Applying Target Costing to the Service Sector: Sunline Auto Insurance Case

1
Applying target costing to the service sector: Sunline
Auto Insurance case
Dr James Wakefield, UTS Business School and Dr Paul Thambar, Monash Business School wrote this case
solely to provide material for class room discussion. The authors do not intend to illustrate either an effective or
ineffective handling of a managerial situation. The authors have based this case on a real-life firm but may have
disguised certain names and other identifying information to protect confidentiality.
https://www.coursehero.com/file/21806254/Sunline-Auto-Insurance/
This study resource was
shared via CourseHero.com

2
TEACHING CASE
Background and strategy
Janet Pretty, Business Manager of Sunline Auto Insurance based in Los Angeles, was
in her office on a bright Monday morning in January 2017 reviewing her monthly
performance report. Janet was worried as she reviewed the performance of Sunline for the
last quarter (October to December 2016). The report showed that while sales were growing,
so were losses (Refer Exhibit 1-Table 1).
Sunline was wholly owned by Palm Investments, headquartered in San Francisco,
which owned eight other companies in the finance and insurance sector. Sunline was
managed on a decentralised management by exception basis. The headquarters provided legal
and compliance advice to the subsidiaries and ultimately closely monitored each subsidiary.
Janet Pretty had significant autonomy to develop, promote, sell and manage the activities of
Sunline. Accordingly, she was very concerned about the current state of performance, as she
was directly accountable for the performance realised, even though she had only been
working at Sunline for six months.
Auto insurance was very popular in the state of California due to the high levels of
motor vehicle ownership. Federal government statistics showed that on average, each family
in California owned four motor vehicles. Injury and property damage insurance were legally
required in California. Sunline was only established five years ago and faced a very
competitive market. Customers were quite demanding in the prices they paid for auto
insurance policies and also very selective in terms of the features of the policies. The unique
positioning of insurance policy products to acquire market share was therefore very
important. Since establishment Sunline had grown its market share and customer base
relatively quickly in Los Angeles.
https://www.coursehero.com/file/21806254/Sunline-Auto-Insurance/
This study resource was
shared via CourseHero.com

3
Consistent with the management autonomy extended to each subsidiary, Sunline
management could develop unique product offerings. Sunline had developed and focused
solely on a unique product called Ride Cover, specifically targeted at car enthusiasts with
unique cars. The product packaged the compulsory insurance coverage (based on minimum
legal requirements in California1) with comprehensive and collision insurance. Ride Cover
offered unique benefits including full replacement value, a loan vehicle with no mileage limit
while the owner’s vehicle was off the road being repaired, the owner’s choice of repairer and
unlimited roadside assistance in the event of a breakdown. The product was particularly
appealing to customers with customised cars, who had spent significant money and time
modifying these vehicles. The modified nature of these vehicles also meant that mechanical
problems were more likely. Accordingly customers placed great value on the ability to take
the car to the owner’s repairer of choice and receive unlimited roadside assistance. Customers
could also opt for higher levels of injury and property coverage, beyond that required in
California, and lower deductibles as part of the Ride Cover policy.
Ride Cover could be acquired by customers through Sunline stores (in major shopping
centres such as Glendale Galleria, South Coast Plaza and The Beverley Centre), Sunline’s
webpage, Wells Fargo Banks and supermarkets (such as Ralphs). The company also had pop
up stalls at motoring events (including the annual LA Motor Show and various Cars and
Coffee meets) to specifically target enthusiast car owners. In each of these distribution
channels, dedicated staff and/or representatives from the Sunline were available to provide
customer service including assessing customer needs, answering inquiries, pricing policies
and providing general support to customers. The use of multiple distribution channels
provided customers with easy access to Ride Cover.
1 See http://www.dmv.org/ca-california/car-insurance.php
https://www.coursehero.com/file/21806254/Sunline-Auto-Insurance/
This study resource was
shared via CourseHero.com

