Nissan Motor Company, Ltd. (Nissan) was by 1990 the world's fourth-largest automobile manufacturer. In 1990, Nissan...

           

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Nissan Motor Company, Ltd. (Nissan) was by 1990 the world's fourth-largest automobile manufacturer. In 1990, Nissan produced just over 3 million vehicles, supplying approximately 10% of the world's demand for cars and trucks. Of these vehicles, slightly over two million were passenger cars. Nissan, founded in 1933, considered itself the most highly globalized of the Japanese automobile companies, producing vehicles at 36 plants in 22 countries and marketing in 150 countries through 390 distributorships and over 10,000 dealerships. Nissan had a stated policy of increasing its globalization through a five-step process: first, by increasing local production; second, by raising the local content of its products through expanded use of locally sourced parts and components; third, by strengthening local research and development capabilities; fourth, by localizing management functions; and finally, by localizing decision-making processes. As a result, four out of the five major overseas manufacturing plants were managed by local chief executive officer and in 1990 regional headquarters were opened in Europe and North America. The domestic Japanese passenger automobile market was intensely competitive. The largest manufacturer was Toyota, with approximately 45% of the domestic market. Nissan was second with approximately 25%, followed by Honda and Mazda, who together represented about another 20%. In an attempt to increase its market share in the expanding but fiercely contested domestic market, Nissan implemented a plan to achieve annual domestic sales of 1.5 million cars by 1992 and to obtain the number-one rating in terms of customer satisfaction. This strategy depended on designing products that were engineered around clearly defined concepts chosen to offer customers automobiles that matched their lifestyles. Automobile firms had been steadily increasing their range of products since the 1950s. This increase was driven primarily by changes in consumer preferences. For example, US consumers in the 1950s viewed the automobile as a status symbol, using the make of automobile they owned to signal the level of their economic success. Nissan executives characterized the consumer in this era as "keeping up with the Joneses." As automobile ownership became more widespread, consumers began to view their automobiles as making a statement about who they were. Nissan executives characterized Professor Robin Cooper of The Peter F. Drucker Graduate Management Center at The Claremont Graduate School prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. The assistance of Ms. May Mukuda, KPMG Peat Marwick, is gratefully acknowledged. Copyright © 1994 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call (800) 545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means- electronic, mechanical, photocopying, recording, or otherwise without the permission of Harvard Business School. 194-040 Nissan Motor Company, Ltd.: Target Costing System the consumer of this era as "doing his or her own thing." Consumer demand of the 1960s required more variations and a broader range of model types than in the 1950s. As the 1960s closed and individualism became less important, consumers came to view their automobiles as making statements about what they were. Nissan executives characterized this era as being dominated by a desire for a "consistency of lifestyle," i.e., bankers wanted automobiles that were appropriate for bankers. This shift required that more models and variations be produced to satisfy consumer demand. During the 1980s, consumers started to demand automobiles that suited multiple lifestyles. As one executive summed up the transition, "the old segmentation that assumed a single lifestyle no longer worked; we now have to design cars that allow people to be bankers by day and punk rockers at night." This transition in consumer preference placed additional pressure on the firm to increase its range of product offerings. Despite this pressure, Nissan had chosen to systematically reduce the number of distinct models it would introduce in the 1990s. This decision reflected two additional trends. First, the differences between consumers in the three major markets-Japan, North America, and Europe-were decreasing, and second, the costs associated with introducing new models were increasing. The decrease in differences among consumers in the three major markets reduced the need to develop models specific to a single market. The increased costs associated with launching new models made it difficult to make acceptable profits if the number of new models introduced each year was too large. These trends suggested to Nissan top management that overall profitability would be increased by reducing the number of distinct models supported, while maintaining the same level of effort to design and market the remaining models. Introducing New Products Over the years, Nissan had developed a formal procedure to introduce new products. One of the major elements of this procedure was a sophisticated target costing system. In this system, a target selling price for each new model was first established; then, a target margin was determined based upon corporate profitability objectives; finally, the model's target cost was identified as the difference between the target selling price and the target margin. Once the target cost of the new model was established, value engineering was used to ensure that the new model, when it entered production, could be manufactured at the desired target cost. The procedure to introduce new models was divided into three distinct stages: in the conceptual design stage, projects to introduce new product models were initiated; in the product development stage, the new models were readied for production; and in the production stage, they were manufactured. Taken together, these three stages lasted about 10 years, the average life cycle of a modern passenger automobile. The conceptual design stage required about two years complete, the product development stage required about four years, and the production stage typically lasted about another four years. Thus, it was not unusual for Nissan to be simultaneously producing the current model, preparing its replacement for introduction, and conceptualizing the next model's replacement. The Conceptual Design Stage New product models were designed in the conceptual design stage. First, the designers identified the mixture of models that Nissan expected to sell over the next ten years. This mix was described in a matrix of vehicles by major market and body type (e.g., coupe or sedan). The matrix Nissan Motor Company, Ltd.: Target Costing System 194-040 contained qualitative information about each model, such as its price range, target customers and their income levels, and the range of body types supported. This information was maintained for both current and future models and effectively described each model's market position. The primary purpose of the product matrix was to ensure that Nissan achieved the desired level of market coverage. New entries in the matrix were identified using consumer analysis. This analysis was undertaken by market consulting firms using a number of different techniques, including general economic, psychological, and anthropological surveys as well as direct observation. In recent years, this analysis had identified over 50 potential models that theoretically could be successfully introduced by Nissan. However, top management had identified the optimum number of models that Nissan could successfully support at under 30. This number was limited by several factors, including the cost of differentiating each model in the minds of consumers, research and development, and the cash flow associated with maintaining dealer floor inventory. Thus, the challenge that Nissan management faced was to select the approximately 30 models that would maximize market coverage. New models were conceptualized by identifying consumer "mind-sets." Mind-sets captured characteristics of the way consumers viewed themselves in relation to their cars. These mind-sets could be used to identify design attributes that consumers took into account when purchasing a new car. Typical mind-sets included value seeker, confident and sophisticated, aggressive enthusiast, and budget/speed star. By identifying clusters of these mind-sets, Nissan could identify niches that contained a sufficient percentage of the automobile-purchasing public to warrant introducing a model specifically tailored for that niche. For example, the Sentra (a mid-price family sedan) was designed to satisfy the confident/sophisticated and value seeker mind-sets, while the ZX (a high-performance sports car) was designed to satisfy the budget/speed star and aggressive enthusiast mind-sets. As a Nissan marketing executive commented, "If we believe that a sufficient market will exist in four to five years, then we will develop a model to fit it." Thus, each model and its body shape variations, such as sedan, coupe, hatchback, and wagon, was specifically designed to satisfy a different group of consumers. As a final check on the appropriateness of the proposed model line-up, each model was categorized using three primary attributes: performance, aesthetics, and comfort. For example, comfort was considered the most important attribute for the Sentra model and performance the least important, while for the ZX model, performance was considered the most important and comfort the least. A plot of the attribute characteristics of both current, future, and competitive models allowed top management to determine that the proposed product mix covered an adequate percentage of the market. At this stage of the product introduction process, the conceptual design was sufficiently developed to allow a rough estimate of the number of vehicles to be sold and the costs associated with its development. These estimates were used in a life cycle contribution study to estimate the overall profitability of the proposed model. The purpose of this study was to ensure that the new model was likely to generate a positive contribution over its life. The life cycle contribution study consisted of comparing the estimated revenues generated by the new model to the expected cost of the product across its life (see Exhibit 1). The model's revenue was estimated by using a rough estimate of the selling price and the anticipated volume of sales. From this estimate the anticipated direct material cost, which included raw material, paint, and purchased parts, was subtracted. The difference between these two quantities was the estimated direct material marginal profit of the new model. 194-040 Nissan Motor Company, Ltd.: Target Costing System From this profit, four additional sets of expenses were subtracted. The first set contained the direct manufacturing and sales expenses. These were expenses that were predominantly driven by the number of units produced and sold. The direct manufacturing expenses included elements such as the cost of the energy, cutting tools, and indirect materials consumed. The direct sales expenses included logistics costs such as the costs of shipping and delivery. The second set contained the estimated direct labor costs. The third set contained the depreciation charges for machining, die casting, and other major production steps. Finally, the estimated research and development expenses were subtracted to give the life cycle contribution of the particular model under development. The depreciation charges used in the life cycle contribution analysis were estimated by taking the total depreciation for each machine or process and dividing that by the number of units expected to be produced on that equipment over its life. If the equipment was dedicated to the new model, as was typically the case with stamping dies, then the number of units was the estimated volume of production for that model; if the equipment was common to several models, as was often the case with conveyors, then the number of units was the total of all units expected to be produced of all models using that equipment. The depreciation charge used for the life cycle contribution analysis was not the one used for financial reporting purposes. Nissan reported depreciation using a declining balance approach for both tax and financial reporting purposes. However, for the life cycle contribution calculation it used a straight-line approach. Management modified the depreciation calculation because it felt that the straight-line approach better captured the relationship between asset use and models produced than the declining balance approach. If the life cycle contribution was deemed satisfactory, the conceptual design process was allowed to continue. As the conceptual design of the new model progressed, additional consumer analysis and financial analysis was undertaken. Consumer analysis was used to obtain a better idea of the price range over which the model would sell and the level of functionality that the consumer expected. The financial analysis consisted of a rough profitability study in which the profitability of the highest volume variant of the new model was estimated using historical cost estimates and the latest estimate of that variant's target price. This target price was determined by taking into account a number of internal and external factors. The internal factors included the position of the model in the matrix and the strategic and profitability objectives of top management for that model. The external factors considered included the corporation's image and level of customer loyalty in the model's niche, the expected quality level and functionality of the model compared to competitive offerings, the model's expected market share, and finally, the expected price of competitive models. The first stage of value engineering was designed to determine whether the new model could be manufactured at an acceptable profit (see Exhibit 2). The process began by developing an order sheet detailing the characteristics of the 20 to 30 major functions of the proposed model. Examples of the major functions included the engine, air conditioner, transmission, and sound system. The characteristics of each major function were chosen to satisfy the collection of consumer mind-sets for which the model was designed. For example, the engine specified for a ZX would be a high- performance one, while for the Sentra it would be smaller, less powerful, and less expensive. The current cost of the model was determined by summing the current manufacturing cost of each major function of the new model. This current cost was compared with the model's allowable cost to determine the level of cost reduction required to achieve the desired level of profitability. Nissan Motor Company, Ltd.: Target Costing System 194-040 The allowable cost of the new model was determined by subtracting its target profit margin from its target price. The target margin was determined by careful consideration of available information on the consumer, the firm's anticipated future product mix, and its long-term profit objective. Each new model's target margin was established by running simulations of the firm's overall profitability for the next 10 years if it was selling the models identified in the product matrix at expected sales volumes. The simulations started by plotting the actual profit margins of existing products (see existing product curve in Exhibit 3). The desired profitability of planned models was then added (see Exhibit 4) and the firm's overall profitability determined over the years at various sales levels. This predicted overall profitability was compared to the firm's long-term profitability objectives set by senior management (see Exhibit 5). Once a satisfactory future product matrix was established that achieved the firm's profit objective, the target margins for each new model were set. To help minimize the risk that Nissan would not achieve its overall profitability targets, the simulations explored the impact on overall profitability of different price/margin curves for different product mixes. For example, historically higher margins had been earned on higher priced vehicles (see existing product curve in Exhibit 3). However, with the reduced product offering and the increased profitability expected, the future curve might be higher. Alternatively, because there was no guarantee that the existing relationship between price and margin would remain unchanged, simulations were also run to explore the impact of fundamentally different relationships between selling price and margins. The first stage of value engineering and the identification of target price was an interactive process. When the allowable costs were considered to be too far below the estimated cost, the appropriate price range and functionality were reviewed until an allowable cost that was considered achievable was identified (see Exhibit 6). The excess of the current manufacturing cost over the allowable cost determined the level of cost reduction that had to be identified by value engineering. For example, the current manufacturing cost of the model might be ¥3,000,000 and the allowed cost ¥2,700,000, which identified a required cost reduction of 10%. The next step in the value engineering process was to identify the allowable cost of each major function. This cost was set by teams derived from almost every functional area of the firm, including product design, engineering, purchasing, production engineering, manufacturing, and parts supply. Although the allowable cost was usually lower than the current cost, sometimes the allowable cost was higher because the new product specifications demanded higher performance and functionality than existing designs. In total, the sum of the cost reduction for each major component was meant to equal the required level of cost reduction to achieve the model's allowable cost (see Exhibit 7). Several critical decisions about the model were made during this stage of the conceptual design process, including the number of body variations, the number of engine types, and the basic technology used in the vehicle. For example, the original concept for the model might include a five- door variant. However, if during this stage of the analysis it was determined that developing such a variant would be too costly or take an excessive amount of time, plans for a five-door variant would be postponed to the next version of that automobile. Once projected cost of each major component had been identified, the expected cost of manufacture could be computed. 194-040 Nissan Motor Company, Ltd.: Target Costing System After the first value engineering stage was completed, a major review of the new model was conducted. This review included an updated profitability study and an analysis of the performance characteristics of the model. In the profitability study, the expected profitability of the model given by the target price minus the target cost was compared to the latest estimates of the capital investment and remaining research and development expenditures required to complete the design of the product and allow production to commence. In the performance analysis, factors such as the quality of the hardware, engine capacity, exhaust emissions, and safety were considered. If both the financial and performance analyses were considered acceptable, the project to introduce the new vehicle was authorized and the model shifted from the conceptual design to the product development stage. The Product Development Stage The first step in the product development stage was to prepare a detailed order sheet for the new model. This order sheet listed all of the components required in the new model and was analyzed to see which components would likely be sourced internally versus externally. Suppliers, both internal and external, were provided with a description of each component and their potential production volumes. Suppliers were expected to provide price and delivery timing estimates for each component. The next step in the development of a new model was to produce the engineering drawings for trial production. Value engineering was used at this stage of product development to determine allowable costs for each of the components in every major function of the automobile. This estimate was achieved by identifying a cost reduction objective for each component (see Exhibit 8). There were several ways that cost reduction objectives for components were identified. First, competitors' products were purchased, disassembled, and analyzed. From this analysis, ideas for cost reduction were sometimes generated. Second, parts suppliers were asked to generate cost reduction ideas. An incentive plan was used to motivate the suppliers. For example, if an idea was accepted, the supplier that suggested the cost reduction idea would be awarded a significant percentage of the contract for that component for a specified time period, say 50% for 12 months. This incentive scheme was viewed as particularly important because even if a cost reduction could not be achieved for this model, it signalled to the suppliers that when the next model was developed this component would be subject to cost reduction pressures. Third, ways to increase the commonality of parts across variations and models were identified (e.g., the same seats might be used in two different models). Fourth, ways to reduce the number of components in each model were identified. For example, originally the kick plates used to protect the door were held in place by plastic nuts. However, a way to mold the plastic interior of the door so that no nuts were required had been developed. To avoid having to develop target costs for all 20,000 components in a typical new model line, the engineers only performed detailed target costing on two or three representative variations. Each variation contained approximately 3,500 components, and typically 80% of the components were common across variations. Therefore, about 5,000 components were subjected to detailed target costing. The target costs of the other 15,000 components were estimated by comparing them to similar components in the 5,000 already target-costed. The completion of this target costing exercise provided cost reduction objectives for all of the components in the new model. The comparison of the allowable cost of each function and the sum of the expected cost of the components in that function after cost reduction indicated whether the major function could be produced at about the Nissan Motor Company, Ltd.: Target Costing System 194-040 allowable cost. When the sum of the component costs was too high, additional cost reductions were identified until the total target cost of the representative variation was acceptable. The target costs for each component were compared to the prices quoted by the suppliers. If the quoted prices were acceptable, the quote was accepted. If the initial quote was too high, then further negotiations were undertaken until an agreement could be reached. The next phase in product development was to construct two or three prototype vehicles. Several important lessons were learned from the construction of these prototypes. First, any components that were difficult to assemble were identified. Typically, these components or the assemblies into which they fitted were redesigned to improve the ease of assembly. Second, assembly times could now be estimated quite accurately. In the third stage of value engineering, the effect of these redesigns on the target costs of the components was determined and assembly target costs were identified. The output of this stage of value engineering was called the final target cost (see Exhibit 9). It differed from the draft target cost in two ways. First, it included assembly costs and second, the indirect manufacturing costs. The indirect manufacturing costs were assigned to products using the same procedures as the firm's cost system. Thus, the final target cost for a model variant was expected to be equal to its reported product cost during manufacture. A comparison of the final target costs for each model variant and its expected selling price allowed the anticipated profit on the vehicle to be determined. The expected selling price was reviewed by marketing in light of recent competitive products and market conditions, and a final selling price recommended. Accounting was responsible for authorizing the actual selling price of each variation. It took into account marketing's review of existing conditions, the final target cost of the vehicle, and the target margin for the vehicle. Once set, accounting notified marketing of the recommended selling price. In Japan, this was the price at which the car would be sold across its life. In other markets, such as North America, incentive plans and other marketing techniques could cause the effective price to change across the life of the product. Accounting was not involved in the value engineering process, which was the responsibility of the cost design and engineering department. The primary function of accounting was to set the final target cost for each model variant and ensure that the vehicles were manufactured for that amount. As the vehicle entered production, accounting would monitor all component and assembly costs and if these were not in line with the final target costs, accounting would notify cost design and engineering that the final target costs were not being met. When the target costs were exceeded, additional value engineering was performed to reduce costs back to the target levels. Thus, the fourth and final value engineering stage ensured that the actual component and assembly costs were equal to their final target costs. Unless the production cost exceeded the target cost, no cost reduction efforts were undertaken during the production stage. Management had determined that the incremental savings from such efforts were more than offset by disturbances they created to the production process. When inflation or other factors caused costs to rise, pressure was exerted upon the suppliers to find ways to keep component costs at their final target levels. Similarly, pressure was exerted on the assembly plants to achieve the assembly target costs. The Production Stage The Zama facility, located a few miles from Tokyo, was one of Nissan's five major domestic manufacturing facilities. Built in 1964, it was 852,000 square meters in area and contained two complete stamping and assembly facilities. In addition, the facility housed a car delivery area and the firm's machinery design center. No production parts were produced at Zama. The plant was only involved in producing pressed metal parts, welding them together, assembling the body, painting it, and then assembling the finished automobile. The Zama plant was designed to produce 90 cars per hour, operating on a two-shift basis with production occurring for 15 hours and 