The purpose of this research paper is to provide an overview of the use of target costing method in the Fiat Chrysler Automobile company. We detail the implementation and advantages and disadvantages that surround the choice of this particular costing method in the car manufacturing industry compared to other methods used by the competition, including activity-based costing. We discuss how various companies use this method during the development of new products on the market. Another point of our focus is the relationship Fiat Chrysler Automobile has with its customers and how it plans to keep high customer value and lifetime profitability. Next, we point out the effects that the target costing has towards profitability, from the design phase, until the delivery. Later analyzing the target margin, the company focuses on when introducing new goods to the market, explaining how to calculate and implement it for each respective product. We provide an outline of every step of the use of target costing in the Fiat Chrysler Automobile and its consequences for the future of the company.
This report provides information about the Target Costing system of American automotive company Chrysler Group LLC. A goal of every company is to control their cost in this global economic crisis. Managers sometimes underestimate that target costing is actually a powerful tool for cost management, when they look a the word ‘’cost’’ they automatically think that this is an issue for the finance department. Primarily, Target costing is a management tool originally from Japan that was created to reduce the cost of a product and determine the life cycle cost of products. It is implemented before the planning and designing stage processes start and to make the most of cost control and increase profitability, companies like Chrysler have to set assertive targets to meet their satisfaction. We will briefly explain this furthermore in this report.
Chrysler is a car manufacturer from the United States. The company was the third largest car manufacturer for many years after General Motors Corporation and the Ford Motor Company. Chrysler was the brand that invented minivans in 1980 and is now mainly manufacturing minivans and full-size cars in America. After the financial crisis, the company's profit decreased during the years with nearly 35%, therefore, the company decided to apply target costing to their system to manage their cost. As a result, they were able to turn around this trend and managed to get back to the market and face their main competitors with new products that were being manufactured at lower costs but still fulfilling the requirements of their customers and delivering high quality cars.
The purpose of target costing is all about finding the cost at which the firm is expecting to sell the product they are producing. Products always have a certain quality and based on their quality company generate the level of profitability and its expecting selling price. The main purpose of target costing is to lower its long-term products costs. Each firm needs to follow a certain process and meet the benefits of its planned products with a real market price that will show in the company by achieving their profitability goals by:
● Determining the price to estimate their benefits.
● Deducting profit the firm wants to achieve from the market price.
● Reducing or limit certain costs.
● Review the market price
The purpose of target costing is to lower the cost of new products. How do they lower those cost? Companies must have a stable profit level to reduce the cost of new products.
The new products have to be delivered on time by using just-in-time system. The price have to be good for the market and the firm, therefore delivering high-quality products as promised so customers will be satisfied with the product.
All companies have to motivate their employees to achieve target profit when the new product comes out.
Chrysler establishes its target cost by:
● Chrysler research young people who buy small cars
● Chrysler finds out what other companies are offering similar cars, they do analysis based on their competitors
● Chrysler develops first a concept that is based on details and customers requirements and makes sure the product will be safe for consumers
● Based on an understanding of the details their consumers want, Chrysler tries to develop those products such as a neon key that glows in dark.
● Chrysler focuses on different adjustments between two products.
Every company that wants to achieve their goals, be effective in decision making and organizing needs to have a balanced system. To achieve this, company has to follow a few steps. Firstly, It is important to get information about products that are in the market and what products are the competitors going to bring to the market. Secondly, company has to determine the price and the cost at which the company wants the product to be sold.
Activity based costing (ABC)
Activity based costing is a method that proper examines indirect costs and allocate manufacturing costs to services and products. ABC method allot costs to processes which are the reasons of the overhead expenses. After, ABC allot costs of those processes to individual goods which really requisite activities. (Averkamp, 2018)
ABC method aids companies clarify which products yield profit and products do not. Moreover, ABC method establishes the areas where the correction process would have a positive effect on goods of organization and it provide accurate cost information data. (Best Costing Method for Manufacturers, n.d.)
