Cost Planning for the Product-Life Cycle

Allegro Automotive

The automotive industry has been beset with various challenges and Allegro Automotive(AA) headquartered in Italy was experiencing the same impact on its line of electric vehicles. AA struggled with product development, cost efficiency, materials purchasing and problems in adapting to changing markets. In 2017, these problems caused the worst sales slump in decades and the luxury car maker lost money for the first time in history. Since then, AA has streamlined the core business, reduced parts and system complexity and established simultaneous engineering programs with suppliers.

In their search for additional market share, new segments, and new niches, AA started developing a range of new products. New product introductions included a variety of vehicles, most of these being electric. Perhaps the largest and most radical of AAs new projects was the Correre. In 2017, AA announced that it would build its first passenger vehicle-manufacturing facility in the United States. The decision emphasized the companys globalization strategy and desire to move closer to its customers and markets. The United States recently enacted legislation which provided significant tax benefits for the development of alternative fuel vehicles as part of the Make America Great Again Tax Act of 2017. AA 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 product the Correre. First-tier suppliers provided systems rather than individual parts or components for production of approximately 65,000 vehicles annually.

The Correre Project Phases

The Correre moved from concept to production in a relatively short period of time. The first phase, the concept phase was initiated in 2016. The concept phase resulted in a feasibility study that was approved by the board. Following board approval, the project realization phase began in 2017, with production commencing shortly after. Key elements of the various phases are described next.

Concept Phase

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 luxury sedan area that was dominated by Tesla, Lexus and Mercedes-Benz. Market research was conducted to estimate potential worldwide sales opportunities for a high-end sedan. A rough 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 Correre for another AA product and product and manufacturing costs that differed from projections.

Based on the economic feasibility study of the concept phase, the board approved the project and initiated a search for potential manufacturing locations. Site located in Italy, Europe and in the United States were evaluated. Consistent with the companys globalization strategy, the decisive factor that brought the plant to the United States was the desire to be close to the major market for the luxury vehicle and the favorable tax codes.

Project Realization Phase, 2016-2018

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, AA would not lower its internal standards for components, even if initial customer expectations might be lower than the AA standard. For example, many automotive experts believed that the superior handling of AA products resulted from manufacturing the best automobile chassis in the world. Thus, each class within the AA line met strict standards for handling, even though these standards might exceed customer expectations in some classes. AA did not use target costing to produce the lowest price vehicle in an automotive class. The companys strategic objective was to deliver products that were slightly more expensive than competitive models. However, the additional cost would have to translate into greater perceived value on the part of the 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 Correre was in development. In addition, crash test results were incorporated into the evolving Correre design. For these reasons, AA found it beneficial to place the design and testing team members in close proximity to other functions within the project to promote fast communication and decision making. Sometimes new technical features were developed by AA. The decision to include the new feature on all AA lines was made at the corporate level because experience had shown that customers; reactions to a vehicle class can affect the entire brand.

Production Phase, 2019

The project was monitored by annual updates of the NPV analysis. In addition, a three-year plan (including income statements) was prepared annually and reported to the headquarters in Italy. Monthly department meetings were held to discuss actual cost performance compared with standards developed during the cost estimation phase. Thus, the accounting system served as a control mechanism to ensure that actual production costs would conform to target costs.

The Correre manufacturing process relied on high-value-added system suppliers. For example, the entire cockpit was purchased as a unit from a systems supplier. Thus, systems suppliers were part of the development process from the beginning of the project. AA expected suppliers to meet established cost targets. To embrace function group effectiveness, suppliers were brought into the discussion at an early stage. 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 cost planners were engineers with manufacturing and design experience, they make reasonable estimates of costs that suppliers would incur in providing systems. Also, AA owned much of the tooling, such as dies to form sheet metal, used by suppliers to produce components. Tooling costs are a substantial part of the one-time costs in the project phase.

Target Costing and the Correre

The process of achieving target cost for the Correre began with an estimate of the existing cost for each function group. Next, components of 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, power train, seats, heating system, cockpit and front end. Next cost reduction targets were established for each component. As part of the competitive benchmark process, AA bought and tore down competitors vehicles to help understand their costs and manufacturing process. The Correre manufacturing process relied on high-value-added systems suppliers. For example, the entire cockpit was purchased as a unit from a systems supplier. Thus, systems suppliers were part of the development process from the beginning of the project. AA expected supplier to meet established cost targets. To enhance function group effectiveness, suppliers were brought into the discussion at an early stage.

The target costing process was led by cost planners who were engineers, not accountants. Because the cost planners were engineers with manufacturing experience, they could make reasonable estimates of costs that suppliers would incur in providing various systems. Also, AA owned much of the tooling such as dies to form sheet metal, used by suppliers to produce components. Tooling costs are a substantial part of the one-time costs of the project phase.

Index Development to Support Target Costing Activities

During the concept development phase, AA team members used various indexes to help them determine critical performance, design and cost relationships for the Correre. To construct the indexes, various forms of information were gathered from customers, suppliers and their own design team. For purposes of this problem, the number of categories has been simplified. For example, values shown in the Importance column resulted from asking a sample of potential customers whether they consider each category extremely important when considering the purchase of a new AA product. See table 1 below:

Table 1
Category	Importance	Relative Percentage
Safety	140	28
Comfort and convenience	120	24
Economy	10	2
Styling	60	12
Performance	170	34
Total	500	100

To gain a better understanding of the various sources of costs, function groups were identified together with target cost estimates. Table 2 demonstrates the relative target cost of each function group as computed

Table 2
Function Group	Target Cost	Percentage of Total
Chassis	$ 5,000	19
Transmission	1,000	4
Air conditioner	700	3
Electrical system	5,000	19
Others	15,000	56
Total	$ 26,700	100

Table 3 summarizes how each function group contributes to the consumer requirements identified in Table 1. For example, safety was identified by potential customers as an important characteristic of the Correre; some function groups contributed more to the safety categories than others.

Table 3					Quality Function Assessment
Air			Electrical				Other
Categories		Chassis		Transmission		Conditioner		System
Safety		0.30		0.10		0.10		0.50
Comfort and convenience		0.30		0.10		0.10		0.50
Economy	0.20		0.20		0.10		0.10		0.40
Styling			0.10				0.90
Performance		0.30		0.20		0.10		0.40

So that expectations of the customers are met while still achieving cost estimates, AA has sought to employ quality function deployment (QFD). The quality function deployment matrix highlights the relationships among competitive offerings, customer requirements and design parameters. The importance indexes derived from the QFD matrix are then used to determine the target cost index.

Required: Your case should be written up using the five steps of Strategic decision making as shown on page 17 or the 5 stages of management decision making as shown on page 3. The following questions should be incorporated into the appropriate area of the decision model. 1) What is the competitive environment faced by AA as it considers launching the Correre? 2) How has AA reacted to the changing world for luxury automobiles? 3) How does the Correre project link with AAs strategy in terms of market coverage? 4) Develop an Importance Index for Each Component. 5) Develop a value index. 6) How do suppliers factor into the target costing process? Why are they so important to the success of the AA Correre? 7) From the value index, make appropriate recommendations in keeping with the strategy of AA