20 minutes per day. A two-shift operation enabled the plant to produce between 1,300 to 1,400 cars per day at full capacity. While preventative maintenance was carried on throughout the day, primary maintenance was performed during the 8 hours and 40 minutes in which no production was scheduled. Zama was a highly automated plant. Of the approximately 3,000 spot welds per car, over 97% were performed automatically. This high level of automation had been achieved over a number of years. The current high level of automatic spot welding was achieved around 1980. To sustain this high level of automation, Zama contained nearly 300 robots. All of these robots were designed by Nissan but only about 40% were actually manufactured by the firm. In 1990, the facility was dedicated to the production of two models and three body types. The Sunny, or Sentra as it was called in the North American market, was produced in two body types: the four-door and two-door coupe configurations and the Presea in a single four-door configuration. Each body type could be produced in numerous variations of key components, such as engine, air conditioning, and transmission. When all possible option variations were included, Zama produced approximately 20,000 different variations of each of the three distinct body types. The large number of variations forced the facility to produce cars to customer order. This production strategy fit well with Nissan's corporate strategy of providing customer satisfaction, high quality, short delivery times, and high functionality. In fact, fast delivery was considered so important that the production strategy was called by a name that translated to "deliver the car with the paint still wet." In 1990, a car ordered from a Japanese dealer and produced in the Zama plant could be delivered to the customer within 2 weeks. Because in Tokyo it required at least a week to get the certificate of space required to enable a car to be purchased, the effective wait for a new Nissan was negligible. This short delivery time despite high product diversity was achieved via aggressive use of just-in-time production. The Product Cost System The same cost system was used throughout Nissan's assembly plants. It reported full product costs that included both direct and indirect expenses. The indirect expenses were traced to the products in two different ways. Direct and indirect manufacturing expenses were directly charged to the production cost center in which they were consumed, and then allocated to the products. Service and administrative expenses and corporate expenses were allocated to the product without first being allocated to a production center. Corporate expenses were equal to about 15% of the sales revenue. They consisted of three major types of expenses: product-related expenses that included advertisements, warranty, and delivery expenses; geographic-related expenses, such as the costs associated with the sales division in Tokyo that supported sales in all three major markets; and finally, Nissan Motor Company, Ltd.: Target Costing System 194-040 there were the expenses associated with corporate administration, legal, and accounting. The product- related portion of corporate expenses was approximately 30%, the geographic-related portion 50%, and the other expenses about 20%. Three different product profitabilities were calculated (see Exhibit 10). The first was the direct material marginal profit. This was calculated by subtracting the cost of the raw materials and purchased parts from the selling price. The second was the product contribution, determined by subtracting direct manufacturing costs, research and development expenses, and corporate expenses directly related to the product from the direct material marginal profit. Direct manufacturing expenses included manufacturing supplies such as cutting tools and machine depreciation. The procedures used to assign these expenses to products varied depending upon the nature of the expenses and how they were consumed. For example, the costs of manufacturing supplies were assigned to the products based upon the number of direct labor hours the product consumed in the center if the department produced several different models, and number of units if only one model was produced; machine depreciation was assigned to products based upon the number of units irrespective of model. Research and development expenses included the cost of the labor, facilities, and supplies consumed in the research and development facility. They were allocated to products based upon the labor hours consumed in research and development on that product. The corporate expenses directly related to the product included items such as product advertisements, product incentives, warranty costs, and delivery expenses. The third product profitability, operating profit, was calculated by subtracting indirect manufacturing, service, administrative, and the remaining corporate expenses from the product contributions. Indirect manufacturing expenses were directly charged to the production cost center in which they were incurred. Examples of indirect manufacturing expenses included transportation, maintenance, and facility depreciation. These expenses were assigned to the products based on the total direct cost of the products produced in that center. Service and administrative expenses were assigned to the products without first being assigned to the production centers. These expenses were assigned based on the total direct cost of the product. Corporate expenses were first assigned to the facility and then to the products based on their total direct costs in the same way as were service and administrative expenses. The breakdown of product profitability and cost is shown in Exhibit 11. The Nissan cost system was continuously undergoing modification. In particular, a program had been initiated to trace as many costs as possible directly to the production departments. Thus, over time the service and administrative categories were dropping in relationship to the direct and indirect manufacturing costs. The success of this program and the heavy reliance upon external parts and service suppliers were visible from the relative importance of the three major cost categories. The direct costs, i.e., those costs that were traced directly to the products, represented 85% of total manufacturing costs; the direct and indirect manufacturing costs that were charged to the production departments and then assigned to the products represented about 10% of total manufacturing costs; while service and administrative costs amounted to only 5% of total costs. The product costs reported by the cost system had four primary uses. First, they were used in the long-range strategic plan as a basis for estimating future profitability. Second, they were used for cost-control purposes, in particular to ensure that across the production life of a product its target cost was maintained. Third, they were used to help select the product mix, in particular with respect to the variations of a given model. Finally, they were used to identify unprofitable variants that were candidates for discontinuance. Nissan Motor Company, Ltd.: Target Costing System Exhibit 10 Breakdown of Product Profitability Revenue Direct Material Cost 1) Purchased parts 2) Raw materials Direct Material Marginal Profit Direct Cost & Expenses Direct Manufacturing Cost 1) Direct labor cost 2) Manufacturing expenses directly variable (Directly Characterized to the number of units produced (e.g. cutting tools) 3) Tools & machinery Depreciation charge to Products) Maintenance cost Energy cost (****) R&D Expense (labor, expenses, facilities) (****) Corporate Expenses Directly Related to Product 1) Product advertisements 2) Product incentives 3) Warranty 4) Delivery expenses (***** Product Contribution Indirect Manufacturing Cost Consumed by Manufacturing Shop Floors 1) Indirect materials (e.g. monkey wrench, sand paper) 2) Indirect labor cost Indirect Cost 3) Shop floor facilities. Depreciation charge Maintenance cost Energy cost (****) 1) Quality inspection (labor, expenses, facilities) 2) Logistics (labor, expenses, facilities) 3) Energy consumed in service department (Irrespective of Product Characteristics) (****) 4) Maintenance consumed in service department 1) Labor cost 2) General expenses 3) Facilities Depreciation charge Maintenance cost Energy cost (****) Corporate Expense (excluding "directly related to product") 1) Expense consumed by geographic sales division Corporate Expenses. a) Maintenance costs of sales network b) Labor cost consumed in the divisions c) General expenses consumed in the divisions. 2) General Administration (****) **** Services Administration Operating Profit **** ***** **** **** **** **** **** **** **** ****** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** ******* 1. What are the strengths and weaknesses of the target costing system? 2. What would you change? 3. Describe Nissan's cost system. Is it strong enough to support the target costing system? 4. How does your firm (or firms with which you are familiar) determine the cost to man- ufacture new products? 5. Is target costing transferrable to U.S. companies? Nissan Motor Company, Ltd. (Nissan) was by 1990 the world's fourth-largest automobile manufacturer. In 1990, Nissan produced just over 3 million vehicles, supplying approximately 10% of the world's demand for cars and trucks. Of these vehicles, slightly over two million were passenger cars. Nissan, founded in 1933, considered itself the most highly globalized of the Japanese automobile companies, producing vehicles at 36 plants in 22 countries and marketing in 150 countries through 390 distributorships and over 10,000 dealerships. Nissan had a stated policy of increasing its globalization through a five-step process: first, by increasing local production; second, by raising the local content of its products through expanded use of locally sourced parts and components; third, by strengthening local research and development capabilities; fourth, by localizing management functions; and finally, by localizing decision-making processes. As a result, four out of the five major overseas manufacturing plants were managed by local chief executive officer and in 1990 regional headquarters were opened in Europe and North America. The domestic Japanese passenger automobile market was intensely competitive. The largest manufacturer was Toyota, with approximately 45% of the domestic market. Nissan was second with approximately 25%, followed by Honda and Mazda, who together represented about another 20%. In an attempt to increase its market share in the expanding but fiercely contested domestic market, Nissan implemented a plan to achieve annual domestic sales of 1.5 million cars by 1992 and to obtain the number-one rating in terms of customer satisfaction. This strategy depended on designing products that were engineered around clearly defined concepts chosen to offer customers automobiles that matched their lifestyles. Automobile firms had been steadily increasing their range of products since the 1950s. This increase was driven primarily by changes in consumer preferences. For example, US consumers in the 1950s viewed the automobile as a status symbol, using the make of automobile they owned to signal the level of their economic success. Nissan executives characterized the consumer in this era as "keeping up with the Joneses." As automobile ownership became more widespread, consumers began to view their automobiles as making a statement about who they were. Nissan executives characterized Professor Robin Cooper of The Peter F. Drucker Graduate Management Center at The Claremont Graduate School prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. The assistance of Ms. May Mukuda, KPMG Peat Marwick, is gratefully acknowledged. Copyright © 1994 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call (800) 545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means- electronic, mechanical, photocopying, recording, or otherwise without the permission of Harvard Business School. 194-040 Nissan Motor Company, Ltd.: Target Costing System the consumer of this era as "doing his or her own thing." Consumer demand of the 1960s required more variations and a broader range of model types than in the 1950s. As the 1960s closed and individualism became less important, consumers came to view their automobiles as making statements about what they were. Nissan executives characterized this era as being dominated by a desire for a "consistency of lifestyle," i.e., bankers wanted automobiles that were appropriate for bankers. This shift required that more models and variations be produced to satisfy consumer demand. During the 1980s, consumers started to demand automobiles that suited multiple lifestyles. As one executive summed up the transition, "the old segmentation that assumed a single lifestyle no longer worked; we now have to design cars that allow people to be bankers by day and punk rockers at night." This transition in consumer preference placed additional pressure on the firm to increase its range of product offerings. Despite this pressure, Nissan had chosen to systematically reduce the number of distinct models it would introduce in the 1990s. This decision reflected two additional trends. First, the differences between consumers in the three major markets-Japan, North America, and Europe-were decreasing, and second, the costs associated with introducing new models were increasing. The decrease in differences among consumers in the three major markets reduced the need to develop models specific to a single market. The increased costs associated with launching new models made it difficult to make acceptable profits if the number of new models introduced each year was too large. These trends suggested to Nissan top management that overall profitability would be increased by reducing the number of distinct models supported, while maintaining the same level of effort to design and market the remaining models. Introducing New Products Over the years, Nissan had developed a formal procedure to introduce new products. One of the major elements of this procedure was a sophisticated target costing system. In this system, a target selling price for each new model was first established; then, a target margin was determined based upon corporate profitability objectives; finally, the model's target cost was identified as the difference between the target selling price and the target margin. Once the target cost of the new model was established, value engineering was used to ensure that the new model, when it entered production, could be manufactured at the desired target cost. The procedure to introduce new models was divided into three distinct stages: in the conceptual design stage, projects to introduce new product models were initiated; in the product development stage, the new models were readied for production; and in the production stage, they were manufactured. Taken together, these three stages lasted about 10 years, the average life cycle of a modern passenger automobile. The conceptual design stage required about two years complete, the product development stage required about four years, and the production stage typically lasted about another four years. Thus, it was not unusual for Nissan to be simultaneously producing the current model, preparing its replacement for introduction, and conceptualizing the next model's replacement. The Conceptual Design Stage New product models were designed in the conceptual design stage. First, the designers identified the mixture of models that Nissan expected to sell over the next ten years. This mix was described in a matrix of vehicles by major market and body type (e.g., coupe or sedan). The matrix Nissan Motor Company, Ltd.: Target Costing System 194-040 contained qualitative information about each model, such as its price range, target customers and their income levels, and the range of body types supported. This information was maintained for both current and future models and effectively described each model's market position. The primary purpose of the product matrix was to ensure that Nissan achieved the desired level of market coverage. New entries in the matrix were identified using consumer analysis. This analysis was undertaken by market consulting firms using a number of different techniques, including general economic, psychological, and anthropological surveys as well as direct observation. In recent years, this analysis had identified over 50 potential models that theoretically could be successfully introduced by Nissan. However, top management had identified the optimum number of models that Nissan could successfully support at under 30. This number was limited by several factors, including the cost of differentiating each model in the minds of consumers, research and development, and the cash flow associated with maintaining dealer floor inventory. Thus, the challenge that Nissan management faced was to select the approximately 30 models that would maximize market coverage. New models were conceptualized by identifying consumer "mind-sets." Mind-sets captured characteristics of the way consumers viewed themselves in relation to their cars. These mind-sets could be used to identify design attributes that consumers took into account when purchasing a new car. Typical mind-sets included value seeker, confident and sophisticated, aggressive enthusiast, and budget/speed star. By identifying clusters of these mind-sets, Nissan could identify niches that contained a sufficient percentage of the automobile-purchasing public to warrant introducing a model specifically tailored for that niche. For example, the Sentra (a mid-price family sedan) was designed to satisfy the confident/sophisticated and value seeker mind-sets, while the ZX (a high-performance sports car) was designed to satisfy the budget/speed star and aggressive enthusiast mind-sets. As a Nissan marketing executive commented, "If we believe that a sufficient market will exist in four to five years, then we will develop a model to fit it." Thus, each model and its body shape variations, such as sedan, coupe, hatchback, and wagon, was specifically designed to satisfy a different group of consumers. As a final check on the appropriateness of the proposed model line-up, each model was categorized using three primary attributes: performance, aesthetics, and comfort. For example, comfort was considered the most important attribute for the Sentra model and performance the least important, while for the ZX model, performance was considered the most important and comfort the least. A plot of the attribute characteristics of both current, future, and competitive models allowed top management to determine that the proposed product mix covered an adequate percentage of the market. At this stage of the product introduction process, the conceptual design was sufficiently developed to allow a rough estimate of the number of vehicles to be sold and the costs associated with its development. These estimates were used in a life cycle contribution study to estimate the overall profitability of the proposed model. The purpose of this study was to ensure that the new model was likely to generate a positive contribution over its life. The life cycle contribution study consisted of comparing the estimated revenues generated by the new model to the expected cost of the product across its life (see Exhibit 1). The model's revenue was estimated by using a rough estimate of the selling price and the anticipated volume of sales. From this estimate the anticipated direct material cost, which included raw material, paint, and purchased parts, was subtracted. The difference between these two quantities was the estimated direct material marginal profit of the new model. 194-040 Nissan Motor Company, Ltd.: Target Costing System From this profit, four additional sets of expenses were subtracted. The first set contained the direct manufacturing and sales expenses. These were expenses that were predominantly driven by the number of units produced and sold. The direct manufacturing expenses included elements such as the cost of the energy, cutting tools, and indirect materials consumed. The direct sales expenses included logistics costs such as the costs of shipping and delivery. The second set contained the estimated direct labor costs. The third set contained the depreciation charges for machining, die casting, and other major production steps. Finally, the estimated research and development expenses were subtracted to give the life cycle contribution of the particular model under development. The depreciation charges used in the life cycle contribution analysis were estimated by taking the total depreciation for each machine or process and dividing that by the number of units expected to be produced on that equipment over its life. If the equipment was dedicated to the new model, as was typically the case with stamping dies, then the number of units was the estimated volume of production for that model; if the equipment was common to several models, as was often the case with conveyors, then the number of units was the total of all units expected to be produced of all models using that equipment. The depreciation charge used for the life cycle contribution analysis was not the one used for financial reporting purposes. Nissan reported depreciation using a declining balance approach for both tax and financial reporting purposes. However, for the life cycle contribution calculation it used a straight-line approach. Management modified the depreciation calculation because it felt that the straight-line approach better captured the relationship between asset use and models produced than the declining balance approach. If the life cycle contribution was deemed satisfactory, the conceptual design process was allowed to continue. As the conceptual design of the new model progressed, additional consumer analysis and financial analysis was undertaken. Consumer analysis was used to obtain a better idea of the price range over which the model would sell and the level of functionality that the consumer expected. The financial analysis consisted of a rough profitability study in which the profitability of the highest volume variant of the new model was estimated using historical cost estimates and the latest estimate of that variant's target price. This target price was determined by taking into account a number of internal and external factors. The internal factors included the position of the model in the matrix and the strategic and profitability objectives of top management for that model. The external factors considered included the corporation's image and level of customer loyalty in the model's niche, the expected quality level and functionality of the model compared to competitive offerings, the model's expected market share, and finally, the expected price of competitive models. The first stage of value engineering was designed to determine whether the new model could be manufactured at an acceptable profit (see Exhibit 2). The process began by developing an order sheet detailing the characteristics of the 20 to 30 major functions of the proposed model. Examples of the major functions included the engine, air conditioner, transmission, and sound system. The characteristics of each major function were chosen to satisfy the collection of consumer mind-sets for which the model was designed. For example, the engine specified for a ZX would be a high- performance one, while for the Sentra it would be smaller, less powerful, and less expensive. The current cost of the model was determined by summing the current manufacturing cost of each major function of the new model. This current cost was compared with the model's allowable cost to determine the level of cost reduction required to achieve the desired level of profitability. Nissan Motor Company, Ltd.: Target Costing System 194-040 The allowable cost of the new model was determined by subtracting its target profit margin from its target price. The target margin was determined by careful consideration of available information on the consumer, the firm's anticipated future product mix, and its long-term profit objective. Each new model's target margin was established by running simulations of the firm's overall profitability for the next 10 years if it was selling the models identified in the product matrix at expected sales volumes. The simulations started by plotting the actual profit margins of existing products (see existing product curve in Exhibit 3). The desired profitability of planned models was then added (see Exhibit 4) and the firm's overall profitability determined over the years at various sales levels. This predicted overall profitability was compared to the firm's long-term profitability objectives set by senior management (see Exhibit 5). Once a satisfactory future product matrix was established that achieved the firm's profit objective, the target margins for each new model were set. To help minimize the risk that Nissan would not achieve its overall profitability targets, the simulations explored the impact on overall profitability of different price/margin curves for different product mixes. For example, historically higher margins had been earned on higher priced vehicles (see existing product curve in Exhibit 3). However, with the reduced product offering and the increased profitability expected, the future curve might be higher. Alternatively, because there was no guarantee that the existing relationship between price and margin would remain unchanged, simulations were also run to explore the impact of fundamentally different relationships between selling price and margins. The first stage of value engineering and the identification of target price was an interactive process. When the allowable costs were considered to be too far below the estimated cost, the appropriate price range and functionality were reviewed until an allowable cost that was considered achievable was identified (see Exhibit 6). The excess of the current manufacturing cost over the allowable cost determined the level of cost reduction that had to be identified by value engineering. For example, the current manufacturing cost of the model might be ¥3,000,000 and the allowed cost ¥2,700,000, which identified a required cost reduction of 10%. The next step in the value engineering process was to identify the allowable cost of each major function. This cost was set by teams derived from almost every functional area of the firm, including product design, engineering, purchasing, production engineering, manufacturing, and parts supply. Although the allowable cost was usually lower than the current cost, sometimes the allowable cost was higher because the new product specifications demanded higher performance and functionality than existing designs. In total, the sum of the cost reduction for each major component was meant to equal the required level of cost reduction to achieve the model's allowable cost (see Exhibit 7). Several critical decisions about the model were made during this stage of the conceptual design process, including the number of body variations, the number of engine types, and the basic technology used in the vehicle. For example, the original concept for the model might include a five- door variant. However, if during this stage of the analysis it was determined that developing such a variant would be too costly or take an excessive amount of time, plans for a five-door variant would be postponed to the next version of that automobile. Once projected cost of each major component had been identified, the expected cost of manufacture could be computed. 