Use of Activity based costing method by Chrysler will lead to large increases in benefits in the company by making designs of the products simpler. Furthermore, ABC method increase benefits of removing not productive or not efficient activities. Use of ABC methods would also show costs of each process individually and revealing inefficiencies. Study shows, that when Chrysler used ABC system, it has 10 to 20 times more benefits than investments in company’s program. (Cucuzza, 1995)
Operation Costing
An operation costing is a method used as combination of job costing and process costing. (Bragg, 2017)
Process costing method is used for the goods which undergo various process stages. Particularly this method is used for similar products. For each process, the costs are calculated individually. This method summarizes collected data related to costs, over a fixed time period. (Costing Methods & Important Cost Terms , 2017)
Job costing method is mainly used for goods where batches or products are singular. With job costing methods are costs defined separately for each working process, because working process has specific scope and specifications. (Costing Methods & Important Cost Terms , 2017)
Operation costing method will aid Chrysler to track accurate costs of the products and provide trustful information related to continuous costs of current job. (Putra, n.d.) Process costing is a flexible manufacturing procedure, which allow companies to add or remove processes when needed. Therefore, companies can decrease production costs. (Vitez, n.d.)
Operating costing method gathers detailed data, which will be expensive on costs. Also, it is not time efficient to gather all the information needed and there is risk of gathering not relevant or false data. (Putra, n.d.)
As every other method target costing has its strong and weak sides. We are providing them in relation to use of target costing in Fiat Chrysler Automobiles and other companies in the same industry. The other costing method that the competitors use, among others, is activity-based costing. We will compare them to provide an overview of various aspects of target costing and decide whether its use is profitable for the company.
Advantages of Target Costing in Fiat Chrysler Automobiles:
Activity-based costing is more useful for companies that have a broad scope of products and want to allocate accumulated costs to each product based on activity rate, which is not the case in most of the automobile manufacturers, including Chrysler. Target costing, on the other hand, lets the company use more suitable costing method, which predicts product life-cycle cost.
Another advantage that target costing offers is having low costs of data gathering required for calculating product costs using this method. When Fiat Chrysler Automobiles uses this costing method they don’t have to waste resources on data gathering, which they would have to do using other ways to calculate costs for specific products. Compared to the activity-based method the company would have to spend more to calculate usage and the activity rates for each step of the manufacturing processes, in order to allocate them to the I direct cost pool.
Other aspect of target costing that is an advantage in this industry is value analysis. It includes a detailed evaluation of every aspect and feature that is included in a prototype, ensuring that it will only take the required resources and adds value to the product. This step requires the cooperation of various departments, from engineers to the financial analysts. Thanks to this detailed analysis the company approves only the prototypes that are profitable and provides the best value for money for prospective clients, eliminating non-vital expenses.
Target costing is its focus on a short development cycle, which leads to reduced development costs since each step of production is optimized. Thanks to this focus on cost reduction, each product spends in the production only enough time required for its production to be complete,
which in turn leads to reduced costs. Short development cycle also improves time in which innovative technologies and solutions can be implemented creating product best suited for the customers.
Using the target costing method improves net profit that the company foresees for the entire relationship with the client. The Lifetime Profitability rises thanks to the high focus on the client’s requirements during the development cycle which is later adapted to the market in order to gain a competitive advantage.
Disadvantages of Target Costing for Fiat Chrysler Automobiles:
The biggest disadvantage of target costing method is miscalculating the selling price, the vital step of calculating the maximal costs that the company is ready to spend on respective products. When there are changes in market price, or the company has the wrong data the entire method could be useless. If miscalculated the costs could lead the company to spend more on production than possible in order to still have enough profit to cover the target cost and bring profit.
Other weaknesses include the focus on keeping costs low. It can lead to not foreseeing customer needs during the designing and prototype stage of developing new products. The company can be too preoccupied with cost reduction and not take notice of other aspects of a new product design, which are adding value. It can lead to unnecessary loss of value and undermine the company position in the industry. If the competitors add value to their products through implementation of new technological solutions, as often is the case in a car manufacturing industry, it can put the company using target cost method at a disadvantage.
