FORTUNE — Every three months a team of top executives from Volkswagen Group boards a plane at headquarters in northern Germany and flies 1,000 miles southeast to a secret location near Barcelona to review the design of proposed new models under the shimmering Mediterranean light. Although the break from Wolfsburg’s climate is welcome, nobody would characterize the meetings as junkets; chief executive Martin Winterkorn, a demanding engineer, is in charge, and there is a lot of work to do. VW makes 245 different models sold under 10 car and truck brands, ranging from economical SEATs built in Spain to upscale Audis and MAN trucks and buses and, at the very top, Bugatti Veyrons that sell for up to $2.4 million. Every single passenger car receives a careful going-over. VW has to get its cars right because it doesn’t change them very often. After all, this is the company that built the Beetle for 65 years. Even with the intensive reviews, mistakes are made — like the garish Bentley SUV concept VW revealed at the Geneva Motor Show in March, which one blogger described as looking “like a poor person’s idea of a rich person’s car.” As a VW executive admitted, “In this galaxy of models we sell, there is always a decision that escapes.”
The latest chapter in VW’s saga of long-running designs will be written this fall when the seventh generation of the Golf hatchback is unveiled at the Paris Motor Show. The 2013 Golf is expected to be fundamentally similar to the hatchback that was introduced in 1974, but with enough design tweaks and technological flourishes to enable it to remain the bestselling car in Europe. Few other mass-market manufacturers could get away with such predictability, but VW is making a virtue of consistency. Long the dominant automaker in Western Europe, VW is now the top-selling manufacturer in China and South America, and it is quickly gaining momentum in the U.S., where it has moved 30% more cars so far in 2012 than the year before. Globally, VW added sales of more than 1 million passenger cars last year and roared past General Motors (GM) and Toyota (TM) to become the largest automaker in the world. (GM claimed unit sales of 9.03 million last year, compared with VW’s 8.27 million, but that included 1.2 million units contributed by its Chinese affiliate, Wuling, in which it holds a minority interest.)
VW (No. 12 on the Fortune Global 500) has always enjoyed ample technological resources — it numbers 35,000 engineers among its more than 500,000 employees — and a stable ownership base; 20% of its shares are owned by the province of Lower Saxony. What it lacked in the past was direction, focus, and urgency. As recently as 2007, it recorded a pretax profit margin of a skimpy 6% on sales of 6.2 million vehicles. The company was stagnating, so Winterkorn created some stretch targets — annual sales of 10 million cars and trucks with a pretax profit margin above 8% — and set a goal to reach them by 2018. He wants VW to become the world’s most profitable automaker. And that’s not all. He also decreed that it should be the “world’s most fascinating and sustainable” one.
Winterkorn bundled those somewhat contradictory targets under the single heading “Strategy 2018.” The transparent timetable worked like a turbocharger on a Beetle. In addition to the record sales in 2011, pretax margins (including one-time gains) climbed close to 12% — slim for a software maker but robust for the car business. One financial analyst described VW as a “juggernaut.” Aligning all those engineers with a single set of goals has improved productivity and product quality. Most important, it has enabled VW to execute a strategy that carmakers often attempt, seldom with success: using the same basic parts in dozens of car models marketed under different brands, thereby slashing costs for engineering, procurement, and manufacturing. VW calls it the “toolkit strategy.” Mishandled, it can lead to a fleet of commoditized cars, but it can generate formidable efficiencies when properly executed.
VW’s ability to meet its ambitious targets will be tested this year. It is launching the new Golf in the teeth of a slowdown in China and a recession in Europe. At the same time, it is rolling out a new version of its toolkit strategy for small cars (called MQW) with all the glitches that come with a new engineering and manufacturing process. And VW will be finding room in its portfolio for Ducati, the Italian motorcycle maker that it acquired in April, and Porsche, whose purchase is expected to be completed by year’s end. With 2011 sales of 116,978 units, the elite sports car manufacturer will be a minnow swimming in the VW ocean. But it will give a boost to the income statement with its industry-leading operating margins — and help with the “fascinating” part of those Strategy 2018 goals.