194-040 Nissan Motor Company, Ltd.: Target Costing System After the first value engineering stage was completed, a major review of the new model was conducted. This review included an updated profitability study and an analysis of the performance characteristics of the model. In the profitability study, the expected profitability of the model given by the target price minus the target cost was compared to the latest estimates of the capital investment and remaining research and development expenditures required to complete the design of the product and allow production to commence. In the performance analysis, factors such as the quality of the hardware, engine capacity, exhaust emissions, and safety were considered. If both the financial and performance analyses were considered acceptable, the project to introduce the new vehicle was authorized and the model shifted from the conceptual design to the product development stage. The Product Development Stage The first step in the product development stage was to prepare a detailed order sheet for the new model. This order sheet listed all of the components required in the new model and was analyzed to see which components would likely be sourced internally versus externally. Suppliers, both internal and external, were provided with a description of each component and their potential production volumes. Suppliers were expected to provide price and delivery timing estimates for each component. The next step in the development of a new model was to produce the engineering drawings for trial production. Value engineering was used at this stage of product development to determine allowable costs for each of the components in every major function of the automobile. This estimate was achieved by identifying a cost reduction objective for each component (see Exhibit 8). There were several ways that cost reduction objectives for components were identified. First, competitors' products were purchased, disassembled, and analyzed. From this analysis, ideas for cost reduction were sometimes generated. Second, parts suppliers were asked to generate cost reduction ideas. An incentive plan was used to motivate the suppliers. For example, if an idea was accepted, the supplier that suggested the cost reduction idea would be awarded a significant percentage of the contract for that component for a specified time period, say 50% for 12 months. This incentive scheme was viewed as particularly important because even if a cost reduction could not be achieved for this model, it signalled to the suppliers that when the next model was developed this component would be subject to cost reduction pressures. Third, ways to increase the commonality of parts across variations and models were identified (e.g., the same seats might be used in two different models). Fourth, ways to reduce the number of components in each model were identified. For example, originally the kick plates used to protect the door were held in place by plastic nuts. However, a way to mold the plastic interior of the door so that no nuts were required had been developed. To avoid having to develop target costs for all 20,000 components in a typical new model line, the engineers only performed detailed target costing on two or three representative variations. Each variation contained approximately 3,500 components, and typically 80% of the components were common across variations. Therefore, about 5,000 components were subjected to detailed target costing. The target costs of the other 15,000 components were estimated by comparing them to similar components in the 5,000 already target-costed. The completion of this target costing exercise provided cost reduction objectives for all of the components in the new model. The comparison of the allowable cost of each function and the sum of the expected cost of the components in that function after cost reduction indicated whether the major function could be produced at about the Nissan Motor Company, Ltd.: Target Costing System 194-040 allowable cost. When the sum of the component costs was too high, additional cost reductions were identified until the total target cost of the representative variation was acceptable. The target costs for each component were compared to the prices quoted by the suppliers. If the quoted prices were acceptable, the quote was accepted. If the initial quote was too high, then further negotiations were undertaken until an agreement could be reached. The next phase in product development was to construct two or three prototype vehicles. Several important lessons were learned from the construction of these prototypes. First, any components that were difficult to assemble were identified. Typically, these components or the assemblies into which they fitted were redesigned to improve the ease of assembly. Second, assembly times could now be estimated quite accurately. In the third stage of value engineering, the effect of these redesigns on the target costs of the components was determined and assembly target costs were identified. The output of this stage of value engineering was called the final target cost (see Exhibit 9). It differed from the draft target cost in two ways. First, it included assembly costs and second, the indirect manufacturing costs. The indirect manufacturing costs were assigned to products using the same procedures as the firm's cost system. Thus, the final target cost for a model variant was expected to be equal to its reported product cost during manufacture. A comparison of the final target costs for each model variant and its expected selling price allowed the anticipated profit on the vehicle to be determined. The expected selling price was reviewed by marketing in light of recent competitive products and market conditions, and a final selling price recommended. Accounting was responsible for authorizing the actual selling price of each variation. It took into account marketing's review of existing conditions, the final target cost of the vehicle, and the target margin for the vehicle. Once set, accounting notified marketing of the recommended selling price. In Japan, this was the price at which the car would be sold across its life. In other markets, such as North America, incentive plans and other marketing techniques could cause the effective price to change across the life of the product. Accounting was not involved in the value engineering process, which was the responsibility of the cost design and engineering department. The primary function of accounting was to set the final target cost for each model variant and ensure that the vehicles were manufactured for that amount. As the vehicle entered production, accounting would monitor all component and assembly costs and if these were not in line with the final target costs, accounting would notify cost design and engineering that the final target costs were not being met. When the target costs were exceeded, additional value engineering was performed to reduce costs back to the target levels. Thus, the fourth and final value engineering stage ensured that the actual component and assembly costs were equal to their final target costs. Unless the production cost exceeded the target cost, no cost reduction efforts were undertaken during the production stage. Management had determined that the incremental savings from such efforts were more than offset by disturbances they created to the production process. When inflation or other factors caused costs to rise, pressure was exerted upon the suppliers to find ways to keep component costs at their final target levels. Similarly, pressure was exerted on the assembly plants to achieve the assembly target costs. The Production Stage The Zama facility, located a few miles from Tokyo, was one of Nissan's five major domestic manufacturing facilities. Built in 1964, it was 852,000 square meters in area and contained two complete stamping and assembly facilities. In addition, the facility housed a car delivery area and the firm's machinery design center. No production parts were produced at Zama. The plant was only involved in producing pressed metal parts, welding them together, assembling the body, painting it, and then assembling the finished automobile. The Zama plant was designed to produce 90 cars per hour, operating on a two-shift basis with production occurring for 15 hours and 20 minutes per day. A two-shift operation enabled the plant to produce between 1,300 to 1,400 cars per day at full capacity. While preventative maintenance was carried on throughout the day, primary maintenance was performed during the 8 hours and 40 minutes in which no production was scheduled. Zama was a highly automated plant. Of the approximately 3,000 spot welds per car, over 97% were performed automatically. This high level of automation had been achieved over a number of years. The current high level of automatic spot welding was achieved around 1980. To sustain this high level of automation, Zama contained nearly 300 robots. All of these robots were designed by Nissan but only about 40% were actually manufactured by the firm. In 1990, the facility was dedicated to the production of two models and three body types. The Sunny, or Sentra as it was called in the North American market, was produced in two body types: the four-door and two-door coupe configurations and the Presea in a single four-door configuration. Each body type could be produced in numerous variations of key components, such as engine, air conditioning, and transmission. When all possible option variations were included, Zama produced approximately 20,000 different variations of each of the three distinct body types. The large number of variations forced the facility to produce cars to customer order. This production strategy fit well with Nissan's corporate strategy of providing customer satisfaction, high quality, short delivery times, and high functionality. In fact, fast delivery was considered so important that the production strategy was called by a name that translated to "deliver the car with the paint still wet." In 1990, a car ordered from a Japanese dealer and produced in the Zama plant could be delivered to the customer within 2 weeks. Because in Tokyo it required at least a week to get the certificate of space required to enable a car to be purchased, the effective wait for a new Nissan was negligible. This short delivery time despite high product diversity was achieved via aggressive use of just-in-time production. The Product Cost System The same cost system was used throughout Nissan's assembly plants. It reported full product costs that included both direct and indirect expenses. The indirect expenses were traced to the products in two different ways. Direct and indirect manufacturing expenses were directly charged to the production cost center in which they were consumed, and then allocated to the products. Service and administrative expenses and corporate expenses were allocated to the product without first being allocated to a production center. Corporate expenses were equal to about 15% of the sales revenue. They consisted of three major types of expenses: product-related expenses that included advertisements, warranty, and delivery expenses; geographic-related expenses, such as the costs associated with the sales division in Tokyo that supported sales in all three major markets; and finally, Nissan Motor Company, Ltd.: Target Costing System 194-040 there were the expenses associated with corporate administration, legal, and accounting. The product- related portion of corporate expenses was approximately 30%, the geographic-related portion 50%, and the other expenses about 20%. Three different product profitabilities were calculated (see Exhibit 10). The first was the direct material marginal profit. This was calculated by subtracting the cost of the raw materials and purchased parts from the selling price. The second was the product contribution, determined by subtracting direct manufacturing costs, research and development expenses, and corporate expenses directly related to the product from the direct material marginal profit. Direct manufacturing expenses included manufacturing supplies such as cutting tools and machine depreciation. The procedures used to assign these expenses to products varied depending upon the nature of the expenses and how they were consumed. For example, the costs of manufacturing supplies were assigned to the products based upon the number of direct labor hours the product consumed in the center if the department produced several different models, and number of units if only one model was produced; machine depreciation was assigned to products based upon the number of units irrespective of model. Research and development expenses included the cost of the labor, facilities, and supplies consumed in the research and development facility. They were allocated to products based upon the labor hours consumed in research and development on that product. The corporate expenses directly related to the product included items such as product advertisements, product incentives, warranty costs, and delivery expenses. The third product profitability, operating profit, was calculated by subtracting indirect manufacturing, service, administrative, and the remaining corporate expenses from the product contributions. Indirect manufacturing expenses were directly charged to the production cost center in which they were incurred. Examples of indirect manufacturing expenses included transportation, maintenance, and facility depreciation. These expenses were assigned to the products based on the total direct cost of the products produced in that center. Service and administrative expenses were assigned to the products without first being assigned to the production centers. These expenses were assigned based on the total direct cost of the product. Corporate expenses were first assigned to the facility and then to the products based on their total direct costs in the same way as were service and administrative expenses. The breakdown of product profitability and cost is shown in Exhibit 11. The Nissan cost system was continuously undergoing modification. In particular, a program had been initiated to trace as many costs as possible directly to the production departments. Thus, over time the service and administrative categories were dropping in relationship to the direct and indirect manufacturing costs. The success of this program and the heavy reliance upon external parts and service suppliers were visible from the relative importance of the three major cost categories. The direct costs, i.e., those costs that were traced directly to the products, represented 85% of total manufacturing costs; the direct and indirect manufacturing costs that were charged to the production departments and then assigned to the products represented about 10% of total manufacturing costs; while service and administrative costs amounted to only 5% of total costs. The product costs reported by the cost system had four primary uses. First, they were used in the long-range strategic plan as a basis for estimating future profitability. Second, they were used for cost-control purposes, in particular to ensure that across the production life of a product its target cost was maintained. Third, they were used to help select the product mix, in particular with respect to the variations of a given model. Finally, they were used to identify unprofitable variants that were candidates for discontinuance. Nissan Motor Company, Ltd.: Target Costing System Exhibit 10 Breakdown of Product Profitability Revenue Direct Material Cost 1) Purchased parts 2) Raw materials Direct Material Marginal Profit Direct Cost & Expenses Direct Manufacturing Cost 1) Direct labor cost 2) Manufacturing expenses directly variable (Directly Characterized to the number of units produced (e.g. cutting tools) 3) Tools & machinery Depreciation charge to Products) Maintenance cost Energy cost (****) R&D Expense (labor, expenses, facilities) (****) Corporate Expenses Directly Related to Product 1) Product advertisements 2) Product incentives 3) Warranty 4) Delivery expenses (***** Product Contribution Indirect Manufacturing Cost Consumed by Manufacturing Shop Floors 1) Indirect materials (e.g. monkey wrench, sand paper) 2) Indirect labor cost Indirect Cost 3) Shop floor facilities. Depreciation charge Maintenance cost Energy cost (****) 1) Quality inspection (labor, expenses, facilities) 2) Logistics (labor, expenses, facilities) 3) Energy consumed in service department (Irrespective of Product Characteristics) (****) 4) Maintenance consumed in service department 1) Labor cost 2) General expenses 3) Facilities Depreciation charge Maintenance cost Energy cost (****) Corporate Expense (excluding "directly related to product") 1) Expense consumed by geographic sales division Corporate Expenses. a) Maintenance costs of sales network b) Labor cost consumed in the divisions c) General expenses consumed in the divisions. 2) General Administration (****) **** Services Administration Operating Profit **** ***** **** **** **** **** **** **** **** ****** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** ******* 1. What are the strengths and weaknesses of the target costing system? 2. What would you change? 3. Describe Nissan's cost system. Is it strong enough to support the target costing system? 4. How does your firm (or firms with which you are familiar) determine the cost to man- ufacture new products? 5. Is target costing transferrable to U.S. companies? Nissan Motor Company, Ltd. (Nissan) was by 1990 the world's fourth-largest automobile manufacturer. In 1990, Nissan produced just over 3 million vehicles, supplying approximately 10% of the world's demand for cars and trucks. Of these vehicles, slightly over two million were passenger cars. Nissan, founded in 1933, considered itself the most highly globalized of the Japanese automobile companies, producing vehicles at 36 plants in 22 countries and marketing in 150 countries through 390 distributorships and over 10,000 dealerships. Nissan had a stated policy of increasing its globalization through a five-step process: first, by increasing local production; second, by raising the local content of its products through expanded use of locally sourced parts and components; third, by strengthening local research and development capabilities; fourth, by localizing management functions; and finally, by localizing decision-making processes. As a result, four out of the five major overseas manufacturing plants were managed by local chief executive officer and in 1990 regional headquarters were opened in Europe and North America. The domestic Japanese passenger automobile market was intensely competitive. The largest manufacturer was Toyota, with approximately 45% of the domestic market. Nissan was second with approximately 25%, followed by Honda and Mazda, who together represented about another 20%. In an attempt to increase its market share in the expanding but fiercely contested domestic market, Nissan implemented a plan to achieve annual domestic sales of 1.5 million cars by 1992 and to obtain the number-one rating in terms of customer satisfaction. This strategy depended on designing products that were engineered around clearly defined concepts chosen to offer customers automobiles that matched their lifestyles. Automobile firms had been steadily increasing their range of products since the 1950s. This increase was driven primarily by changes in consumer preferences. For example, US consumers in the 1950s viewed the automobile as a status symbol, using the make of automobile they owned to signal the level of their economic success. Nissan executives characterized the consumer in this era as "keeping up with the Joneses." As automobile ownership became more widespread, consumers began to view their automobiles as making a statement about who they were. Nissan executives characterized Professor Robin Cooper of The Peter F. Drucker Graduate Management Center at The Claremont Graduate School prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. The assistance of Ms. May Mukuda, KPMG Peat Marwick, is gratefully acknowledged. Copyright © 1994 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call (800) 545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means- electronic, mechanical, photocopying, recording, or otherwise without the permission of Harvard Business School. 194-040 Nissan Motor Company, Ltd.: Target Costing System the consumer of this era as "doing his or her own thing." Consumer demand of the 1960s required more variations and a broader range of model types than in the 1950s. As the 1960s closed and individualism became less important, consumers came to view their automobiles as making statements about what they were. Nissan executives characterized this era as being dominated by a desire for a "consistency of lifestyle," i.e., bankers wanted automobiles that were appropriate for bankers. This shift required that more models and variations be produced to satisfy consumer demand. During the 1980s, consumers started to demand automobiles that suited multiple lifestyles. As one executive summed up the transition, "the old segmentation that assumed a single lifestyle no longer worked; we now have to design cars that allow people to be bankers by day and punk rockers at night." This transition in consumer preference placed additional pressure on the firm to increase its range of product offerings. Despite this pressure, Nissan had chosen to systematically reduce the number of distinct models it would introduce in the 1990s. This decision reflected two additional trends. First, the differences between consumers in the three major markets-Japan, North America, and Europe-were decreasing, and second, the costs associated with introducing new models were increasing. The decrease in differences among consumers in the three major markets reduced the need to develop models specific to a single market. The increased costs associated with launching new models made it difficult to make acceptable profits if the number of new models introduced each year was too large. These trends suggested to Nissan top management that overall profitability would be increased by reducing the number of distinct models supported, while maintaining the same level of effort to design and market the remaining models. Introducing New Products Over the years, Nissan had developed a formal procedure to introduce new products. One of the major elements of this procedure was a sophisticated target costing system. In this system, a target selling price for each new model was first established; then, a target margin was determined based upon corporate profitability objectives; finally, the model's target cost was identified as the difference between the target selling price and the target margin. Once the target cost of the new model was established, value engineering was used to ensure that the new model, when it entered production, could be manufactured at the desired target cost. The procedure to introduce new models was divided into three distinct stages: in the conceptual design stage, projects to introduce new product models were initiated; in the product development stage, the new models were readied for production; and in the production stage, they were manufactured. Taken together, these three stages lasted about 10 years, the average life cycle of a modern passenger automobile. The conceptual design stage required about two years complete, the product development stage required about four years, and the production stage typically lasted about another four years. Thus, it was not unusual for Nissan to be simultaneously producing the current model, preparing its replacement for introduction, and conceptualizing the next model's replacement. The Conceptual Design Stage New product models were designed in the conceptual design stage. First, the designers identified the mixture of models that Nissan expected to sell over the next ten years. This mix was described in a matrix of vehicles by major market and body type (e.g., coupe or sedan). The matrix Nissan Motor Company, Ltd.: Target Costing System 194-040 contained qualitative information about each model, such as its price range, target customers and their income levels, and the range of body types supported. This information was maintained for both current and future models and effectively described each model's market position. The primary purpose of the product matrix was to ensure that Nissan achieved the desired level of market coverage. New entries in the matrix were identified using consumer analysis. This analysis was undertaken by market consulting firms using a number of different techniques, including general economic, psychological, and anthropological surveys as well as direct observation. In recent years, this analysis had identified over 50 potential models that theoretically could be successfully introduced by Nissan. However, top management had identified the optimum number of models that Nissan could successfully support at under 30. This number was limited by several factors, including the cost of differentiating each model in the minds of consumers, research and development, and the cash flow associated with maintaining dealer floor inventory. Thus, the challenge that Nissan management faced was to select the approximately 30 models that would maximize market coverage. New models were conceptualized by identifying consumer "mind-sets." Mind-sets captured characteristics of the way consumers viewed themselves in relation to their cars. These mind-sets could be used to identify design attributes that consumers took into account when purchasing a new car. Typical mind-sets included value seeker, confident and sophisticated, aggressive enthusiast, and budget/speed star. By identifying clusters of these mind-sets, Nissan could identify niches that contained a sufficient percentage of the automobile-purchasing public to warrant introducing a model specifically tailored for that niche. For example, the Sentra (a mid-price family sedan) was designed to satisfy the confident/sophisticated and value seeker mind-sets, while the ZX (a high-performance sports car) was designed to satisfy the budget/speed star and aggressive enthusiast mind-sets. As a Nissan marketing executive commented, "If we believe that a sufficient market will exist in four to five years, then we will develop a model to fit it." Thus, each model and its body shape variations, such as sedan, coupe, hatchback, and wagon, was specifically designed to satisfy a different group of consumers. As a final check on the appropriateness of the proposed model line-up, each model was categorized using three primary attributes: performance, aesthetics, and comfort. For example, comfort was considered the most important attribute for the Sentra model and performance the least important, while for the ZX model, performance was considered the most important and comfort the least. A plot of the attribute characteristics of both current, future, and competitive models allowed top management to determine that the proposed product mix covered an adequate percentage of the market. At this stage of the product introduction process, the conceptual design was sufficiently developed to allow a rough estimate of the number of vehicles to be sold and the costs associated with its development. These estimates were used in a life cycle contribution study to estimate the overall profitability of the proposed model. The purpose of this study was to ensure that the new model was likely to generate a positive contribution over its life. The life cycle contribution study consisted of comparing the estimated revenues generated by the new model to the expected cost of the product across its life (see Exhibit 1). The model's revenue was estimated by using a rough estimate of the selling price and the anticipated volume of sales. From this estimate the anticipated direct material cost, which included raw material, paint, and purchased parts, was subtracted. The difference between these two quantities was the estimated direct material marginal profit of the new model. 