The main focus of the target costing method is cutting the costs, which can be taken too far and impact the quality of manufactured goods. If the company is too focused on the financial aspect they cannot put enough effort into providing the best value to the customers and fall behind competition if they hesitate to implement required technological innovations and features. The activity-based costing, on the other hand, pays attention to the overhead costs and activities itself, which can be more helpful in the industry which is intertwined with fast-paced technological innovations and large competition.
Another requirement for implementing the target costing system is the need for cooperation of all of the departments during the development cycle. When the company is not used to that it
can lead to miscommunication or even errors in the prototype, each department has to have a clear overview of which information and tasks are required of them in order to complete them, which can take some time to use to and plan for during the implementation of target costing.
Choosing a costing method is an important one for the company, and every aspect of it should be considered before implementing it. After this overview of various aspects of the implementation of target costing in the Fiat Chrysler Automobile company, it is clear why most of the companies in the car manufacturing industry use this method. It fits the need for high customer satisfaction and constant technological improvements.
The concept of target Costing arrived when Chrysler wanted to see an improvement in the cost of their products and product development when their profit margin decreased significantly. The traditional cost management like activity-based costing and other allocation methods are used for many years, but this has failed as cost management tools. The cause of this is because many manufacturers focal point is the cost of their products rather than focusing on customers’ expectations. The role of the consumer plays a big role because their needs and desires are important to the company. Their role also determines the price they are willing to spend on a product. To find out what price they are willing to spend on a product. First, you need to know if they are pleased with the quality of the product. Every customer that buys a product is unique they all have different expectations and opinions towards similar products/services. Looking at a long relationship term, Chrysler finds that keeping your customers satisfied is the key to success especially when this transforms in loyalty. If this not the case, companies, and manufacturers try to bring a new product on the market with a lower price and better quality to keep their satisfied. Fiat Chrysler CEO Sergio Marchionne stated that their second-quarter earnings in 2015 increased their profit margin with more than 50% because “we got smart on pricing” (Brent Snavely, 2015). From $650 million dollars to $1,5 billion dollars because their transaction price went down with 5,8%.
Value-based pricing considers the customer's wishes and desires which is a price management system that manufactures products while considering the customer prospects. While cost-based pricing focuses on the cost of the product than the customer values. In the figure below, you will see the difference of a product development process between value-based costing and cost-based costing. Furthermore, value-based pricing focuses more on the perceived importance to the customer instead of the cost of the product.
The goal of this pricing approach is adjusting prices to delivered customer values. Suppliers will get a huge advantage of this price management because with the low prices and high quality they will beat their competitors and their share in the market will also increase. When the
quality and price of a product is the same in an industry, competition will be crueler. The price of the products will be a significant factor for many companies because this maintains the gratification and loyalty to customers.
In the model (figure 3), scholars tried to discover what the actual desires are of customers. As I mentioned before, customers find the price and quality very important when they are looking for a product. Not only do they influence the quality of the products but they also profit from a big share when decisions are made associated with pricing. The model is also based on the feedback to the new prices because this based on the interests and requirements of the customer. Target costing ignores the customer's interests and needs when making decisions associated with pricing while value-based pricing is the opposite of this. Companies should take necessary action in this competitive market by considering their customer's interests. They only focus on reducing costs and expenditures but value based is a better solution. It does not only give you a better result but it also satisfies your customers at the same time. This will actually reduce cost and expenses by considering their customer's desires and wishes. Further, this will also increase the income and develop and better relationship between the customer and an organization.
Target costing, in general, can have a positive impact on the profitability of the firm. It depends on the product useful lifetime and the strategy the company follows.
Target costing can improve profitability firstly, by dividing products based on their importance based on product costs. Secondly, by improving profitability by having the right prices what will help is selling current products. Having the right prices is important because high prices of products do not attract customers.