4
Product costing and pricing strategy
Sunline operated a “cost plus” product costing and pricing strategy, which had been in
place since establishment, five years ago. The cost-plus pricing model was based on the
assumption that customers were willing to wear a reasonable level of pricing for the auto
insurance product. Essentially the cost associated with all operations were added up, referring
to actual and budgeted costs, and averaged across the number of estimated policies sold in the
period. An average target profit margin was then added to the average costs, to price the
product. This was an “average target profit margin” as product pricing was determined to a
great extent by individual customer risk profile and government insurance pricing
regulations, and accordingly policy pricing for different customers.
Table 2 in Exhibit 1 outlines the costs related to Sunline. There are five groups of
costs that relate to operating the business: administration, sales and marketing, technology,
financing and headquarter costs. Administration costs were incurred for training programs of
sales staff and representatives, administration of traffic accident cases and claims,
recruitment, payroll and financial accounting and performance reporting. Sales staff training
programs were a key element in preparing staff to understand market requirements and
product features, helping to lift product sales through channel partners. However, training
costs had continued to rise and this issue was not helped by high staff turnover.
Administration and payment of insurance claims was the largest component of administrative
costs and how this process was managed, how timely they were paid out for Ride Cover
customers with choice of repairer, had a direct bearing on customer service, future sales and
market share growth. This cost continued to grow and headquarters felt Janet and her team
were not doing enough in a focused manner to educate staff and customers on how to reduce
accidents, improve claims processes and to enable reduction of these costs.
https://www.coursehero.com/file/21806254/Sunline-Auto-Insurance/
This study resource was
shared via CourseHero.com

5
The sales and marketing team focused on promoting the Ride Cover policy through
different advertising campaigns and event engagement. The policy was heavily promoted
through local television and billboards to convey the unique benefits and value of the Ride
Cover policy to potential customers. Online advertising and social media engagement was
also used to promote products. Some attention was directed to engaging with local
automotive events, through pop up stalls. Headquarters had expressed concern about the
effectiveness of the marketing spend and if Sunline had realised the full impact expected
from the marking campaigns.
Technology costs related to the online sales channels and information systems used by
Sunline to manage the operations of auto insurance sales. These costs also included costs of
new media platform, cloud based database systems and related data analytics which were
increasingly used to understand customer behaviour and to predict future sales and market
share growth. The increased use of technology at Sunline had not been accompanied by
improvements to operational efficiency and effectiveness. Since joining Sunline, Janet was of
the view that operations required a transformation project to leverage the benefits of the
greater use of technology through efficiencies in processes and staffing. Janet wondered if the
cost-plus approach to pricing had created a management perspective that didn’t focus
strategically on cost management.
Financing costs involved funding the operations of Sunline and investing the cash
from Ride Cover premia raised. The dedicated and specialised financing support team also
invested excess cash in sophisticated equity and debt securities. The costs associated with
these investment transactions were covered by the revenue raised by this team through its
investment activities. Janet considered this team made an important contribution to Sunline
performance, however she had little interaction with them.
https://www.coursehero.com/file/21806254/Sunline-Auto-Insurance/
This study resource was
shared via CourseHero.com

6
The total cost of operating the headquarters was charged back to the nine subsidiaries.
To keep matters simple, headquarters charged back one ninth of the cost to each of the nine
subsidiaries. Janet was not convinced that the simple allocation basis matched the actual level
of services and transactions at Sunline. While this caused some tension between the different
subsidiaries, the overall cost associated with this was relatively small.
Table 3 in Exhibit 1 sets out the key financials related to the cost-plus pricing
approach undertaken for Ride Cover policy. These financials relate to quarter 4 and show the
average premium revenue and costs per policy. The loss per policy is $389.17 based on an
average target policy premium of $1,589.17. Due to market pressure, including customers
threatening to take their business elsewhere, the average premium is actually $1,200,
inconsistent with the cost-plus approach.
Strategic cost and revenue management
As she pondered on the performance in the last quarter, it became clear to Janet that
the current revenue and cost strategy based on a “cost plus” approach was not sustainable in
the future. Customers were becoming very choosy about the pricing of auto insurance
products and were demanding cheaper insurance products. She recalled reading an article on
Target Costing (TC) which was a strategic cost and revenue approach for improving product
sales through a more strategic view of customers’ preferences and needs. Janet wondered if
she could develop a position paper on TC to demonstrate to headquarters how Sunline would
strategically consider cost priorities and manage down cost not closely associated with the
competitive position of the product offering.
As she recalled, TC focused on the price the customer was willing to pay for a
product and enabled a firm to reverse engineer its product cost structure based on this target
price. A firm estimated the target price by carrying out market analysis, to understand what
https://www.coursehero.com/file/21806254/Sunline-Auto-Insurance/
This study resource was
shared via CourseHero.com