194-040 Nissan Motor Company, Ltd.: Target Costing System From this profit, four additional sets of expenses were subtracted. The first set contained the direct manufacturing and sales expenses. These were expenses that were predominantly driven by the number of units produced and sold. The direct manufacturing expenses included elements such as the cost of the energy, cutting tools, and indirect materials consumed. The direct sales expenses included logistics costs such as the costs of shipping and delivery. The second set contained the estimated direct labor costs. The third set contained the depreciation charges for machining, die casting, and other major production steps. Finally, the estimated research and development expenses were subtracted to give the life cycle contribution of the particular model under development. The depreciation charges used in the life cycle contribution analysis were estimated by taking the total depreciation for each machine or process and dividing that by the number of units expected to be produced on that equipment over its life. If the equipment was dedicated to the new model, as was typically the case with stamping dies, then the number of units was the estimated volume of production for that model; if the equipment was common to several models, as was often the case with conveyors, then the number of units was the total of all units expected to be produced of all models using that equipment. The depreciation charge used for the life cycle contribution analysis was not the one used for financial reporting purposes. Nissan reported depreciation using a declining balance approach for both tax and financial reporting purposes. However, for the life cycle contribution calculation it used a straight-line approach. Management modified the depreciation calculation because it felt that the straight-line approach better captured the relationship between asset use and models produced than the declining balance approach. If the life cycle contribution was deemed satisfactory, the conceptual design process was allowed to continue. As the conceptual design of the new model progressed, additional consumer analysis and financial analysis was undertaken. Consumer analysis was used to obtain a better idea of the price range over which the model would sell and the level of functionality that the consumer expected. The financial analysis consisted of a rough profitability study in which the profitability of the highest volume variant of the new model was estimated using historical cost estimates and the latest estimate of that variant's target price. This target price was determined by taking into account a number of internal and external factors. The internal factors included the position of the model in the matrix and the strategic and profitability objectives of top management for that model. The external factors considered included the corporation's image and level of customer loyalty in the model's niche, the expected quality level and functionality of the model compared to competitive offerings, the model's expected market share, and finally, the expected price of competitive models. The first stage of value engineering was designed to determine whether the new model could be manufactured at an acceptable profit (see Exhibit 2). The process began by developing an order sheet detailing the characteristics of the 20 to 30 major functions of the proposed model. Examples of the major functions included the engine, air conditioner, transmission, and sound system. The characteristics of each major function were chosen to satisfy the collection of consumer mind-sets for which the model was designed. For example, the engine specified for a ZX would be a high- performance one, while for the Sentra it would be smaller, less powerful, and less expensive. The current cost of the model was determined by summing the current manufacturing cost of each major function of the new model. This current cost was compared with the model's allowable cost to determine the level of cost reduction required to achieve the desired level of profitability. Nissan Motor Company, Ltd.: Target Costing System 194-040 The allowable cost of the new model was determined by subtracting its target profit margin from its target price. The target margin was determined by careful consideration of available information on the consumer, the firm's anticipated future product mix, and its long-term profit objective. Each new model's target margin was established by running simulations of the firm's overall profitability for the next 10 years if it was selling the models identified in the product matrix at expected sales volumes. The simulations started by plotting the actual profit margins of existing products (see existing product curve in Exhibit 3). The desired profitability of planned models was then added (see Exhibit 4) and the firm's overall profitability determined over the years at various sales levels. This predicted overall profitability was compared to the firm's long-term profitability objectives set by senior management (see Exhibit 5). Once a satisfactory future product matrix was established that achieved the firm's profit objective, the target margins for each new model were set. To help minimize the risk that Nissan would not achieve its overall profitability targets, the simulations explored the impact on overall profitability of different price/margin curves for different product mixes. For example, historically higher margins had been earned on higher priced vehicles (see existing product curve in Exhibit 3). However, with the reduced product offering and the increased profitability expected, the future curve might be higher. Alternatively, because there was no guarantee that the existing relationship between price and margin would remain unchanged, simulations were also run to explore the impact of fundamentally different relationships between selling price and margins. The first stage of value engineering and the identification of target price was an interactive process. When the allowable costs were considered to be too far below the estimated cost, the appropriate price range and functionality were reviewed until an allowable cost that was considered achievable was identified (see Exhibit 6). The excess of the current manufacturing cost over the allowable cost determined the level of cost reduction that had to be identified by value engineering. For example, the current manufacturing cost of the model might be ¥3,000,000 and the allowed cost ¥2,700,000, which identified a required cost reduction of 10%. The next step in the value engineering process was to identify the allowable cost of each major function. This cost was set by teams derived from almost every functional area of the firm, including product design, engineering, purchasing, production engineering, manufacturing, and parts supply. Although the allowable cost was usually lower than the current cost, sometimes the allowable cost was higher because the new product specifications demanded higher performance and functionality than existing designs. In total, the sum of the cost reduction for each major component was meant to equal the required level of cost reduction to achieve the model's allowable cost (see Exhibit 7). Several critical decisions about the model were made during this stage of the conceptual design process, including the number of body variations, the number of engine types, and the basic technology used in the vehicle. For example, the original concept for the model might include a five- door variant. However, if during this stage of the analysis it was determined that developing such a variant would be too costly or take an excessive amount of time, plans for a five-door variant would be postponed to the next version of that automobile. Once projected cost of each major component had been identified, the expected cost of manufacture could be computed. 194-040 Nissan Motor Company, Ltd.: Target Costing System After the first value engineering stage was completed, a major review of the new model was conducted. This review included an updated profitability study and an analysis of the performance characteristics of the model. In the profitability study, the expected profitability of the model given by the target price minus the target cost was compared to the latest estimates of the capital investment and remaining research and development expenditures required to complete the design of the product and allow production to commence. In the performance analysis, factors such as the quality of the hardware, engine capacity, exhaust emissions, and safety were considered. If both the financial and performance analyses were considered acceptable, the project to introduce the new vehicle was authorized and the model shifted from the conceptual design to the product development stage. The Product Development Stage The first step in the product development stage was to prepare a detailed order sheet for the new model. This order sheet listed all of the components required in the new model and was analyzed to see which components would likely be sourced internally versus externally. Suppliers, both internal and external, were provided with a description of each component and their potential production volumes. Suppliers were expected to provide price and delivery timing estimates for each component. The next step in the development of a new model was to produce the engineering drawings for trial production. Value engineering was used at this stage of product development to determine allowable costs for each of the components in every major function of the automobile. This estimate was achieved by identifying a cost reduction objective for each component (see Exhibit 8). There were several ways that cost reduction objectives for components were identified. First, competitors' products were purchased, disassembled, and analyzed. From this analysis, ideas for cost reduction were sometimes generated. Second, parts suppliers were asked to generate cost reduction ideas. An incentive plan was used to motivate the suppliers. For example, if an idea was accepted, the supplier that suggested the cost reduction idea would be awarded a significant percentage of the contract for that component for a specified time period, say 50% for 12 months. This incentive scheme was viewed as particularly important because even if a cost reduction could not be achieved for this model, it signalled to the suppliers that when the next model was developed this component would be subject to cost reduction pressures. Third, ways to increase the commonality of parts across variations and models were identified (e.g., the same seats might be used in two different models). Fourth, ways to reduce the number of components in each model were identified. For example, originally the kick plates used to protect the door were held in place by plastic nuts. However, a way to mold the plastic interior of the door so that no nuts were required had been developed. To avoid having to develop target costs for all 20,000 components in a typical new model line, the engineers only performed detailed target costing on two or three representative variations. Each variation contained approximately 3,500 components, and typically 80% of the components were common across variations. Therefore, about 5,000 components were subjected to detailed target costing. The target costs of the other 15,000 components were estimated by comparing them to similar components in the 5,000 already target-costed. The completion of this target costing exercise provided cost reduction objectives for all of the components in the new model. The comparison of the allowable cost of each function and the sum of the expected cost of the components in that function after cost reduction indicated whether the major function could be produced at about the Nissan Motor Company, Ltd.: Target Costing System 194-040 allowable cost. When the sum of the component costs was too high, additional cost reductions were identified until the total target cost of the representative variation was acceptable. The target costs for each component were compared to the prices quoted by the suppliers. If the quoted prices were acceptable, the quote was accepted. If the initial quote was too high, then further negotiations were undertaken until an agreement could be reached. The next phase in product development was to construct two or three prototype vehicles. Several important lessons were learned from the construction of these prototypes. First, any components that were difficult to assemble were identified. Typically, these components or the assemblies into which they fitted were redesigned to improve the ease of assembly. Second, assembly times could now be estimated quite accurately. In the third stage of value engineering, the effect of these redesigns on the target costs of the components was determined and assembly target costs were identified. The output of this stage of value engineering was called the final target cost (see Exhibit 9). It differed from the draft target cost in two ways. First, it included assembly costs and second, the indirect manufacturing costs. The indirect manufacturing costs were assigned to products using the same procedures as the firm's cost system. Thus, the final target cost for a model variant was expected to be equal to its reported product cost during manufacture. A comparison of the final target costs for each model variant and its expected selling price allowed the anticipated profit on the vehicle to be determined. The expected selling price was reviewed by marketing in light of recent competitive products and market conditions, and a final selling price recommended. Accounting was responsible for authorizing the actual selling price of each variation. It took into account marketing's review of existing conditions, the final target cost of the vehicle, and the target margin for the vehicle. Once set, accounting notified marketing of the recommended selling price. In Japan, this was the price at which the car would be sold across its life. In other markets, such as North America, incentive plans and other marketing techniques could cause the effective price to change across the life of the product. Accounting was not involved in the value engineering process, which was the responsibility of the cost design and engineering department. The primary function of accounting was to set the final target cost for each model variant and ensure that the vehicles were manufactured for that amount. As the vehicle entered production, accounting would monitor all component and assembly costs and if these were not in line with the final target costs, accounting would notify cost design and engineering that the final target costs were not being met. When the target costs were exceeded, additional value engineering was performed to reduce costs back to the target levels. Thus, the fourth and final value engineering stage ensured that the actual component and assembly costs were equal to their final target costs. Unless the production cost exceeded the target cost, no cost reduction efforts were undertaken during the production stage. Management had determined that the incremental savings from such efforts were more than offset by disturbances they created to the production process. When inflation or other factors caused costs to rise, pressure was exerted upon the suppliers to find ways to keep component costs at their final target levels. Similarly, pressure was exerted on the assembly plants to achieve the assembly target costs. The Production Stage The Zama facility, located a few miles from Tokyo, was one of Nissan's five major domestic manufacturing facilities. Built in 1964, it was 852,000 square meters in area and contained two complete stamping and assembly facilities. In addition, the facility housed a car delivery area and the firm's machinery design center. No production parts were produced at Zama. The plant was only involved in producing pressed metal parts, welding them together, assembling the body, painting it, and then assembling the finished automobile. The Zama plant was designed to produce 90 cars per hour, operating on a two-shift basis with production occurring for 15 hours and 20 minutes per day. A two-shift operation enabled the plant to produce between 1,300 to 1,400 cars per day at full capacity. While preventative maintenance was carried on throughout the day, primary maintenance was performed during the 8 hours and 40 minutes in which no production was scheduled. Zama was a highly automated plant. Of the approximately 3,000 spot welds per car, over 97% were performed automatically. This high level of automation had been achieved over a number of years. The current high level of automatic spot welding was achieved around 1980. To sustain this high level of automation, Zama contained nearly 300 robots. All of these robots were designed by Nissan but only about 40% were actually manufactured by the firm. In 1990, the facility was dedicated to the production of two models and three body types. The Sunny, or Sentra as it was called in the North American market, was produced in two body types: the four-door and two-door coupe configurations and the Presea in a single four-door configuration. Each body type could be produced in numerous variations of key components, such as engine, air conditioning, and transmission. When all possible option variations were included, Zama produced approximately 20,000 different variations of each of the three distinct body types. The large number of variations forced the facility to produce cars to customer order. This production strategy fit well with Nissan's corporate strategy of providing customer satisfaction, high quality, short delivery times, and high functionality. In fact, fast delivery was considered so important that the production strategy was called by a name that translated to "deliver the car with the paint still wet." In 1990, a car ordered from a Japanese dealer and produced in the Zama plant could be delivered to the customer within 2 weeks. Because in Tokyo it required at least a week to get the certificate of space required to enable a car to be purchased, the effective wait for a new Nissan was negligible. This short delivery time despite high product diversity was achieved via aggressive use of just-in-time production. The Product Cost System The same cost system was used throughout Nissan's assembly plants. It reported full product costs that included both direct and indirect expenses. The indirect expenses were traced to the products in two different ways. Direct and indirect manufacturing expenses were directly charged to the production cost center in which they were consumed, and then allocated to the products. Service and administrative expenses and corporate expenses were allocated to the product without first being allocated to a production center. Corporate expenses were equal to about 15% of the sales revenue. They consisted of three major types of expenses: product-related expenses that included advertisements, warranty, and delivery expenses; geographic-related expenses, such as the costs associated with the sales division in Tokyo that supported sales in all three major markets; and finally, Nissan Motor Company, Ltd.: Target Costing System 194-040 there were the expenses associated with corporate administration, legal, and accounting. The product- related portion of corporate expenses was approximately 30%, the geographic-related portion 50%, and the other expenses about 20%. Three different product profitabilities were calculated (see Exhibit 10). The first was the direct material marginal profit. This was calculated by subtracting the cost of the raw materials and purchased parts from the selling price. The second was the product contribution, determined by subtracting direct manufacturing costs, research and development expenses, and corporate expenses directly related to the product from the direct material marginal profit. Direct manufacturing expenses included manufacturing supplies such as cutting tools and machine depreciation. The procedures used to assign these expenses to products varied depending upon the nature of the expenses and how they were consumed. For example, the costs of manufacturing supplies were assigned to the products based upon the number of direct labor hours the product consumed in the center if the department produced several different models, and number of units if only one model was produced; machine depreciation was assigned to products based upon the number of units irrespective of model. Research and development expenses included the cost of the labor, facilities, and supplies consumed in the research and development facility. They were allocated to products based upon the labor hours consumed in research and development on that product. The corporate expenses directly related to the product included items such as product advertisements, product incentives, warranty costs, and delivery expenses. The third product profitability, operating profit, was calculated by subtracting indirect manufacturing, service, administrative, and the remaining corporate expenses from the product contributions. Indirect manufacturing expenses were directly charged to the production cost center in which they were incurred. Examples of indirect manufacturing expenses included transportation, maintenance, and facility depreciation. These expenses were assigned to the products based on the total direct cost of the products produced in that center. Service and administrative expenses were assigned to the products without first being assigned to the production centers. These expenses were assigned based on the total direct cost of the product. Corporate expenses were first assigned to the facility and then to the products based on their total direct costs in the same way as were service and administrative expenses. The breakdown of product profitability and cost is shown in Exhibit 11. The Nissan cost system was continuously undergoing modification. In particular, a program had been initiated to trace as many costs as possible directly to the production departments. Thus, over time the service and administrative categories were dropping in relationship to the direct and indirect manufacturing costs. The success of this program and the heavy reliance upon external parts and service suppliers were visible from the relative importance of the three major cost categories. The direct costs, i.e., those costs that were traced directly to the products, represented 85% of total manufacturing costs; the direct and indirect manufacturing costs that were charged to the production departments and then assigned to the products represented about 10% of total manufacturing costs; while service and administrative costs amounted to only 5% of total costs. The product costs reported by the cost system had four primary uses. First, they were used in the long-range strategic plan as a basis for estimating future profitability. Second, they were used for cost-control purposes, in particular to ensure that across the production life of a product its target cost was maintained. Third, they were used to help select the product mix, in particular with respect to the variations of a given model. Finally, they were used to identify unprofitable variants that were candidates for discontinuance. Nissan Motor Company, Ltd.: Target Costing System Exhibit 10 Breakdown of Product Profitability Revenue Direct Material Cost 1) Purchased parts 2) Raw materials Direct Material Marginal Profit Direct Cost & Expenses Direct Manufacturing Cost 1) Direct labor cost 2) Manufacturing expenses directly variable (Directly Characterized to the number of units produced (e.g. cutting tools) 3) Tools & machinery Depreciation charge to Products) Maintenance cost Energy cost (****) R&D Expense (labor, expenses, facilities) (****) Corporate Expenses Directly Related to Product 1) Product advertisements 2) Product incentives 3) Warranty 4) Delivery expenses (***** Product Contribution Indirect Manufacturing Cost Consumed by Manufacturing Shop Floors 1) Indirect materials (e.g. monkey wrench, sand paper) 2) Indirect labor cost Indirect Cost 3) Shop floor facilities. Depreciation charge Maintenance cost Energy cost (****) 1) Quality inspection (labor, expenses, facilities) 2) Logistics (labor, expenses, facilities) 3) Energy consumed in service department (Irrespective of Product Characteristics) (****) 4) Maintenance consumed in service department 1) Labor cost 2) General expenses 3) Facilities Depreciation charge Maintenance cost Energy cost (****) Corporate Expense (excluding "directly related to product") 1) Expense consumed by geographic sales division Corporate Expenses. a) Maintenance costs of sales network b) Labor cost consumed in the divisions c) General expenses consumed in the divisions. 2) General Administration (****) **** Services Administration Operating Profit **** ***** **** **** **** **** **** **** **** ****** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** ******* 1. What are the strengths and weaknesses of the target costing system? 2. What would you change? 3. Describe Nissan's cost system. Is it strong enough to support the target costing system? 4. How does your firm (or firms with which you are familiar) determine the cost to man- ufacture new products? 