budgeting decision: Manufacture wireless chip in house or farm out
Home-on-the-Range Chips, Inc. (HORCI)
Chips, Inc. is a high-tech engineering firm that specializes in designing chips
for intelligent wireless applications.
They recently completed work on an easily customizable chip with
networking capabilities that allows common household appliances and electronic
devices to communicate with a central computer or smart phone as well as with
each other. The decision HORCI faces,
and for which they seek your advice, is whether to produce the chip themselves
or outsource production to a company with chip manufacturing expertise.
estimates the market for this chip will last 5 years, after which the chip will
be obsolete. They expect total sales of
3.5 million chips (700,000 chips per year) at $9.50 per chip. The new chip will neither cannibalize nor
enhance the sales of any other HORCI chips.
you can set up this capital budgeting problem, you need a brief primer on the
chip manufacturing process. The fundamental
unit in semiconductor production is the wafer, a disk of pure silicon polished
to mirror-like brilliance on one side. Each
wafer costs $32.00. Individual chips are
etched onto this wafer, with one wafer capable of producing many chips. The chips are referred to, singularly and
collectively, as “die.” The average
number of die obtained from one wafer is referred to as the “gross die per
wafer.” Not every die produced from a
wafer is useable. Each must be
tested. The percentage of the gross die
that is of high enough quality to move on to the next phase of production is
called the “probe yield.” HORCI believes
its gross die per wafer will be 150 with a probe yield of 82%. This means that the average number of die per
wafer that advances to the next phase of production will be 123 (150 * 0.82).
the next production phase, each die is programmed and tested. The percentage of die that pass this final
test and become salable chips is called the “final test yield.” HORCI believes that 96% of the die tested will
pass. The final test cost per die is
expected to be $0.25. Those that pass
will be packaged at a cost of $1.38 per chip.
The total costs per wafer and the calculations for the yielded part cost
are shown in Exhibit 1.
meet expected demand, HORCI plans to build a plant capable of processing 5,930
wafers per year. The plant, along with
the equipment in it, will cost $8 million and be put in place over the first
year of the project (year 1). Beginning
in year 2, plant and equipment will be depreciated to 0 using a 5-year
straight-line schedule. Salvage value is expected to be $1.2 million. In addition, HORCI expects overhead charges
related to producing the new chip will be $920,000 per year, beginning in the
first year of the project (plant construction) and continuing through the
entire 5-year production run. Finally,
HORCI will need to purchase the silicon wafers required during the first year
(as working capital) to produce the chips it plans to sell beginning in year
2. This investment in working capital
(inventory) will be recovered when the project terminates.
is a 6-year project, with one year to put the plant into place and begin
production, and 5 years of sales. Your
model should recognize cash flows at the end of each year. For example, the $8 million for the new
plant, $200,000 or so for the wafer inventory, and the $920,000 for overhead
will be recognized at the end of year 1.
Note that the $920,000 overhead in year 1 is a charge against revenue
(which is, or course, zero). This will
produce earnings before tax of a negative $920,000. Because HORCI can write this loss off against
other operating income, the resulting negative income tax of $276,000 in effect
becomes a tax deduction, reducing the operating loss in year 1 to $644,000. The entire project will be financed with
equity only. The costs or values for
these and all other input parameters are summarized in Exhibit 2 below. (HINT: This is a copy the input sector for my
in the design phase It was clear that HORCI’s new chip was going to be a
winner. Preliminary analysis of the
chip’s potential value assumed that HORCI would have the chip produced by a
firm that specialized in chip manufacturing.
After all, HORCI’s engineers were experts in chip design, not chip
manufacturing. The lowest bid they received
was $5.50 per chip, excluding packaging costs, from Production Clean Up Corp.
(PCUC). A cursory analysis for this
project, assuming PCUC produces the chip, suggested that the project would
increase HORCI’s equity value by approximately $1.0 million and have an
internal rate of return of around 30%. However,
a recent informal internal study found that HORCI could manufacture the chip
themselves for a yielded or final part cost of just $1.91, inclusive of
packaging costs (see Exhibit 1). If so,
the value of the chip project would almost double.