In 1990 Chrysler was not as profitable as they wish they would be and they had decided to change their car design. They came up with a smaller car that could be more affordable for people at a lower price range. As Chrysler introduced target costing their profits had a rapid increase. Within five years the price per share went from ten dollars to fifty-four dollars.
One decade ago Chrysler went bankrupt what had the impact on merging with Fiat. This had the impact that Chrysler had a lot of debt to pay off.
In 2016 Chrysler made a net profit of 1.8 billion euros. In the financial year of 2017 Chrysler nearly doubles its profit. The financial year 2017 ended with a net profit of 3.5 billion euros. Comparing the year 2016 and 2017 is a big difference of 1.7 billion euros what is a huge success for Chrysler. The first quarter of 2018 so far Chrysler has earned a net profit of one billion euros. Chrysler is playing on paying off the rest of the debt till the end of this year.
The definition of target margin is desired profit from any sales which are made by the organization. Furthermore, the use of target margin can contribute to determine sales price with known major costs. (Target Margin on Sales, n.d.)
In order to calculate the sales price of the new selling product with known wanted profit margin, the following formula is used:
The retail price of new product = Cost price / (1-(Desired profit margin % / 100))
As an example, with cost price € 15 and desired profit margin 35% the sales price will be:
The retail price of new product = 15 / (1-(35/100)) = € 23,08
With a known selling price, the unknown desired profit can be calculated with the almost the same formula. The formula would be:
(1-(Cost price/ Retail price)) x 100%
(Baskerville, 2017)
In order to have a positive financial yield, the organization need to set an achievable and reasonable target margin. If that is not happening, organizations can make a loss because costs will exceed income, or selling price will be too high which leads to low selling rate. To determine a suitable target margin,
market research can be very helpful. Market research can show what average profit margin organization can expect in certain industries. Car industries have relatively low profit margin, what means that Chrysler can’t count on high wanted profit. (Johnston, n.d.)
A lot of companies mistaken by looking at the total profitability. While it is important to see of each sold product. That is where the target margin is very needful. To increase profitability in general, the organization needs to examine each sold product separately. (Osteryoung, 2016)
As stated in this report, the purpose of target costing is to decrease a product’s life-cycle costs. Its intent is to, through a proper process, match a planned product’s benefits with a real market price that achieves the company’s profitability goals. Target Costing is all about planning or projecting the cost of a product prior to its introduction, to make sure that products with low margin are not introduced, as they are not able to reap sufficient returns. It is also used for controlling the design specification and production techniques, and encouraging a focus on the customer.
The consumer plays a big role because their expectations are important to a company. To keep the customers satisfied you will need to know if they are pleased with the price and quality of the product. When a company focuses more on the perceived importance to the customer instead of the cost of the product we call this value-based pricing. Value-based pricing considers the customer's interests and desires while cost-based pricing focuses on the cost of the product than the customer values. Implementing value-based pricing will not only satisfy your customer but also develop and better relationship between the consumer and company.
The quality of the final products depends a lot on the supplier. The company and the supplier need to have a good relationship so that the process flows smoothly the interests of both the supplier and the company so that there is a mutual commitment for the best results. When using the target costing system the goal is that the supplier is involved in the process as much as possible so that he can give feedback on materials used and purchase prices, but also in ways of developing design that will be more cost efficient for the developed product. There is also a huge positive impact on profitability, depending on the obligation of management to its use. The constant participation of cost accountants in all phases of a product’s life cycle, and the type of strategy a company follows. Chryslers target costing system allows them to introduce new car models that will meet the company's profit objective in a shorter period of time.
Lastly, when compared to the other most used method in the car manufacturing industry; activity based costing, the target costing seems to have more of the advantages than disadvantages. Nevertheless, target costing enables the company to accurately predict the company life-cycle cost and improves the lifetime profitability of the customers of the company.