5. Is target costing transferrable to U.S. companies? Nissan Motor Company, Ltd. (Nissan) was by 1990 the world's fourth-largest automobile manufacturer. In 1990, Nissan produced just over 3 million vehicles, supplying approximately 10% of the world's demand for cars and trucks. Of these vehicles, slightly over two million were passenger cars. Nissan, founded in 1933, considered itself the most highly globalized of the Japanese automobile companies, producing vehicles at 36 plants in 22 countries and marketing in 150 countries through 390 distributorships and over 10,000 dealerships. Nissan had a stated policy of increasing its globalization through a five-step process: first, by increasing local production; second, by raising the local content of its products through expanded use of locally sourced parts and components; third, by strengthening local research and development capabilities; fourth, by localizing management functions; and finally, by localizing decision-making processes. As a result, four out of the five major overseas manufacturing plants were managed by local chief executive officer and in 1990 regional headquarters were opened in Europe and North America. The domestic Japanese passenger automobile market was intensely competitive. The largest manufacturer was Toyota, with approximately 45% of the domestic market. Nissan was second with approximately 25%, followed by Honda and Mazda, who together represented about another 20%. In an attempt to increase its market share in the expanding but fiercely contested domestic market, Nissan implemented a plan to achieve annual domestic sales of 1.5 million cars by 1992 and to obtain the number-one rating in terms of customer satisfaction. This strategy depended on designing products that were engineered around clearly defined concepts chosen to offer customers automobiles that matched their lifestyles. Automobile firms had been steadily increasing their range of products since the 1950s. This increase was driven primarily by changes in consumer preferences. For example, US consumers in the 1950s viewed the automobile as a status symbol, using the make of automobile they owned to signal the level of their economic success. Nissan executives characterized the consumer in this era as "keeping up with the Joneses." As automobile ownership became more widespread, consumers began to view their automobiles as making a statement about who they were. Nissan executives characterized Professor Robin Cooper of The Peter F. Drucker Graduate Management Center at The Claremont Graduate School prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. The assistance of Ms. May Mukuda, KPMG Peat Marwick, is gratefully acknowledged. Copyright © 1994 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call (800) 545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means- electronic, mechanical, photocopying, recording, or otherwise without the permission of Harvard Business School. 194-040 Nissan Motor Company, Ltd.: Target Costing System the consumer of this era as "doing his or her own thing." Consumer demand of the 1960s required more variations and a broader range of model types than in the 1950s. As the 1960s closed and individualism became less important, consumers came to view their automobiles as making statements about what they were. Nissan executives characterized this era as being dominated by a desire for a "consistency of lifestyle," i.e., bankers wanted automobiles that were appropriate for bankers. This shift required that more models and variations be produced to satisfy consumer demand. During the 1980s, consumers started to demand automobiles that suited multiple lifestyles. As one executive summed up the transition, "the old segmentation that assumed a single lifestyle no longer worked; we now have to design cars that allow people to be bankers by day and punk rockers at night." This transition in consumer preference placed additional pressure on the firm to increase its range of product offerings. Despite this pressure, Nissan had chosen to systematically reduce the number of distinct models it would introduce in the 1990s. This decision reflected two additional trends. First, the differences between consumers in the three major markets-Japan, North America, and Europe-were decreasing, and second, the costs associated with introducing new models were increasing. The decrease in differences among consumers in the three major markets reduced the need to develop models specific to a single market. The increased costs associated with launching new models made it difficult to make acceptable profits if the number of new models introduced each year was too large. These trends suggested to Nissan top management that overall profitability would be increased by reducing the number of distinct models supported, while maintaining the same level of effort to design and market the remaining models. Introducing New Products Over the years, Nissan had developed a formal procedure to introduce new products. One of the major elements of this procedure was a sophisticated target costing system. In this system, a target selling price for each new model was first established; then, a target margin was determined based upon corporate profitability objectives; finally, the model's target cost was identified as the difference between the target selling price and the target margin. Once the target cost of the new model was established, value engineering was used to ensure that the new model, when it entered production, could be manufactured at the desired target cost. The procedure to introduce new models was divided into three distinct stages: in the conceptual design stage, projects to introduce new product models were initiated; in the product development stage, the new models were readied for production; and in the production stage, they were manufactured. Taken together, these three stages lasted about 10 years, the average life cycle of a modern passenger automobile. The conceptual design stage required about two years complete, the product development stage required about four years, and the production stage typically lasted about another four years. Thus, it was not unusual for Nissan to be simultaneously producing the current model, preparing its replacement for introduction, and conceptualizing the next model's replacement. The Conceptual Design Stage New product models were designed in the conceptual design stage. First, the designers identified the mixture of models that Nissan expected to sell over the next ten years. This mix was described in a matrix of vehicles by major market and body type (e.g., coupe or sedan). The matrix Nissan Motor Company, Ltd.: Target Costing System 194-040 contained qualitative information about each model, such as its price range, target customers and their income levels, and the range of body types supported. This information was maintained for both current and future models and effectively described each model's market position. The primary purpose of the product matrix was to ensure that Nissan achieved the desired level of market coverage. New entries in the matrix were identified using consumer analysis. This analysis was undertaken by market consulting firms using a number of different techniques, including general economic, psychological, and anthropological surveys as well as direct observation. In recent years, this analysis had identified over 50 potential models that theoretically could be successfully introduced by Nissan. However, top management had identified the optimum number of models that Nissan could successfully support at under 30. This number was limited by several factors, including the cost of differentiating each model in the minds of consumers, research and development, and the cash flow associated with maintaining dealer floor inventory. Thus, the challenge that Nissan management faced was to select the approximately 30 models that would maximize market coverage. New models were conceptualized by identifying consumer "mind-sets." Mind-sets captured characteristics of the way consumers viewed themselves in relation to their cars. These mind-sets could be used to identify design attributes that consumers took into account when purchasing a new car. Typical mind-sets included value seeker, confident and sophisticated, aggressive enthusiast, and budget/speed star. By identifying clusters of these mind-sets, Nissan could identify niches that contained a sufficient percentage of the automobile-purchasing public to warrant introducing a model specifically tailored for that niche. For example, the Sentra (a mid-price family sedan) was designed to satisfy the confident/sophisticated and value seeker mind-sets, while the ZX (a high-performance sports car) was designed to satisfy the budget/speed star and aggressive enthusiast mind-sets. As a Nissan marketing executive commented, "If we believe that a sufficient market will exist in four to five years, then we will develop a model to fit it." Thus, each model and its body shape variations, such as sedan, coupe, hatchback, and wagon, was specifically designed to satisfy a different group of consumers. As a final check on the appropriateness of the proposed model line-up, each model was categorized using three primary attributes: performance, aesthetics, and comfort. For example, comfort was considered the most important attribute for the Sentra model and performance the least important, while for the ZX model, performance was considered the most important and comfort the least. A plot of the attribute characteristics of both current, future, and competitive models allowed top management to determine that the proposed product mix covered an adequate percentage of the market. At this stage of the product introduction process, the conceptual design was sufficiently developed to allow a rough estimate of the number of vehicles to be sold and the costs associated with its development. These estimates were used in a life cycle contribution study to estimate the overall profitability of the proposed model. The purpose of this study was to ensure that the new model was likely to generate a positive contribution over its life. The life cycle contribution study consisted of comparing the estimated revenues generated by the new model to the expected cost of the product across its life (see Exhibit 1). The model's revenue was estimated by using a rough estimate of the selling price and the anticipated volume of sales. From this estimate the anticipated direct material cost, which included raw material, paint, and purchased parts, was subtracted. The difference between these two quantities was the estimated direct material marginal profit of the new model. 194-040 Nissan Motor Company, Ltd.: Target Costing System From this profit, four additional sets of expenses were subtracted. The first set contained the direct manufacturing and sales expenses. These were expenses that were predominantly driven by the number of units produced and sold. The direct manufacturing expenses included elements such as the cost of the energy, cutting tools, and indirect materials consumed. The direct sales expenses included logistics costs such as the costs of shipping and delivery. The second set contained the estimated direct labor costs. The third set contained the depreciation charges for machining, die casting, and other major production steps. Finally, the estimated research and development expenses were subtracted to give the life cycle contribution of the particular model under development. The depreciation charges used in the life cycle contribution analysis were estimated by taking the total depreciation for each machine or process and dividing that by the number of units expected to be produced on that equipment over its life. If the equipment was dedicated to the new model, as was typically the case with stamping dies, then the number of units was the estimated volume of production for that model; if the equipment was common to several models, as was often the case with conveyors, then the number of units was the total of all units expected to be produced of all models using that equipment. The depreciation charge used for the life cycle contribution analysis was not the one used for financial reporting purposes. Nissan reported depreciation using a declining balance approach for both tax and financial reporting purposes. However, for the life cycle contribution calculation it used a straight-line approach. Management modified the depreciation calculation because it felt that the straight-line approach better captured the relationship between asset use and models produced than the declining balance approach. If the life cycle contribution was deemed satisfactory, the conceptual design process was allowed to continue. As the conceptual design of the new model progressed, additional consumer analysis and financial analysis was undertaken. Consumer analysis was used to obtain a better idea of the price range over which the model would sell and the level of functionality that the consumer expected. The financial analysis consisted of a rough profitability study in which the profitability of the highest volume variant of the new model was estimated using historical cost estimates and the latest estimate of that variant's target price. This target price was determined by taking into account a number of internal and external factors. The internal factors included the position of the model in the matrix and the strategic and profitability objectives of top management for that model. The external factors considered included the corporation's image and level of customer loyalty in the model's niche, the expected quality level and functionality of the model compared to competitive offerings, the model's expected market share, and finally, the expected price of competitive models. The first stage of value engineering was designed to determine whether the new model could be manufactured at an acceptable profit (see Exhibit 2). The process began by developing an order sheet detailing the characteristics of the 20 to 30 major functions of the proposed model. Examples of the major functions included the engine, air conditioner, transmission, and sound system. The characteristics of each major function were chosen to satisfy the collection of consumer mind-sets for which the model was designed. For example, the engine specified for a ZX would be a high- performance one, while for the Sentra it would be smaller, less powerful, and less expensive. The current cost of the model was determined by summing the current manufacturing cost of each major function of the new model. This current cost was compared with the model's allowable cost to determine the level of cost reduction required to achieve the desired level of profitability. Nissan Motor Company, Ltd.: Target Costing System 194-040 The allowable cost of the new model was determined by subtracting its target profit margin from its target price. The target margin was determined by careful consideration of available information on the consumer, the firm's anticipated future product mix, and its long-term profit objective. Each new model's target margin was established by running simulations of the firm's overall profitability for the next 10 years if it was selling the models identified in the product matrix at expected sales volumes. The simulations started by plotting the actual profit margins of existing products (see existing product curve in Exhibit 3). The desired profitability of planned models was then added (see Exhibit 4) and the firm's overall profitability determined over the years at various sales levels. This predicted overall profitability was compared to the firm's long-term profitability objectives set by senior management (see Exhibit 5). Once a satisfactory future product matrix was established that achieved the firm's profit objective, the target margins for each new model were set. To help minimize the risk that Nissan would not achieve its overall profitability targets, the simulations explored the impact on overall profitability of different price/margin curves for different product mixes. For example, historically higher margins had been earned on higher priced vehicles (see existing product curve in Exhibit 3). However, with the reduced product offering and the increased profitability expected, the future curve might be higher. Alternatively, because there was no guarantee that the existing relationship between price and margin would remain unchanged, simulations were also run to explore the impact of fundamentally different relationships between selling price and margins. The first stage of value engineering and the identification of target price was an interactive process. When the allowable costs were considered to be too far below the estimated cost, the appropriate price range and functionality were reviewed until an allowable cost that was considered achievable was identified (see Exhibit 6). The excess of the current manufacturing cost over the allowable cost determined the level of cost reduction that had to be identified by value engineering. For example, the current manufacturing cost of the model might be ¥3,000,000 and the allowed cost ¥2,700,000, which identified a required cost reduction of 10%. The next step in the value engineering process was to identify the allowable cost of each major function. This cost was set by teams derived from almost every functional area of the firm, including product design, engineering, purchasing, production engineering, manufacturing, and parts supply. Although the allowable cost was usually lower than the current cost, sometimes the allowable cost was higher because the new product specifications demanded higher performance and functionality than existing designs. In total, the sum of the cost reduction for each major component was meant to equal the required level of cost reduction to achieve the model's allowable cost (see Exhibit 7). Several critical decisions about the model were made during this stage of the conceptual design process, including the number of body variations, the number of engine types, and the basic technology used in the vehicle. For example, the original concept for the model might include a five- door variant. However, if during this stage of the analysis it was determined that developing such a variant would be too costly or take an excessive amount of time, plans for a five-door variant would be postponed to the next version of that automobile. Once projected cost of each major component had been identified, the expected cost of manufacture could be computed. 194-040 Nissan Motor Company, Ltd.: Target Costing System After the first value engineering stage was completed, a major review of the new model was conducted. This review included an updated profitability study and an analysis of the performance characteristics of the model. In the profitability study, the expected profitability of the model given by the target price minus the target cost was compared to the latest estimates of the capital investment and remaining research and development expenditures required to complete the design of the product and allow production to commence. In the performance analysis, factors such as the quality of the hardware, engine capacity, exhaust emissions, and safety were considered. If both the financial and performance analyses were considered acceptable, the project to introduce the new vehicle was authorized and the model shifted from the conceptual design to the product development stage. The Product Development Stage The first step in the product development stage was to prepare a detailed order sheet for the new model. This order sheet listed all of the components required in the new model and was analyzed to see which components would likely be sourced internally versus externally. Suppliers, both internal and external, were provided with a description of each component and their potential production volumes. Suppliers were expected to provide price and delivery timing estimates for each component. The next step in the development of a new model was to produce the engineering drawings for trial production. Value engineering was used at this stage of product development to determine allowable costs for each of the components in every major function of the automobile. This estimate was achieved by identifying a cost reduction objective for each component (see Exhibit 8). There were several ways that cost reduction objectives for components were identified. First, competitors' products were purchased, disassembled, and analyzed. From this analysis, ideas for cost reduction were sometimes generated. Second, parts suppliers were asked to generate cost reduction ideas. An incentive plan was used to motivate the suppliers. For example, if an idea was accepted, the supplier that suggested the cost reduction idea would be awarded a significant percentage of the contract for that component for a specified time period, say 50% for 12 months. This incentive scheme was viewed as particularly important because even if a cost reduction could not be achieved for this model, it signalled to the suppliers that when the next model was developed this component would be subject to cost reduction pressures. Third, ways to increase the commonality of parts across variations and models were identified (e.g., the same seats might be used in two different models). Fourth, ways to reduce the number of components in each model were identified. For example, originally the kick plates used to protect the door were held in place by plastic nuts. However, a way to mold the plastic interior of the door so that no nuts were required had been developed. To avoid having to develop target costs for all 20,000 components in a typical new model line, the engineers only performed detailed target costing on two or three representative variations. Each variation contained approximately 3,500 components, and typically 80% of the components were common across variations. Therefore, about 5,000 components were subjected to detailed target costing. The target costs of the other 15,000 components were estimated by comparing them to similar components in the 5,000 already target-costed. The completion of this target costing exercise provided cost reduction objectives for all of the components in the new model. The comparison of the allowable cost of each function and the sum of the expected cost of the components in that function after cost reduction indicated whether the major function could be produced at about the Nissan Motor Company, Ltd.: Target Costing System 194-040 allowable cost. When the sum of the component costs was too high, additional cost reductions were identified until the total target cost of the representative variation was acceptable. The target costs for each component were compared to the prices quoted by the suppliers. If the quoted prices were acceptable, the quote was accepted. If the initial quote was too high, then further negotiations were undertaken until an agreement could be reached. The next phase in product development was to construct two or three prototype vehicles. Several important lessons were learned from the construction of these prototypes. First, any components that were difficult to assemble were identified. Typically, these components or the assemblies into which they fitted were redesigned to improve the ease of assembly. Second, assembly times could now be estimated quite accurately. In the third stage of value engineering, the effect of these redesigns on the target costs of the components was determined and assembly target costs were identified. The output of this stage of value engineering was called the final target cost (see Exhibit 9). It differed from the draft target cost in two ways. First, it included assembly costs and second, the indirect manufacturing costs. The indirect manufacturing costs were assigned to products using the same procedures as the firm's cost system. Thus, the final target cost for a model variant was expected to be equal to its reported product cost during manufacture. A comparison of the final target costs for each model variant and its expected selling price allowed the anticipated profit on the vehicle to be determined. The expected selling price was reviewed by marketing in light of recent competitive products and market conditions, and a final selling price recommended. Accounting was responsible for authorizing the actual selling price of each variation. It took into account marketing's review of existing conditions, the final target cost of the vehicle, and the target margin for the vehicle. Once set, accounting notified marketing of the recommended selling price. In Japan, this was the price at which the car would be sold across its life. In other markets, such as North America, incentive plans and other marketing techniques could cause the effective price to change across the life of the product. Accounting was not involved in the value engineering process, which was the responsibility of the cost design and engineering department. The primary function of accounting was to set the final target cost for each model variant and ensure that the vehicles were manufactured for that amount. As the vehicle entered production, accounting would monitor all component and assembly costs and if these were not in line with the final target costs, accounting would notify cost design and engineering that the final target costs were not being met. When the target costs were exceeded, additional value engineering was performed to reduce costs back to the target levels. Thus, the fourth and final value engineering stage ensured that the actual component and assembly costs were equal to their final target costs. Unless the production cost exceeded the target cost, no cost reduction efforts were undertaken during the production stage. Management had determined that the incremental savings from such efforts were more than offset by disturbances they created to the production process. When inflation or other factors caused costs to rise, pressure was exerted upon the suppliers to find ways to keep component costs at their final target levels. Similarly, pressure was exerted on the assembly plants to achieve the assembly target costs. The Production Stage The Zama facility, located a few miles from Tokyo, was one of Nissan's five major domestic manufacturing facilities. Built in 1964, it was 852,000 square meters in area and contained two complete stamping and assembly facilities. In addition, the facility housed a car delivery area and the firm's machinery design center. No production parts were produced at Zama. The plant was only involved in producing pressed metal parts, welding them together, assembling the body, painting it, and then assembling the finished automobile. The Zama plant was designed to produce 90 cars per hour, operating on a two-shift basis with production occurring for 15 hours and 20 minutes per day. A two-shift operation enabled the plant to produce between 1,300 to 1,400 