

cost percentage of each function group was computed.

Table 3 summarizes how each function group contributes to

the consumer requirements identified in Table 1. For example,

safety was identified by potential customers to be an important

characteristic of the AAV; some function groups contributed

more to the safety category than others. Mercedes engineers

determined that chassis quality was an important element of

safety (50% of the total function group contribution).

Table 4 combines the category weighting percentages

from Table 1 with the Function Group contribution from

Table 3. The result is an Importance Index that measures

the relative importance of each function group across all

categories. For example, potential customers weighted the

categories of safety, comfort, economy, and styling as .41,

.32, .18, and .09, respectively. The rows in Table 4 represent

the contribution of each function group to the various

categories. The Importance Index for the chassis is calculated

by multiplying each row value by its corresponding category

value, and summing the results ((.50 x .41) + (.30 x .32) +

(.10 x .18) + (.10 x .09) = .33).

As shown in Table 5, the Target Cost Index is calculated

by dividing the Importance Index by the Target Cost

percentage by Function Group. Managers at Mercedes used

indexes such as these during the concept design phase to

understand the relationship of the importance of a function

group to the target cost of a function group. Indexes less than

1 could indicate a cost in excess of the perceived value of

the function group. Thus, opportunities for cost reduction,

consistent with customer demands, could be identified and

managed during the early stages of product development.

Choices made during the project realization phase were

largely irreversible during the production phase because

approximately 80% of the production cost of the AAV was

for materials and systems provided by external suppliers.

Table 2 : Target Cost and Percentage by Function group

Function group Target Cost Percentage of Total

Chassis $ X,XXX 20%

transmission $ X,XXX 25%

Air conditioner $ X,XXX 5%

Electrical system $ X,XXX 7%

other function groups $ X,XXX 43%

total $ X,XXX 100%

Table 3: Function group Contribution to Customer Requirements

Function group Safety Comfort Economy Styling

Chassis 50% 30% 10% 10%

transmission 20% 20% 30%

Air conditioner 20% 5%

Electrical system 5% 20%

other groups 25% 30% 40% 85%

total 100% 100% 100% 100%

Table 1

Category Importance Relative Percentage

Safety 32 41%

Comfort 25 32%

Economy 15 18%

Styling 7 9%

total 79 100%

Table 4: Importance Index of Various Function groups Importance Function group Safety Comfort Economy Styling Index

Chassis .50 .30 .10 .10 .33

transmission .20 .20 .30 .20

Air conditioner .20 .05 .07

Electrical system .05 .20 .06

other systems .25 .30 .40 .85 .35

total 1.00 1.00 1.00 1.00

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The AAV project used a streamlined management

structure in order to facilitate efficient and rapid development.

The streamlined Mercedes organization produced an entirely

new vehicle from concept to production in four years. Using

the target costing process as a key management element,

Mercedes manufactured the first production AAV in 1997.

QUESTIONS FOR DISCUSSION

1. What is the competitive environment faced by

Mercedes?

2. How has Mercedes reacted to the changing world

market for luxury automobiles?

3. Consider two of the elements of target costing, i.e.,

the target selling price and required margin. How might

Mercedes determine the values for these elements?

4. Explain the process of developing a component-

importance index. How can such an index guide

managers in making cost reduction decisions?

5. How does Mercedes approach cost reduction to

achieve target costs?

6. How do suppliers factor into the target costing process?

Why are they so critically important to the success of

the Mercedes AAV?

7. What types of organizations typically benefit (do not

benefit) from target costing?

The author wishes to express his gratitude to Ola Kallenius,

Johnathan DeHart, Jason Hoff, Henrik Jonsson, Josef Pfau, and

Günther Thuss of Mercedes-Benz for their generous contributions to

the development of this case. Subsequent to the preparation of this

case, Mercedes designated the all-activity vehicle as the “M Class”.

Table 5: Target Cost Index (A) (B) % of (c) A/B Importance Target Cost Target Cost Function group Index Index

Chassis .33 .20 1.65

transmission .20 .25 .80

Air conditioner .07 .05 1.40

Electrical system .06 .07 .86

other systems .35 .43 .81

total 1.00 1.00 1.00