VW’s extraordinary revival is largely a result of the vision of one man and its execution by another. The vision belongs to Ferdinand Piëch, VW Group’s chief executive from 1993 to 2002 and now chairman of its supervisory board. Imperious and mercurial, Piëch is the grandson of Porsche founder Ferdinand Porsche, the designer of the original Beetle, and is still the owner of a substantial piece of the automaker. Piëch is also an engineer; he is credited with developing the four-wheel-drive system that turned Audi into a strong competitor for Mercedes-Benz and BMW. While group chief executive, he built VW into a brand superstore by acquiring Lamborghini and Bentley and creating a new company around the historic Bugatti name. The 75-yearold Piëch was recently elected to the VW supervisory board for another five years, and membership was also extended to his third wife, a former nanny in the Piëch household.
After moving upstairs to the supervisory board in 2003, Piëch had a falling out with his successor, former BMW executive Bernd Pischetsrieder, and replaced him with his protégé, Winterkorn. More consistent and methodical than his mentor, Winterkorn is a metallurgist by training who got his start working on refrigerator compressor coolants for manufacturer Robert Bosch. A passionate soccer fan who rarely misses a game in Wolfsburg and travels to many on the road, Winterkorn played goalkeeper in his youth and aspired to become a professional. “I have always had a passion for cars and soccer,” Winterkorn told Fortune. Today he guards Piëch’s legacy the way he would the net, sharpening the focus on engineering and brand integrity.
Despite its accelerating growth and expanding international presence, VW remains solidly attached to the remote city in northern Germany where it was founded 75 years ago. Like VW, the city has undergone a transformation. Wolfsburg was created out of farmland on the eve of World War II and for years consisted of little more than a 2½-square-mile factory complex surrounded by housing and services for its 50,000 workers. On my last visit there, 19 years ago, the town’s lack of diversions made Detroit seem like Paris. The highest-rated hotel was a Holiday Inn, and the local delicacies were white asparagus and currywurst, a pork sausage that is made in a corner of the VW plant and served sliced on a plate of warm curry ketchup. Berlin, an hour to the east by train, might as well have been on a different continent.
In 1993, VW was in no great shape either. The company was squeezed by a deadly combination of high-cost, low-productivity manufacturing that produced expensive cars of poor quality. VW looked none too competitive in Europe and even worse outside it. China was still in its early stages of growth, and VW’s North American presence was fading. VW and Audi combined sold fewer than 100,000 cars in the U.S. in 1992, down from their high of about 570,000 units in 1970. The group was barely breaking even.
Today Wolfsburg has been transformed. In an unusually close partnership between company and city, VW, at Piëch’s urging, has pumped hundreds of millions of deutsche marks and euros into developing the banks of the River Aller in the city center to create an Epcot-like park, called Autostadt, devoted to cars. Its centerpiece is an immense hall where several hundred customers a day take delivery of their VWs after seeing them plucked mechanically from one of two 200-foot-tall glass silos. SUV enthusiasts can try out two models on an off-road course that winds its way along the river, while history buffs can perambulate through a museum housing 500 cars. Winterkorn’s beloved soccer team plays in the nearby VW stadium, where VW executives and dealers occupy $325 seats in corporate boxes. Those more culturally inclined pack a 1,000-seat theater that is erected each year in one of VW’s power plants for a six-week season of musical events. Across a canal is a Ritz-Carlton owned by VW that houses a three-star Michelin restaurant, one of only a dozen in Germany.
Comfortable as Wolfsburg has become, it increasingly serves as a launching pad for VW’s international initiatives. With the European car market flattened, VW is focusing on two other markets with greater potential. VW led the way for Western manufacturers into China in 1985 and remains the biggest seller there. Last year it delivered 2.26 million vehicles in China, and it saw sales in the first quarter grow by 15.6%. While the China market may be cooling, VW isn’t slackening. It is building three new assembly plants and in April announced plans for a fourth in western China, the first in that region.
VW has equally ambitious targets for the U.S., where it has to win back buyers after ignoring the market for two decades. VW is making the right long-term moves, adapting its designs to domestic tastes, cutting prices, and adding local production capability at bargain rates. Analysts figure that wages and benefits at VW’s Tennessee plant cost $27 an hour, vs. $50 for Japanese transplants and $60 for GM. Still, VW needs another high-volume car to reach its 2018 goal for the U.S: 800,000 VWs and 200,000 Audis, twice the current total.