cars per day at full capacity. While preventative maintenance was carried on throughout the day, primary maintenance was performed during the 8 hours and 40 minutes in which no production was scheduled. Zama was a highly automated plant. Of the approximately 3,000 spot welds per car, over 97% were performed automatically. This high level of automation had been achieved over a number of years. The current high level of automatic spot welding was achieved around 1980. To sustain this high level of automation, Zama contained nearly 300 robots. All of these robots were designed by Nissan but only about 40% were actually manufactured by the firm. In 1990, the facility was dedicated to the production of two models and three body types. The Sunny, or Sentra as it was called in the North American market, was produced in two body types: the four-door and two-door coupe configurations and the Presea in a single four-door configuration. Each body type could be produced in numerous variations of key components, such as engine, air conditioning, and transmission. When all possible option variations were included, Zama produced approximately 20,000 different variations of each of the three distinct body types. The large number of variations forced the facility to produce cars to customer order. This production strategy fit well with Nissan's corporate strategy of providing customer satisfaction, high quality, short delivery times, and high functionality. In fact, fast delivery was considered so important that the production strategy was called by a name that translated to "deliver the car with the paint still wet." In 1990, a car ordered from a Japanese dealer and produced in the Zama plant could be delivered to the customer within 2 weeks. Because in Tokyo it required at least a week to get the certificate of space required to enable a car to be purchased, the effective wait for a new Nissan was negligible. This short delivery time despite high product diversity was achieved via aggressive use of just-in-time production. The Product Cost System The same cost system was used throughout Nissan's assembly plants. It reported full product costs that included both direct and indirect expenses. The indirect expenses were traced to the products in two different ways. Direct and indirect manufacturing expenses were directly charged to the production cost center in which they were consumed, and then allocated to the products. Service and administrative expenses and corporate expenses were allocated to the product without first being allocated to a production center. Corporate expenses were equal to about 15% of the sales revenue. They consisted of three major types of expenses: product-related expenses that included advertisements, warranty, and delivery expenses; geographic-related expenses, such as the costs associated with the sales division in Tokyo that supported sales in all three major markets; and finally, Nissan Motor Company, Ltd.: Target Costing System 194-040 there were the expenses associated with corporate administration, legal, and accounting. The product- related portion of corporate expenses was approximately 30%, the geographic-related portion 50%, and the other expenses about 20%. Three different product profitabilities were calculated (see Exhibit 10). The first was the direct material marginal profit. This was calculated by subtracting the cost of the raw materials and purchased parts from the selling price. The second was the product contribution, determined by subtracting direct manufacturing costs, research and development expenses, and corporate expenses directly related to the product from the direct material marginal profit. Direct manufacturing expenses included manufacturing supplies such as cutting tools and machine depreciation. The procedures used to assign these expenses to products varied depending upon the nature of the expenses and how they were consumed. For example, the costs of manufacturing supplies were assigned to the products based upon the number of direct labor hours the product consumed in the center if the department produced several different models, and number of units if only one model was produced; machine depreciation was assigned to products based upon the number of units irrespective of model. Research and development expenses included the cost of the labor, facilities, and supplies consumed in the research and development facility. They were allocated to products based upon the labor hours consumed in research and development on that product. The corporate expenses directly related to the product included items such as product advertisements, product incentives, warranty costs, and delivery expenses. The third product profitability, operating profit, was calculated by subtracting indirect manufacturing, service, administrative, and the remaining corporate expenses from the product contributions. Indirect manufacturing expenses were directly charged to the production cost center in which they were incurred. Examples of indirect manufacturing expenses included transportation, maintenance, and facility depreciation. These expenses were assigned to the products based on the total direct cost of the products produced in that center. Service and administrative expenses were assigned to the products without first being assigned to the production centers. These expenses were assigned based on the total direct cost of the product. Corporate expenses were first assigned to the facility and then to the products based on their total direct costs in the same way as were service and administrative expenses. The breakdown of product profitability and cost is shown in Exhibit 11. The Nissan cost system was continuously undergoing modification. In particular, a program had been initiated to trace as many costs as possible directly to the production departments. Thus, over time the service and administrative categories were dropping in relationship to the direct and indirect manufacturing costs. The success of this program and the heavy reliance upon external parts and service suppliers were visible from the relative importance of the three major cost categories. The direct costs, i.e., those costs that were traced directly to the products, represented 85% of total manufacturing costs; the direct and indirect manufacturing costs that were charged to the production departments and then assigned to the products represented about 10% of total manufacturing costs; while service and administrative costs amounted to only 5% of total costs. The product costs reported by the cost system had four primary uses. First, they were used in the long-range strategic plan as a basis for estimating future profitability. Second, they were used for cost-control purposes, in particular to ensure that across the production life of a product its target cost was maintained. Third, they were used to help select the product mix, in particular with respect to the variations of a given model. Finally, they were used to identify unprofitable variants that were candidates for discontinuance. Nissan Motor Company, Ltd.: Target Costing System Exhibit 10 Breakdown of Product Profitability Revenue Direct Material Cost 1) Purchased parts 2) Raw materials Direct Material Marginal Profit Direct Cost & Expenses Direct Manufacturing Cost 1) Direct labor cost 2) Manufacturing expenses directly variable (Directly Characterized to the number of units produced (e.g. cutting tools) 3) Tools & machinery Depreciation charge to Products) Maintenance cost Energy cost (****) R&D Expense (labor, expenses, facilities) (****) Corporate Expenses Directly Related to Product 1) Product advertisements 2) Product incentives 3) Warranty 4) Delivery expenses (***** Product Contribution Indirect Manufacturing Cost Consumed by Manufacturing Shop Floors 1) Indirect materials (e.g. monkey wrench, sand paper) 2) Indirect labor cost Indirect Cost 3) Shop floor facilities. Depreciation charge Maintenance cost Energy cost (****) 1) Quality inspection (labor, expenses, facilities) 2) Logistics (labor, expenses, facilities) 3) Energy consumed in service department (Irrespective of Product Characteristics) (****) 4) Maintenance consumed in service department 1) Labor cost 2) General expenses 3) Facilities Depreciation charge Maintenance cost Energy cost (****) Corporate Expense (excluding "directly related to product") 1) Expense consumed by geographic sales division Corporate Expenses. a) Maintenance costs of sales network b) Labor cost consumed in the divisions c) General expenses consumed in the divisions. 2) General Administration (****) **** Services Administration Operating Profit **** ***** **** **** **** **** **** **** **** ****** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** ******* 1. What are the strengths and weaknesses of the target costing system? 2. What would you change? 3. Describe Nissan's cost system. Is it strong enough to support the target costing system? 4. How does your firm (or firms with which you are familiar) determine the cost to man- ufacture new products? 5. Is target costing transferrable to U.S. companies? Nissan Motor Company, Ltd. (Nissan) was by 1990 the world's fourth-largest automobile manufacturer. In 1990, Nissan produced just over 3 million vehicles, supplying approximately 10% of the world's demand for cars and trucks. Of these vehicles, slightly over two million were passenger cars. Nissan, founded in 1933, considered itself the most highly globalized of the Japanese automobile companies, producing vehicles at 36 plants in 22 countries and marketing in 150 countries through 390 distributorships and over 10,000 dealerships. Nissan had a stated policy of increasing its globalization through a five-step process: first, by increasing local production; second, by raising the local content of its products through expanded use of locally sourced parts and components; third, by strengthening local research and development capabilities; fourth, by localizing management functions; and finally, by localizing decision-making processes. As a result, four out of the five major overseas manufacturing plants were managed by local chief executive officer and in 1990 regional headquarters were opened in Europe and North America. The domestic Japanese passenger automobile market was intensely competitive. The largest manufacturer was Toyota, with approximately 45% of the domestic market. Nissan was second with approximately 25%, followed by Honda and Mazda, who together represented about another 20%. In an attempt to increase its market share in the expanding but fiercely contested domestic market, Nissan implemented a plan to achieve annual domestic sales of 1.5 million cars by 1992 and to obtain the number-one rating in terms of customer satisfaction. This strategy depended on designing products that were engineered around clearly defined concepts chosen to offer customers automobiles that matched their lifestyles. Automobile firms had been steadily increasing their range of products since the 1950s. This increase was driven primarily by changes in consumer preferences. For example, US consumers in the 1950s viewed the automobile as a status symbol, using the make of automobile they owned to signal the level of their economic success. Nissan executives characterized the consumer in this era as "keeping up with the Joneses." As automobile ownership became more widespread, consumers began to view their automobiles as making a statement about who they were. Nissan executives characterized Professor Robin Cooper of The Peter F. Drucker Graduate Management Center at The Claremont Graduate School prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. The assistance of Ms. May Mukuda, KPMG Peat Marwick, is gratefully acknowledged. Copyright © 1994 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call (800) 545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means- electronic, mechanical, photocopying, recording, or otherwise without the permission of Harvard Business School. 194-040 Nissan Motor Company, Ltd.: Target Costing System the consumer of this era as "doing his or her own thing." Consumer demand of the 1960s required more variations and a broader range of model types than in the 1950s. As the 1960s closed and individualism became less important, consumers came to view their automobiles as making statements about what they were. Nissan executives characterized this era as being dominated by a desire for a "consistency of lifestyle," i.e., bankers wanted automobiles that were appropriate for bankers. This shift required that more models and variations be produced to satisfy consumer demand. During the 1980s, consumers started to demand automobiles that suited multiple lifestyles. As one executive summed up the transition, "the old segmentation that assumed a single lifestyle no longer worked; we now have to design cars that allow people to be bankers by day and punk rockers at night." This transition in consumer preference placed additional pressure on the firm to increase its range of product offerings. Despite this pressure, Nissan had chosen to systematically reduce the number of distinct models it would introduce in the 1990s. This decision reflected two additional trends. First, the differences between consumers in the three major markets-Japan, North America, and Europe-were decreasing, and second, the costs associated with introducing new models were increasing. The decrease in differences among consumers in the three major markets reduced the need to develop models specific to a single market. The increased costs associated with launching new models made it difficult to make acceptable profits if the number of new models introduced each year was too large. These trends suggested to Nissan top management that overall profitability would be increased by reducing the number of distinct models supported, while maintaining the same level of effort to design and market the remaining models. Introducing New Products Over the years, Nissan had developed a formal procedure to introduce new products. One of the major elements of this procedure was a sophisticated target costing system. In this system, a target selling price for each new model was first established; then, a target margin was determined based upon corporate profitability objectives; finally, the model's target cost was identified as the difference between the target selling price and the target margin. Once the target cost of the new model was established, value engineering was used to ensure that the new model, when it entered production, could be manufactured at the desired target cost. The procedure to introduce new models was divided into three distinct stages: in the conceptual design stage, projects to introduce new product models were initiated; in the product development stage, the new models were readied for production; and in the production stage, they were manufactured. Taken together, these three stages lasted about 10 years, the average life cycle of a modern passenger automobile. The conceptual design stage required about two years complete, the product development stage required about four years, and the production stage typically lasted about another four years. Thus, it was not unusual for Nissan to be simultaneously producing the current model, preparing its replacement for introduction, and conceptualizing the next model's replacement. The Conceptual Design Stage New product models were designed in the conceptual design stage. First, the designers identified the mixture of models that Nissan expected to sell over the next ten years. This mix was described in a matrix of vehicles by major market and body type (e.g., coupe or sedan). The matrix Nissan Motor Company, Ltd.: Target Costing System 194-040 contained qualitative information about each model, such as its price range, target customers and their income levels, and the range of body types supported. This information was maintained for both current and future models and effectively described each model's market position. The primary purpose of the product matrix was to ensure that Nissan achieved the desired level of market coverage. New entries in the matrix were identified using consumer analysis. This analysis was undertaken by market consulting firms using a number of different techniques, including general economic, psychological, and anthropological surveys as well as direct observation. In recent years, this analysis had identified over 50 potential models that theoretically could be successfully introduced by Nissan. However, top management had identified the optimum number of models that Nissan could successfully support at under 30. This number was limited by several factors, including the cost of differentiating each model in the minds of consumers, research and development, and the cash flow associated with maintaining dealer floor inventory. Thus, the challenge that Nissan management faced was to select the approximately 30 models that would maximize market coverage. New models were conceptualized by identifying consumer "mind-sets." Mind-sets captured characteristics of the way consumers viewed themselves in relation to their cars. These mind-sets could be used to identify design attributes that consumers took into account when purchasing a new car. Typical mind-sets included value seeker, confident and sophisticated, aggressive enthusiast, and budget/speed star. By identifying clusters of these mind-sets, Nissan could identify niches that contained a sufficient percentage of the automobile-purchasing public to warrant introducing a model specifically tailored for that niche. For example, the Sentra (a mid-price family sedan) was designed to satisfy the confident/sophisticated and value seeker mind-sets, while the ZX (a high-performance sports car) was designed to satisfy the budget/speed star and aggressive enthusiast mind-sets. As a Nissan marketing executive commented, "If we believe that a sufficient market will exist in four to five years, then we will develop a model to fit it." Thus, each model and its body shape variations, such as sedan, coupe, hatchback, and wagon, was specifically designed to satisfy a different group of consumers. As a final check on the appropriateness of the proposed model line-up, each model was categorized using three primary attributes: performance, aesthetics, and comfort. For example, comfort was considered the most important attribute for the Sentra model and performance the least important, while for the ZX model, performance was considered the most important and comfort the least. A plot of the attribute characteristics of both current, future, and competitive models allowed top management to determine that the proposed product mix covered an adequate percentage of the market. At this stage of the product introduction process, the conceptual design was sufficiently developed to allow a rough estimate of the number of vehicles to be sold and the costs associated with its development. These estimates were used in a life cycle contribution study to estimate the overall profitability of the proposed model. The purpose of this study was to ensure that the new model was likely to generate a positive contribution over its life. The life cycle contribution study consisted of comparing the estimated revenues generated by the new model to the expected cost of the product across its life (see Exhibit 1). The model's revenue was estimated by using a rough estimate of the selling price and the anticipated volume of sales. From this estimate the anticipated direct material cost, which included raw material, paint, and purchased parts, was subtracted. The difference between these two quantities was the estimated direct material marginal profit of the new model. 194-040 Nissan Motor Company, Ltd.: Target Costing System From this profit, four additional sets of expenses were subtracted. The first set contained the direct manufacturing and sales expenses. These were expenses that were predominantly driven by the number of units produced and sold. The direct manufacturing expenses included elements such as the cost of the energy, cutting tools, and indirect materials consumed. The direct sales expenses included logistics costs such as the costs of shipping and delivery. The second set contained the estimated direct labor costs. The third set contained the depreciation charges for machining, die casting, and other major production steps. Finally, the estimated research and development expenses were subtracted to give the life cycle contribution of the particular model under development. The depreciation charges used in the life cycle contribution analysis were estimated by taking the total depreciation for each machine or process and dividing that by the number of units expected to be produced on that equipment over its life. If the equipment was dedicated to the new model, as was typically the case with stamping dies, then the number of units was the estimated volume of production for that model; if the equipment was common to several models, as was often the case with conveyors, then the number of units was the total of all units expected to be produced of all models using that equipment. The depreciation charge used for the life cycle contribution analysis was not the one used for financial reporting purposes. Nissan reported depreciation using a declining balance approach for both tax and financial reporting purposes. However, for the life cycle contribution calculation it used a straight-line approach. Management modified the depreciation calculation because it felt that the straight-line approach better captured the relationship between asset use and models produced than the declining balance approach. If the life cycle contribution was deemed satisfactory, the conceptual design process was allowed to continue. As the conceptual design of the new model progressed, additional consumer analysis and financial analysis was undertaken. Consumer analysis was used to obtain a better idea of the price range over which the model would sell and the level of functionality that the consumer expected. The financial analysis consisted of a rough profitability study in which the profitability of the highest volume variant of the new model was estimated using historical cost estimates and the latest estimate of that variant's target price. This target price was determined by taking into account a number of internal and external factors. The internal factors included the position of the model in the matrix and the strategic and profitability objectives of top management for that model. The external factors considered included the corporation's image and level of customer loyalty in the model's niche, the expected quality level and functionality of the model compared to competitive offerings, the model's expected market share, and finally, the expected price of competitive models. The first stage of value engineering was designed to determine whether the new model could be manufactured at an acceptable profit (see Exhibit 2). The process began by developing an order sheet detailing the characteristics of the 20 to 30 major functions of the proposed model. Examples of the major functions included the engine, air conditioner, transmission, and sound system. The characteristics of each major function were chosen to satisfy the collection of consumer mind-sets for which the model was designed. For example, the engine specified for a ZX would be a high- performance one, while for the Sentra it would be smaller, less powerful, and less expensive. The current cost of the model was determined by summing the current manufacturing cost of each major function of the new model. This current cost was compared with the model's allowable cost to determine the level of cost reduction required to achieve the desired level of profitability. Nissan Motor Company, Ltd.: Target Costing System 194-040 The allowable cost of the new model was determined by subtracting its target profit margin from its target price. The target margin was determined by careful consideration of available information on the consumer, the firm's anticipated future product mix, and its long-term profit objective. Each new model's target margin was established by running simulations of the firm's overall profitability for the next 10 years if it was selling the models identified in the product matrix at expected sales volumes. The simulations started by plotting the actual profit margins of existing products (see existing product curve in Exhibit 3). The desired profitability of planned models was then added (see Exhibit 4) and the firm's overall profitability determined over the years at various sales levels. This predicted overall profitability was compared to the firm's long-term profitability objectives set by senior management (see Exhibit 5). Once a satisfactory future product matrix was established that achieved the firm's profit objective, the target margins for each new model were set. To help minimize the risk that Nissan would not achieve its overall profitability targets, the simulations explored the impact on overall profitability of different price/margin curves for different product mixes. For example, historically higher margins had been earned on higher priced vehicles (see existing product curve in Exhibit 3). However, with the reduced product offering and the increased profitability expected, the future curve might be higher. Alternatively, because there was no guarantee that the existing relationship between price and margin would remain unchanged, simulations were also run to explore the impact of fundamentally different relationships between selling price and margins. The first stage of value engineering and the identification of target price was an interactive process. When the allowable costs were considered to be too far below the estimated cost, the appropriate price range and functionality were reviewed until an allowable cost that was considered achievable was identified (see Exhibit 6). The excess of the current manufacturing cost over the allowable cost determined the level of cost reduction that had to be identified by value engineering. For example, the current manufacturing cost of the model might be ¥3,000,000 and the allowed cost ¥2,700,000, which identified a required cost reduction of 10%. The next step in the value engineering process was to identify the allowable cost of each major function. This cost was set by teams derived from almost every functional area of the firm, including product design, engineering, purchasing, production engineering, manufacturing, and parts supply. Although the allowable cost was usually lower than the current cost, sometimes the allowable cost was higher because the new product specifications demanded higher performance and functionality than existing designs. In total, the sum of the cost reduction for each major component was meant to equal the required level of cost reduction to achieve the model's allowable cost (see Exhibit 7). Several critical decisions about the model were made during this stage of the conceptual design process, including the number of body variations, the number of engine types, and the basic technology used in the vehicle. For example, the original concept for the model might include a five- door variant. However, if during this stage of the analysis it was determined that developing such a variant would be too costly or take an excessive amount of time, plans for a five-door variant would be postponed to the next version of that automobile. Once projected cost of each major component had been identified, the expected cost of manufacture could be computed. 