7
features of the product were attractive to the customer and how much customers were willing
to pay for each feature. Once a target price was determined, the firm had to take profit margin
away to arrive at a target cost. This cost was labelled the allowable cost which, usually,
would be lower than the current product costs within the firm. The firm then had to carry out
cost management activities and strategic realignment to bring the current product costs down
to the target cost (allowable cost) over a period of time.
Table 4 in Exhibit 1 sets out the pricing for Ride Cover if it was based on a target
costing approach. Current market research suggests that the average premium for a policy
would need to be set at an average of $1,200 (based on the current average premium actually
charged) to maintain current sales volumes and market share. Based on earning a profit
margin of 10%, the allowable cost of a policy would need to be set at $1,080 which would
require a 32.04% reduction from the current level of product costs. Cost management and
strategic realignment activities would need to be carried out to improve the costs of Ride
Cover.
The Target Cost approach focused the firm on all aspects of the revenue and costs of a
product and brought in a questioning attitude to all operational activities. Long used in
Japanese firms, Target Costing as a strategic approach to revenue and cost management had
been neglected in Western firms as it required management and cultural changes to enforce.
But, Janet felt it was a useful approach for Sunline to consider and began to gather
information to develop a paper on Target Costing. She began to consider some key issues:
what is the process of Target Costing and how can it be adapted for auto insurance products?
What are the changes to operational priorities and management processes required when
moving Sunline from a cost-plus pricing strategy to a strategic revenue and cost management
strategy such as TC? What key steps should Janet propose to improve performance using TC?
https://www.coursehero.com/file/21806254/Sunline-Auto-Insurance/
This study resource was
shared via CourseHero.com

8
Exhibit 1
Table 1: Quarterly Performance Summary ($M) – Sunline
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Revenue 1.52 1.65 2.11 2.50
Cost 2.02 2.35 2.90 3.31
Profit/(Loss) (0.50) (0.70) (0.79) (0.81)
Table 2: Cost structure – Sunline (Quarter 4)
Amount ($) Percentage (%)
Administration:
Training 450,000 13.59
Insurance claims 785,952 23.74
Payroll (wages and commission) 1,055,885 31.90
Performance reporting 15,689 0.47
Sales and marketing:
Television and bill boards 713,100 21.54
Online and social media ads 267,990 8.10
Event representation 66,779 2.02
Technology:
IT equipment leases 27,121 0.82
Software subscriptions 19,150 0.58
Financing:
Net cost of finance function after
investment returns (150,000) (4.53)
Headquarters cost charge bank 58,584 1.77
Total costs 3,310,250 100.00
https://www.coursehero.com/file/21806254/Sunline-Auto-Insurance/
This study resource was
shared via CourseHero.com

9
Table 3: Ride Cover policy – cost-plus pricing (based on Quarter 4 financials)
Average quarterly sales volume (no. of policies) 2083
Average premium per policy (target) $1,589.17
Target average profit margin 10%
Cost-plus price $1,748.09
Average premium charged (market price) $1,200.00
Profit/(Loss) per policy ($389.17)
Table 4: Ride Cover – target costing (based on Quarter 4 financials)
Average quarterly sales volume (no. of policies) 2083
Average premium charged (market price) $1,200.00
Target average profit margin (%) 10%
Target profit margin ($) $120.00
Allowable cost ($) $1,080.00
Current cost ($) $1,589.17
Cost savings required ($) $509.17
Cost savings required (%) 32.04%
https://www.coursehero.com/file/21806254/Sunline-Auto-Insurance/
This study resource was
shared via CourseHero.com
Powered by TCPDF (www.tcpdf.org)