Wherever it goes, VW takes with it an unmatched competitive advantage: its ability to maintain brand identity while achieving economies of scale. The key is being able to build different models with the same components — without the customer noticing. Done poorly, parts sharing can destroy equity in a brand, as GM discovered in the 1980s when it produced the Chevrolet-based Cadillac Cimarron and the “lookalike” cars. Done right — say, when SEATs and Audis share parts under the skin — it becomes a money machine.
VW’s work on what was then known as “platform sharing” began in 1993 under Piëch. With the purchase of SEAT in 1986 and Czechoslovakia’s Skoda in 1991, VW was making 20 different basic models. Piëch wanted to slash that number by 75% and eliminate unnecessary parts proliferation by developing a few designs that could be sold by all four brands. Reining in the company’s headstrong engineers took time. VW had to learn how to create economies among cars of a similar vehicle class — subcompact, compact, and so on — by putting different bodies, or “hats,” on identical chassis platforms.
Under Winterkorn, VW has refined its modular strategy. In 2007 the company launched what it calls its modular longitudinal matrix (MLB) for large cars. It enabled the automaker to use the same key components (VW calls them assembly kits) in 16 new vehicles. Audi, for instance, could now build its entire product line with the same parts. It was separated from lesser brands by the creation of a unique upper structure, with “plug and play” inner pressings that made variations in body style possible with a minimum of additional parts. The MLB proved so efficient that Audi was able to nearly double its operating profit in 2011 and achieve higher margins than either BMW or Mercedes. “We may have a slightly more intensive relationship with our cars than some of our competitors,” says Winterkorn.
VW is now rolling out an even more ambitious system called the modular transverse matrix, or MQB (modularer Querbaukasten in German), that will be used in more than 40 small cars. By standardizing the parts in the critical area between the front axle and the pedals that represent 60% of a car’s cost, VW can use the same transmission, front axle, steering, heating, air conditioning, and ventilation system. MQB is flexible enough to accommodate a wide range of wheelbases, track widths, and wheel sizes that previously were immovable, giving designers more flexibility.
When the integration of MQB is complete, it will underpin more than 7 million units across VW’s brands, providing unequaled scale and cost advantages. VW figures that standardization will cut product development costs by 20%, parts costs by another 20%, and production time by 30%. Add it all up and the analysts at Société Générale believe the annual savings could reach $3 billion, or about $500 per car.
More: Fortune 2012 Global 500
With the core of its car business running without a misfire, VW is stepping up development of mini cars to satisfy customers in developing markets strapped by high fuel prices. It recently introduced the Up!, a sub-subcompact, at a starting price of under 10,000 euros, or about $13,000 — the least expensive VW in quite a while — which was named the 2012 World Car of the Year. The Up! is powered by a tiny three-cylinder engine displacing one liter that, despite its pokey acceleration, as I discovered during a brief test drive in Wolfsburg, can speed past 100 mph. It also gets 55 miles per gallon — a big selling point in Germany, where gasoline costs nearly $10 per gallon. Spend an additional $4,000, and you can get an Up! with a leather-trimmed interior that rivals a luxury car in refinement.
Even higher mileage will be possible with a radical new vehicle still known only by its code name, XL1. Built of carbon fiber and weighing less than 1,800 pounds, it boasts the amazingly low coefficient of drag of 0.186 (Toyota’s Prius, the slipperiest car now in production, claims a coefficient of 0.25) and extraordinary fuel economy. Powered by a plug-in diesel hybrid, the XL1 is capable of getting 260 mpg.
Winterkorn and Piëch each drove an XL1 nearly 100 miles to VW’s annual meeting in Hamburg. With its butterfly doors, pavement-scraping seats, and space-capsule ergonomics, the car wouldn’t accurately be described as comfortable for the generously proportioned 65-year-old Winterkorn, much less Piëch. But both men were smiling when they extricated themselves from the cars and gave the thumbs-up sign.
The XL1 is too exotic for mass production, so VW plans to build only a few hundred at first. “We will be making a small series from 2013 onwards to gain further experience with feedback from customers,” Winterkorn says. “Then we will see.” Nevertheless, it is a symbol of VW’s technological capabilities and ambition, and a marker for its 35,000 engineers. For sure, the XL1 won’t do anything for VW’s profitability goals for 2018. But it hits pretty high up on the sustainability index, and it’s off the charts for fascinating.
This story is from the July 23, 2012 issue of Fortune.