194-040 Nissan Motor Company, Ltd.: Target Costing System After the first value engineering stage was completed, a major review of the new model was conducted. This review included an updated profitability study and an analysis of the performance characteristics of the model. In the profitability study, the expected profitability of the model given by the target price minus the target cost was compared to the latest estimates of the capital investment and remaining research and development expenditures required to complete the design of the product and allow production to commence. In the performance analysis, factors such as the quality of the hardware, engine capacity, exhaust emissions, and safety were considered. If both the financial and performance analyses were considered acceptable, the project to introduce the new vehicle was authorized and the model shifted from the conceptual design to the product development stage. The Product Development Stage The first step in the product development stage was to prepare a detailed order sheet for the new model. This order sheet listed all of the components required in the new model and was analyzed to see which components would likely be sourced internally versus externally. Suppliers, both internal and external, were provided with a description of each component and their potential production volumes. Suppliers were expected to provide price and delivery timing estimates for each component. The next step in the development of a new model was to produce the engineering drawings for trial production. Value engineering was used at this stage of product development to determine allowable costs for each of the components in every major function of the automobile. This estimate was achieved by identifying a cost reduction objective for each component (see Exhibit 8). There were several ways that cost reduction objectives for components were identified. First, competitors' products were purchased, disassembled, and analyzed. From this analysis, ideas for cost reduction were sometimes generated. Second, parts suppliers were asked to generate cost reduction ideas. An incentive plan was used to motivate the suppliers. For example, if an idea was accepted, the supplier that suggested the cost reduction idea would be awarded a significant percentage of the contract for that component for a specified time period, say 50% for 12 months. This incentive scheme was viewed as particularly important because even if a cost reduction could not be achieved for this model, it signalled to the suppliers that when the next model was developed this component would be subject to cost reduction pressures. Third, ways to increase the commonality of parts across variations and models were identified (e.g., the same seats might be used in two different models). Fourth, ways to reduce the number of components in each model were identified. For example, originally the kick plates used to protect the door were held in place by plastic nuts. However, a way to mold the plastic interior of the door so that no nuts were required had been developed. To avoid having to develop target costs for all 20,000 components in a typical new model line, the engineers only performed detailed target costing on two or three representative variations. Each variation contained approximately 3,500 components, and typically 80% of the components were common across variations. Therefore, about 5,000 components were subjected to detailed target costing. The target costs of the other 15,000 components were estimated by comparing them to similar components in the 5,000 already target-costed. The completion of this target costing exercise provided cost reduction objectives for all of the components in the new model. The comparison of the allowable cost of each function and the sum of the expected cost of the components in that function after cost reduction indicated whether the major function could be produced at about the Nissan Motor Company, Ltd.: Target Costing System 194-040 allowable cost. When the sum of the component costs was too high, additional cost reductions were identified until the total target cost of the representative variation was acceptable. The target costs for each component were compared to the prices quoted by the suppliers. If the quoted prices were acceptable, the quote was accepted. If the initial quote was too high, then further negotiations were undertaken until an agreement could be reached. The next phase in product development was to construct two or three prototype vehicles. Several important lessons were learned from the construction of these prototypes. First, any components that were difficult to assemble were identified. Typically, these components or the assemblies into which they fitted were redesigned to improve the ease of assembly. Second, assembly times could now be estimated quite accurately. In the third stage of value engineering, the effect of these redesigns on the target costs of the components was determined and assembly target costs were identified. The output of this stage of value engineering was called the final target cost (see Exhibit 9). It differed from the draft target cost in two ways. First, it included assembly costs and second, the indirect manufacturing costs. The indirect manufacturing costs were assigned to products using the same procedures as the firm's cost system. Thus, the final target cost for a model variant was expected to be equal to its reported product cost during manufacture. A comparison of the final target costs for each model variant and its expected selling price allowed the anticipated profit on the vehicle to be determined. The expected selling price was reviewed by marketing in light of recent competitive products and market conditions, and a final selling price recommended. Accounting was responsible for authorizing the actual selling price of each variation. It took into account marketing's review of existing conditions, the final target cost of the vehicle, and the target margin for the vehicle. Once set, accounting notified marketing of the recommended selling price. In Japan, this was the price at which the car would be sold across its life. In other markets, such as North America, incentive plans and other marketing techniques could cause the effective price to change across the life of the product. Accounting was not involved in the value engineering process, which was the responsibility of the cost design and engineering department. The primary function of accounting was to set the final target cost for each model variant and ensure that the vehicles were manufactured for that amount. As the vehicle entered production, accounting would monitor all component and assembly costs and if these were not in line with the final target costs, accounting would notify cost design and engineering that the final target costs were not being met. When the target costs were exceeded, additional value engineering was performed to reduce costs back to the target levels. Thus, the fourth and final value engineering stage ensured that the actual component and assembly costs were equal to their final target costs. Unless the production cost exceeded the target cost, no cost reduction efforts were undertaken during the production stage. Management had determined that the incremental savings from such efforts were more than offset by disturbances they created to the production process. When inflation or other factors caused costs to rise, pressure was exerted upon the suppliers to find ways to keep component costs at their final target levels. Similarly, pressure was exerted on the assembly plants to achieve the assembly target costs. The Production Stage The Zama facility, located a few miles from Tokyo, was one of Nissan's five major domestic manufacturing facilities. Built in 1964, it was 852,000 square meters in area and contained two complete stamping and assembly facilities. In addition, the facility housed a car delivery area and the firm's machinery design center. No production parts were produced at Zama. The plant was only involved in producing pressed metal parts, welding them together, assembling the body, painting it, and then assembling the finished automobile. The Zama plant was designed to produce 90 cars per hour, operating on a two-shift basis with production occurring for 15 hours and 20 minutes per day. A two-shift operation enabled the plant to produce between 1,300 to 1,400 cars per day at full capacity. While preventative maintenance was carried on throughout the day, primary maintenance was performed during the 8 hours and 40 minutes in which no production was scheduled. Zama was a highly automated plant. Of the approximately 3,000 spot welds per car, over 97% were performed automatically. This high level of automation had been achieved over a number of years. The current high level of automatic spot welding was achieved around 1980. To sustain this high level of automation, Zama contained nearly 300 robots. All of these robots were designed by Nissan but only about 40% were actually manufactured by the firm. In 1990, the facility was dedicated to the production of two models and three body types. The Sunny, or Sentra as it was called in the North American market, was produced in two body types: the four-door and two-door coupe configurations and the Presea in a single four-door configuration. Each body type could be produced in numerous variations of key components, such as engine, air conditioning, and transmission. When all possible option variations were included, Zama produced approximately 20,000 different variations of each of the three distinct body types. The large number of variations forced the facility to produce cars to customer order. This production strategy fit well with Nissan's corporate strategy of providing customer satisfaction, high quality, short delivery times, and high functionality. In fact, fast delivery was considered so important that the production strategy was called by a name that translated to "deliver the car with the paint still wet." In 1990, a car ordered from a Japanese dealer and produced in the Zama plant could be delivered to the customer within 2 weeks. Because in Tokyo it required at least a week to get the certificate of space required to enable a car to be purchased, the effective wait for a new Nissan was negligible. This short delivery time despite high product diversity was achieved via aggressive use of just-in-time production. The Product Cost System The same cost system was used throughout Nissan's assembly plants. It reported full product costs that included both direct and indirect expenses. The indirect expenses were traced to the products in two different ways. Direct and indirect manufacturing expenses were directly charged to the production cost center in which they were consumed, and then allocated to the products. Service and administrative expenses and corporate expenses were allocated to the product without first being allocated to a production center. Corporate expenses were equal to about 15% of the sales revenue. They consisted of three major types of expenses: product-related expenses that included advertisements, warranty, and delivery expenses; geographic-related expenses, such as the costs associated with the sales division in Tokyo that supported sales in all three major markets; and finally, Nissan Motor Company, Ltd.: Target Costing System 194-040 there were the expenses associated with corporate administration, legal, and accounting. The product- related portion of corporate expenses was approximately 30%, the geographic-related portion 50%, and the other expenses about 20%. Three different product profitabilities were calculated (see Exhibit 10). The first was the direct material marginal profit. This was calculated by subtracting the cost of the raw materials and purchased parts from the selling price. The second was the product contribution, determined by subtracting direct manufacturing costs, research and development expenses, and corporate expenses directly related to the product from the direct material marginal profit. Direct manufacturing expenses included manufacturing supplies such as cutting tools and machine depreciation. The procedures used to assign these expenses to products varied depending upon the nature of the expenses and how they were consumed. For example, the costs of manufacturing supplies were assigned to the products based upon the number of direct labor hours the product consumed in the center if the department produced several different models, and number of units if only one model was produced; machine depreciation was assigned to products based upon the number of units irrespective of model. Research and development expenses included the cost of the labor, facilities, and supplies consumed in the research and development facility. They were allocated to products based upon the labor hours consumed in research and development on that product. The corporate expenses directly related to the product included items such as product advertisements, product incentives, warranty costs, and delivery expenses. The third product profitability, operating profit, was calculated by subtracting indirect manufacturing, service, administrative, and the remaining corporate expenses from the product contributions. Indirect manufacturing expenses were directly charged to the production cost center in which they were incurred. Examples of indirect manufacturing expenses included transportation, maintenance, and facility depreciation. These expenses were assigned to the products based on the total direct cost of the products produced in that center. Service and administrative expenses were assigned to the products without first being assigned to the production centers. These expenses were assigned based on the total direct cost of the product. Corporate expenses were first assigned to the facility and then to the products based on their total direct costs in the same way as were service and administrative expenses. The breakdown of product profitability and cost is shown in Exhibit 11. The Nissan cost system was continuously undergoing modification. In particular, a program had been initiated to trace as many costs as possible directly to the production departments. Thus, over time the service and administrative categories were dropping in relationship to the direct and indirect manufacturing costs. The success of this program and the heavy reliance upon external parts and service suppliers were visible from the relative importance of the three major cost categories. The direct costs, i.e., those costs that were traced directly to the products, represented 85% of total manufacturing costs; the direct and indirect manufacturing costs that were charged to the production departments and then assigned to the products represented about 10% of total manufacturing costs; while service and administrative costs amounted to only 5% of total costs. The product costs reported by the cost system had four primary uses. First, they were used in the long-range strategic plan as a basis for estimating future profitability. Second, they were used for cost-control purposes, in particular to ensure that across the production life of a product its target cost was maintained. Third, they were used to help select the product mix, in particular with respect to the variations of a given model. Finally, they were used to identify unprofitable variants that were candidates for discontinuance. Nissan Motor Company, Ltd.: Target Costing System Exhibit 10 Breakdown of Product Profitability Revenue Direct Material Cost 1) Purchased parts 2) Raw materials Direct Material Marginal Profit Direct Cost & Expenses Direct Manufacturing Cost 1) Direct labor cost 2) Manufacturing expenses directly variable (Directly Characterized to the number of units produced (e.g. cutting tools) 3) Tools & machinery Depreciation charge to Products) Maintenance cost Energy cost (****) R&D Expense (labor, expenses, facilities) (****) Corporate Expenses Directly Related to Product 1) Product advertisements 2) Product incentives 3) Warranty 4) Delivery expenses (***** Product Contribution Indirect Manufacturing Cost Consumed by Manufacturing Shop Floors 1) Indirect materials (e.g. monkey wrench, sand paper) 2) Indirect labor cost Indirect Cost 3) Shop floor facilities. Depreciation charge Maintenance cost Energy cost (****) 1) Quality inspection (labor, expenses, facilities) 2) Logistics (labor, expenses, facilities) 3) Energy consumed in service department (Irrespective of Product Characteristics) (****) 4) Maintenance consumed in service department 1) Labor cost 2) General expenses 3) Facilities Depreciation charge Maintenance cost Energy cost (****) Corporate Expense (excluding "directly related to product") 1) Expense consumed by geographic sales division Corporate Expenses. a) Maintenance costs of sales network b) Labor cost consumed in the divisions c) General expenses consumed in the divisions. 2) General Administration (****) **** Services Administration Operating Profit **** ***** **** **** **** **** **** **** **** ****** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** ******* 1. What are the strengths and weaknesses of the target costing system? 2. What would you change? 3. Describe Nissan's cost system. Is it strong enough to support the target costing system? 4. How does your firm (or firms with which you are familiar) determine the cost to man- ufacture new products? 5. Is target costing transferrable to U.S. companies? Nissan Motor Company, Ltd. (Nissan) was by 1990 the world's fourth-largest automobile manufacturer. In 1990, Nissan produced just over 3 million vehicles, supplying approximately 10% of the world's demand for cars and trucks. Of these vehicles, slightly over two million were passenger cars. Nissan, founded in 1933, considered itself the most highly globalized of the Japanese automobile companies, producing vehicles at 36 plants in 22 countries and marketing in 150 countries through 390 distributorships and over 10,000 dealerships. Nissan had a stated policy of increasing its globalization through a five-step process: first, by increasing local production; second, by raising the local content of its products through expanded use of locally sourced parts and components; third, by strengthening local research and development capabilities; fourth, by localizing management functions; and finally, by localizing decision-making processes. As a result, four out of the five major overseas manufacturing plants were managed by local chief executive officer and in 1990 regional headquarters were opened in Europe and North America. The domestic Japanese passenger automobile market was intensely competitive. The largest manufacturer was Toyota, with approximately 45% of the domestic market. Nissan was second with approximately 25%, followed by Honda and Mazda, who together represented about another 20%. In an attempt to increase its market share in the expanding but fiercely contested domestic market, Nissan implemented a plan to achieve annual domestic sales of 1.5 million cars by 1992 and to obtain the number-one rating in terms of customer satisfaction. This strategy depended on designing products that were engineered around clearly defined concepts chosen to offer customers automobiles that matched their lifestyles. Automobile firms had been steadily increasing their range of products since the 1950s. This increase was driven primarily by changes in consumer preferences. For example, US consumers in the 1950s viewed the automobile as a status symbol, using the make of automobile they owned to signal the level of their economic success. Nissan executives characterized the consumer in this era as "keeping up with the Joneses." As automobile ownership became more widespread, consumers began to view their automobiles as making a statement about who they were. Nissan executives characterized Professor Robin Cooper of The Peter F. Drucker Graduate Management Center at The Claremont Graduate School prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. The assistance of Ms. May Mukuda, KPMG Peat Marwick, is gratefully acknowledged. Copyright © 1994 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call (800) 545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means- electronic, mechanical, photocopying, recording, or otherwise without the permission of Harvard Business School. 194-040 Nissan Motor Company, Ltd.: Target Costing System the consumer of this era as "doing his or her own thing." Consumer demand of the 1960s required more variations and a broader range of model types than in the 1950s. As the 1960s closed and individualism became less important, consumers came to view their automobiles as making statements about what they were. Nissan executives characterized this era as being dominated by a desire for a "consistency of lifestyle," i.e., bankers wanted automobiles that were appropriate for bankers. This shift required that more models and variations be produced to satisfy consumer demand. During the 1980s, consumers started to demand automobiles that suited multiple lifestyles. As one executive summed up the transition, "the old segmentation that assumed a single lifestyle no longer worked; we now have to design cars that allow people to be bankers by day and punk rockers at night." This transition in consumer preference placed additional pressure on the firm to increase its range of product offerings. Despite this pressure, Nissan had chosen to systematically reduce the number of distinct models it would introduce in the 1990s. This decision reflected two additional trends. First, the differences between consumers in the three major markets-Japan, North America, and Europe-were decreasing, and second, the costs associated with introducing new models were increasing. The decrease in differences among consumers in the three major markets reduced the need to develop models specific to a single market. The increased costs associated with launching new models made it difficult to make acceptable profits if the number of new models introduced each year was too large. These trends suggested to Nissan top management that overall profitability would be increased by reducing the number of distinct models supported, while maintaining the same level of effort to design and market the remaining models. Introducing New Products Over the years, Nissan had developed a formal procedure to introduce new products. One of the major elements of this procedure was a sophisticated target costing system. In this system, a target selling price for each new model was first established; then, a target margin was determined based upon corporate profitability objectives; finally, the model's target cost was identified as the difference between the target selling price and the target margin. Once the target cost of the new model was established, value engineering was used to ensure that the new model, when it entered production, could be manufactured at the desired target cost. The procedure to introduce new models was divided into three distinct stages: in the conceptual design stage, projects to introduce new product models were initiated; in the product development stage, the new models were readied for production; and in the production stage, they were manufactured. Taken together, these three stages lasted about 10 years, the average life cycle of a modern passenger automobile. The conceptual design stage required about two years complete, the product development stage required about four years, and the production stage typically lasted about another four years. Thus, it was not unusual for Nissan to be simultaneously producing the current model, preparing its replacement for introduction, and conceptualizing the next model's replacement. The Conceptual Design Stage New product models were designed in the conceptual design stage. First, the designers identified the mixture of models that Nissan expected to sell over the next ten years. This mix was described in a matrix of vehicles by major market and body type (e.g., coupe or sedan). The matrix Nissan Motor Company, Ltd.: Target Costing System 194-040 contained qualitative information about each model, such as its price range, target customers and their income levels, and the range of body types supported. This information was maintained for both current and future models and effectively described each model's market position. The primary purpose of the product matrix was to ensure that Nissan achieved the desired level of market coverage. New entries in the matrix were identified using consumer analysis. This analysis was undertaken by market consulting firms using a number of different techniques, including general economic, psychological, and anthropological surveys as well as direct observation. In recent years, this analysis had identified over 50 potential models that theoretically could be successfully introduced by Nissan. However, top management had identified the optimum number of models that Nissan could successfully support at under 30. This number was limited by several factors, including the cost of differentiating each model in the minds of consumers, research and development, and the cash flow associated with maintaining dealer floor inventory. Thus, the challenge that Nissan management faced was to select the approximately 30 models that would maximize market coverage. New models were conceptualized by identifying consumer "mind-sets." Mind-sets captured characteristics of the way consumers viewed themselves in relation to their cars. These mind-sets could be used to identify design attributes that consumers took into account when purchasing a new car. Typical mind-sets included value seeker, confident and sophisticated, aggressive enthusiast, and budget/speed star. By identifying clusters of these mind-sets, Nissan could identify niches that contained a sufficient percentage of the automobile-purchasing public to warrant introducing a model specifically tailored for that niche. For example, the Sentra (a mid-price family sedan) was designed to satisfy the confident/sophisticated and value seeker mind-sets, while the ZX (a high-performance sports car) was designed to satisfy the budget/speed star and aggressive enthusiast mind-sets. As a Nissan marketing executive commented, "If we believe that a sufficient market will exist in four to five years, then we will develop a model to fit it." Thus, each model and its body shape variations, such as sedan, coupe, hatchback, and wagon, was specifically designed to satisfy a different group of consumers. As a final check on the appropriateness of the proposed model line-up, each model was categorized using three primary attributes: performance, aesthetics, and comfort. For example, comfort was considered the most important attribute for the Sentra model and performance the least important, while for the ZX model, performance was considered the most important and comfort the least. A plot of the attribute characteristics of both current, future, and competitive models allowed top management to determine that the proposed product mix covered an adequate percentage of the market. At this stage of the product introduction process, the conceptual design was sufficiently developed to allow a rough estimate of the number of vehicles to be sold and the costs associated with its development. These estimates were used in a life cycle contribution study to estimate the overall profitability of the proposed model. The purpose of this study was to ensure that the new model was likely to generate a positive contribution over its life. The life cycle contribution study consisted of comparing the estimated revenues generated by the new model to the expected cost of the product across its life (see Exhibit 1). The model's revenue was estimated by using a rough estimate of the selling price and the anticipated volume of sales. From this estimate the anticipated direct material cost, which included raw material, paint, and purchased parts, was subtracted. The difference between these two quantities was the estimated direct material marginal profit of the new model. 194-040 Nissan Motor Company, Ltd.: Target Costing System From this profit, four additional sets of expenses were subtracted. The first set contained the direct manufacturing and sales expenses. These were expenses that were predominantly driven by the number of units produced and sold. The direct manufacturing expenses included elements such as the cost of the energy, cutting tools, and indirect materials consumed. The direct sales expenses included logistics costs such as the costs of shipping and delivery. The second set contained the estimated direct labor costs. The third set contained the depreciation charges for machining, die casting, and other major production steps. Finally, the estimated research and development expenses were subtracted to give the life cycle contribution of the particular model under development. The depreciation charges used in the life cycle contribution analysis were estimated by taking the total depreciation for each machine or process and dividing that by the number of units expected to be produced on that equipment over its life. If the equipment was dedicated to the new model, as was typically the case with stamping dies, then the number of units was the estimated volume of production for that model; if the equipment was common to several models, as was often the case with conveyors, then the number of units was the total of all units expected to be produced of all models using that equipment. The depreciation charge used for the life cycle contribution analysis was not the one used for financial reporting purposes. Nissan reported depreciation using a declining balance approach for both tax and financial reporting purposes. However, for the life cycle contribution calculation it used a straight-line approach. Management modified the depreciation calculation because it felt that the straight-line approach better captured the relationship between asset use and models produced than the declining balance approach. If the life cycle contribution was deemed satisfactory, the conceptual design process was allowed to continue. As the conceptual design of the new model progressed, additional consumer analysis and financial analysis was undertaken. Consumer analysis was used to obtain a better idea of the price range over which the model would sell and the level of functionality that the consumer expected. The financial analysis consisted of a rough profitability study in which the profitability of the highest volume variant of the new model was estimated using historical cost estimates and the latest estimate of that variant's target price. This target price was determined by taking into account a number of internal and external factors. The internal factors included the position of the model in the matrix and the strategic and profitability objectives of top management for that model. The external factors considered included the corporation's image and level of customer loyalty in the model's niche, the expected quality level and functionality of the model compared to competitive offerings, the model's expected market share, and finally, the expected price of competitive models. The first stage of value engineering was designed to determine whether the new model could be manufactured at an acceptable profit (see Exhibit 2). The process began by developing an order sheet detailing the characteristics of the 20 to 30 major functions of the proposed model. Examples of the major functions included the engine, air conditioner, transmission, and sound system. The characteristics of each major function were chosen to satisfy the collection of consumer mind-sets for which the model was designed. For example, the engine specified for a ZX would be a high- performance one, while for the Sentra it would be smaller, less powerful, and less expensive. The current cost of the model was determined by summing the current manufacturing cost of each major function of the new model. This current cost was compared with the model's allowable cost to determine the level of cost reduction required to achieve the desired level of profitability. Nissan Motor Company, Ltd.: Target Costing System 194-040 The allowable cost of the new model was determined by subtracting its target profit margin from its target price. The target margin was determined by careful consideration of available information on the consumer, the firm's anticipated future product mix, and its long-term profit objective. Each new model's target margin was established by running simulations of the firm's overall profitability for the next 10 years if it was selling the models identified in the product matrix at expected sales volumes. The simulations started by plotting the actual profit margins of existing products (see existing product curve in Exhibit 3). The desired profitability of planned models was then added (see Exhibit 4) and the firm's overall profitability determined over the years at various sales levels. This predicted overall profitability was compared to the firm's long-term profitability objectives set by senior management (see Exhibit 5). Once a satisfactory future product matrix was established that achieved the firm's profit objective, the target margins for each new model were set. To help minimize the risk that Nissan would not achieve its overall profitability targets, the simulations explored the impact on overall profitability of different price/margin curves for different product mixes. For example, historically higher margins had been earned on higher priced vehicles (see existing product curve in Exhibit 3). However, with the reduced product offering and the increased profitability expected, the future curve might be higher. Alternatively, because there was no guarantee that the existing relationship between price and margin would remain unchanged, simulations were also run to explore the impact of fundamentally different relationships between selling price and margins. The first stage of value engineering and the identification of target price was an interactive process. When the allowable costs were considered to be too far below the estimated cost, the appropriate price range and functionality were reviewed until an allowable cost that was considered achievable was identified (see Exhibit 6). The excess of the current manufacturing cost over the allowable cost determined the level of cost reduction that had to be identified by value engineering. For example, the current manufacturing cost of the model might be ¥3,000,000 and the allowed cost ¥2,700,000, which identified a required cost reduction of 10%. The next step in the value engineering process was to identify the allowable cost of each major function. This cost was set by teams derived from almost every functional area of the firm, including product design, engineering, purchasing, production engineering, manufacturing, and parts supply. Although the allowable cost was usually lower than the current cost, sometimes the allowable cost was higher because the new product specifications demanded higher performance and functionality than existing designs. In total, the sum of the cost reduction for each major component was meant to equal the required level of cost reduction to achieve the model's allowable cost (see Exhibit 7). Several critical decisions about the model were made during this stage of the conceptual design process, including the number of body variations, the number of engine types, and the basic technology used in the vehicle. For example, the original concept for the model might include a five- door variant. However, if during this stage of the analysis it was determined that developing such a variant would be too costly or take an excessive amount of time, plans for a five-door variant would be postponed to the next version of that automobile. Once projected cost of each major component had been identified, the expected cost of manufacture could be computed. 194-040 Nissan Motor Company, Ltd.: Target Costing System After the first value engineering stage was completed, a major review of the new model was conducted. This review included an updated profitability study and an analysis of the performance characteristics of the model. In the profitability study, the expected profitability of the model given by the target price minus the target cost was compared to the latest estimates of the capital investment and remaining research and development expenditures required to complete the design of the product and allow production to commence. In the performance analysis, factors such as the quality of the hardware, engine capacity, exhaust emissions, and safety were considered. If both the financial and performance analyses were considered acceptable, the project to introduce the new vehicle was authorized and the model shifted from the conceptual design to the product development stage. The Product Development Stage The first step in the product development stage was to prepare a detailed order sheet for the new model. This order sheet listed all of the components required in the new model and was analyzed to see which components would likely be sourced internally versus externally. Suppliers, both internal and external, were provided with a description of each component and their potential production volumes. Suppliers were expected to provide price and delivery timing estimates for each component. The next step in the development of a new model was to produce the engineering drawings for trial production. Value engineering was used at this stage of product development to determine allowable costs for each of the components in every major function of the automobile. This estimate was achieved by identifying a cost reduction objective for each component (see Exhibit 8). There were several ways that cost reduction objectives for components were identified. First, competitors' products were purchased, disassembled, and analyzed. From this analysis, ideas for cost reduction were sometimes generated. Second, parts suppliers were asked to generate cost reduction ideas. An incentive plan was used to motivate the suppliers. For example, if an idea was accepted, the supplier that suggested the cost reduction idea would be awarded a significant percentage of the contract for that component for a specified time period, say 50% for 12 months. This incentive scheme was viewed as particularly important because even if a cost reduction could not be achieved for this model, it signalled to the suppliers that when the next model was developed this component would be subject to cost reduction pressures. Third, ways to increase the commonality of parts across variations and models were identified (e.g., the same seats might be used in two different models). Fourth, ways to reduce the number of components in each model were identified. For example, originally the kick plates used to protect the door were held in place by plastic nuts. However, a way to mold the plastic interior of the door so that no nuts were required had been developed. To avoid having to develop target costs for all 20,000 components in a typical new model line, the engineers only performed detailed target costing on two or three representative variations. Each variation contained approximately 3,500 components, and typically 80% of the components were common across variations. Therefore, about 5,000 components were subjected to detailed target costing. The target costs of the other 15,000 components were estimated by comparing them to similar components in the 5,000 already target-costed. The completion of this target costing exercise provided cost reduction objectives for all of the components in the new model. The comparison of the allowable cost of each function and the sum of the expected cost of the components in that function after cost reduction indicated whether the major function could be produced at about the Nissan Motor Company, Ltd.: Target Costing System 194-040 allowable cost. When the sum of the component costs was too high, additional cost reductions were identified until the total target cost of the representative variation was acceptable. The target costs for each component were compared to the prices quoted by the suppliers. If the quoted prices were acceptable, the quote was accepted. If the initial quote was too high, then further negotiations were undertaken until an agreement could be reached. The next phase in product development was to construct two or three prototype vehicles. Several important lessons were learned from the construction of these prototypes. First, any components that were difficult to assemble were identified. Typically, these components or the assemblies into which they fitted were redesigned to improve the ease of assembly. Second, assembly times could now be estimated quite accurately. In the third stage of value engineering, the effect of these redesigns on the target costs of the components was determined and assembly target costs were identified. The output of this stage of value engineering was called the final target cost (see Exhibit 9). It differed from the draft target cost in two ways. First, it included assembly costs and second, the indirect manufacturing costs. The indirect manufacturing costs were assigned to products using the same procedures as the firm's cost system. Thus, the final target cost for a model variant was expected to be equal to its reported product cost during manufacture. A comparison of the final target costs for each model variant and its expected selling price allowed the anticipated profit on the vehicle to be determined. The expected selling price was reviewed by marketing in light of recent competitive products and market conditions, and a final selling price recommended. Accounting was responsible for authorizing the actual selling price of each variation. It took into account marketing's review of existing conditions, the final target cost of the vehicle, and the target margin for the vehicle. Once set, accounting notified marketing of the recommended selling price. In Japan, this was the price at which the car would be sold across its life. In other markets, such as North America, incentive plans and other marketing techniques could cause the effective price to change across the life of the product. Accounting was not involved in the value engineering process, which was the responsibility of the cost design and engineering department. The primary function of accounting was to set the final target cost for each model variant and ensure that the vehicles were manufactured for that amount. As the vehicle entered production, accounting would monitor all component and assembly costs and if these were not in line with the final target costs, accounting would notify cost design and engineering that the final target costs were not being met. When the target costs were exceeded, additional value engineering was performed to reduce costs back to the target levels. Thus, the fourth and final value engineering stage ensured that the actual component and assembly costs were equal to their final target costs. Unless the production cost exceeded the target cost, no cost reduction efforts were undertaken during the production stage. Management had determined that the incremental savings from such efforts were more than offset by disturbances they created to the production process. When inflation or other factors caused costs to rise, pressure was exerted upon the suppliers to find ways to keep component costs at their final target levels. Similarly, pressure was exerted on the assembly plants to achieve the assembly target costs. The Production Stage The Zama facility, located a few miles from Tokyo, was one of Nissan's five major domestic manufacturing facilities. Built in 1964, it was 852,000 square meters in area and contained two complete stamping and assembly facilities. In addition, the facility housed a car delivery area and the firm's machinery design center. No production parts were produced at Zama. The plant was only involved in producing pressed metal parts, welding them together, assembling the body, painting it, and then assembling the finished automobile. The Zama plant was designed to produce 90 cars per hour, operating on a two-shift basis with production occurring for 15 hours and 20 minutes per day. A two-shift operation enabled the plant to produce between 1,300 to 1,400 cars per day at full capacity. While preventative maintenance was carried on throughout the day, primary maintenance was performed during the 8 hours and 40 minutes in which no production was scheduled. Zama was a highly automated plant. Of the approximately 3,000 spot welds per car, over 97% were performed automatically. This high level of automation had been achieved over a number of years. The current high level of automatic spot welding was achieved around 1980. To sustain this high level of automation, Zama contained nearly 300 robots. All of these robots were designed by Nissan but only about 40% were actually manufactured by the firm. In 1990, the facility was dedicated to the production of two models and three body types. The Sunny, or Sentra as it was called in the North American market, was produced in two body types: the four-door and two-door coupe configurations and the Presea in a single four-door configuration. Each body type could be produced in numerous variations of key components, such as engine, air conditioning, and transmission. When all possible option variations were included, Zama produced approximately 20,000 different variations of each of the three distinct body types. The large number of variations forced the facility to produce cars to customer order. This production strategy fit well with Nissan's corporate strategy of providing customer satisfaction, high quality, short delivery times, and high functionality. In fact, fast delivery was considered so important that the production strategy was called by a name that translated to "deliver the car with the paint still wet." In 1990, a car ordered from a Japanese dealer and produced in the Zama plant could be delivered to the customer within 2 weeks. Because in Tokyo it required at least a week to get the certificate of space required to enable a car to be purchased, the effective wait for a new Nissan was negligible. This short delivery time despite high product diversity was achieved via aggressive use of just-in-time production. The Product Cost System The same cost system was used throughout Nissan's assembly plants. It reported full product costs that included both direct and indirect expenses. The indirect expenses were traced to the products in two different ways. Direct and indirect manufacturing expenses were directly charged to the production cost center in which they were consumed, and then allocated to the products. Service and administrative expenses and corporate expenses were allocated to the product without first being allocated to a production center. Corporate expenses were equal to about 15% of the sales revenue. They consisted of three major types of expenses: product-related expenses that included advertisements, warranty, and delivery expenses; geographic-related expenses, such as the costs associated with the sales division in Tokyo that supported sales in all three major markets; and finally, Nissan Motor Company, Ltd.: Target Costing System 194-040 there were the expenses associated with corporate administration, legal, and accounting. The product- related portion of corporate expenses was approximately 30%, the geographic-related portion 50%, and the other expenses about 20%. Three different product profitabilities were calculated (see Exhibit 10). The first was the direct material marginal profit. This was calculated by subtracting the cost of the raw materials and purchased parts from the selling price. The second was the product contribution, determined by subtracting direct manufacturing costs, research and development expenses, and corporate expenses directly related to the product from the direct material marginal profit. Direct manufacturing expenses included manufacturing supplies such as cutting tools and machine depreciation. The procedures used to assign these expenses to products varied depending upon the nature of the expenses and how they were consumed. For example, the costs of manufacturing supplies were assigned to the products based upon the number of direct labor hours the product consumed in the center if the department produced several different models, and number of units if only one model was produced; machine depreciation was assigned to products based upon the number of units irrespective of model. Research and development expenses included the cost of the labor, facilities, and supplies consumed in the research and development facility. They were allocated to products based upon the labor hours consumed in research and development on that product. The corporate expenses directly related to the product included items such as product advertisements, product incentives, warranty costs, and delivery expenses. The third product profitability, operating profit, was calculated by subtracting indirect manufacturing, service, administrative, and the remaining corporate expenses from the product contributions. Indirect manufacturing expenses were directly charged to the production cost center in which they were incurred. Examples of indirect manufacturing expenses included transportation, maintenance, and facility depreciation. These expenses were assigned to the products based on the total direct cost of the products produced in that center. Service and administrative expenses were assigned to the products without first being assigned to the production centers. These expenses were assigned based on the total direct cost of the product. Corporate expenses were first assigned to the facility and then to the products based on their total direct costs in the same way as were service and administrative expenses. The breakdown of product profitability and cost is shown in Exhibit 11. The Nissan cost system was continuously undergoing modification. In particular, a program had been initiated to trace as many costs as possible directly to the production departments. Thus, over time the service and administrative categories were dropping in relationship to the direct and indirect manufacturing costs. The success of this program and the heavy reliance upon external parts and service suppliers were visible from the relative importance of the three major cost categories. The direct costs, i.e., those costs that were traced directly to the products, represented 85% of total manufacturing costs; the direct and indirect manufacturing costs that were charged to the production departments and then assigned to the products represented about 10% of total manufacturing costs; while service and administrative costs amounted to only 5% of total costs. The product costs reported by the cost system had four primary uses. First, they were used in the long-range strategic plan as a basis for estimating future profitability. Second, they were used for cost-control purposes, in particular to ensure that across the production life of a product its target cost was maintained. Third, they were used to help select the product mix, in particular with respect to the variations of a given model. Finally, they were used to identify unprofitable variants that were candidates for discontinuance. Nissan Motor Company, Ltd.: Target Costing System Exhibit 10 Breakdown of Product Profitability Revenue Direct Material Cost 1) Purchased parts 2) Raw materials Direct Material Marginal Profit Direct Cost & Expenses Direct Manufacturing Cost 1) Direct labor cost 2) Manufacturing expenses directly variable (Directly Characterized to the number of units produced (e.g. cutting tools) 3) Tools & machinery Depreciation charge to Products) Maintenance cost Energy cost (****) R&D Expense (labor, expenses, facilities) (****) Corporate Expenses Directly Related to Product 1) Product advertisements 2) Product incentives 3) Warranty 4) Delivery expenses (***** Product Contribution Indirect Manufacturing Cost Consumed by Manufacturing Shop Floors 1) Indirect materials (e.g. monkey wrench, sand paper) 2) Indirect labor cost Indirect Cost 3) Shop floor facilities. Depreciation charge Maintenance cost Energy cost (****) 1) Quality inspection (labor, expenses, facilities) 2) Logistics (labor, expenses, facilities) 3) Energy consumed in service department (Irrespective of Product Characteristics) (****) 4) Maintenance consumed in service department 1) Labor cost 2) General expenses 3) Facilities Depreciation charge Maintenance cost Energy cost (****) Corporate Expense (excluding "directly related to product") 1) Expense consumed by geographic sales division Corporate Expenses. a) Maintenance costs of sales network b) Labor cost consumed in the divisions c) General expenses consumed in the divisions. 2) General Administration (****) **** Services Administration Operating Profit **** ***** **** **** **** **** **** **** **** ****** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** **** ******* 1. What are the strengths and weaknesses of the target costing system? 2. What would you change? 3. Describe Nissan's cost system. Is it strong enough to support the target costing system? 4. How does your firm (or firms with which you are familiar) determine the cost to man- ufacture new products? 5. Is target costing transferrable to U.S. companies?