QBUS6320: The UK Manufacturing UK LTD is facing an array of issues that require a sound understanding of cost behaviour: Management Decision Making Assignment, UOS, UK

Discussion issues

In reviewing Smith’s assessments and conclusions, has he proposed the optimal recommendations? Specifically:

1. The UK Manufacturing UK LTD is facing an array of issues that require a sound understanding of cost behaviour, process manufacturing, and capacity utilization, and market pricing pressures. Identify both internal and external issues that the UKM Senior management must consider their impact on their planning for 2023 and beyond?

2. There are few reasons in cost calculation that caused the 2023 SPx512 product cost to drop by £227 after reflecting the ABC review and the new costing approach? Did spending decrease or just shift? List those costs with supporting numbers.

3. What are the drivers of manufacturing cost? Of product cost?

4. Was it practical or plausible to reduce direct wafer fabrication by 34 per cent or £23m?

5. Should Smith have looked at areas other than wafer fabrication to identify further cost reductions?

6. Why is there still underutilized manufacturing capacity when the SPx256 is being manufactured? Is the pricing model in fact too aggressive?

7. What pricing advantages does UKM’s competitor, Top Telecommunicating Plc, have, knowing their TT256 has 33 per cent more die/wafer than the SPx256? (Assume the same wafer, probe, assembly and test costs and yields as the SPx256)
Explain how students can find information about assessment criteria.

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UK Manufacturing, Plc. Activity-Based Costing (ABC)

 Before the annual year budget review, Simon Smith, UK Manufacturing’s (UKM) Director of operations, was confident. While he waited for the latest financial estimates, he thought of the plan he and his staff had methodically prepared, which successfully addressed all the crises this new business unit was facing: developing competitive pricing on an ageing product, developing and marketing new products to external customers against an established market leader, reducing manufacturing costs, improving manufacturing utilisation and improving its slim levels of profitability.

When Adam White, UKM’s controller, solemnly delivered the requested pro forma income statements, Simon’s mood changed dramatically. Instead of sustained profit,

Simon was shocked to see significant projected operating losses. He wondered why his extensive planning had not improved UKM’s 2021 and 2022 financial results. With less than 24 hours before he was to offer senior management a viable business plan, he felt abandoned and hopeless.

Background

UKM, a semiconductor design and manufacturing company, is a wholly owned subsidiary of Advanced Hardware Systems, Inc. (AHS), a leading manufacturer of client

/ server systems, workstations and personal computers. During 2021 and 2022, UKM manufactured and sold to AHS a single product – the Server Processor (SPx512) a 512 MHz, 10-nanosecond microprocessor. The SPx512 is a 75-micron device packaged in a 339-pin grid array (PGA) and is used in AHS’s servers and workstations. UKM has sold AHS 150,000 units of the SP in each of the past two years.

Although UKM sells entirely to its corporate parent, the company was required to establish competitive prices for its devices by Q3 2023. Previously, the SPx512 had been sold to AHS at full cost. Establishing competitive prices was one of many changes AHS required UKM to make. In 2023, AHS planned to change all its major business units into profit centres. UKM management felt each business unit needed flexibility and independence to react to rapidly changing market conditions. UKM believed that if its business units were profit centres, they would be more accountable for their own financial success. Their strategies and annual performance would be more visible and measurable as well. This change meant they could sell their devices to external customers using available manufacturing capacity. UKM could also recover the large development costs for future products and control their destiny.

UKM established the competitive market-selling price of the SPx512 at £850, based on industry price / performance comparisons. AHS approved of this market-based method of establishing transfer prices, which ensured that AHS could purchase internally at a competitive price while placing the burden of cost management appropriately on UKM. Adam White, UKM’s controller, prepared revised financial statements applying the £850 transfer price to UKM’s 2021 and 2022 shipments (see Table 4). John English, UKM’s vice-president and general manager, was pleased to see UKM had generated profits of £4.9m and £1.9m for 2021 and 2022, respectively, on annual revenues of £127.5m, after applying the newly established transfer price. The profit decline in 2022 reflected the establishment and staffing of UKM’s new marketing department. This department was created to identify and open external market opportunities for new products currently under development.

As FY2023 approaches, UKM management is faced with a few pressures. AHS is under severe competitive pressures in their server and workstation product lines and is already demanding a price reduction on the SP. They also insist UKM remain profitable.

Sarah Ahmad, head of UKM’s new marketing department, determined from industry studies that the price / performance for microprocessors halves every 18 months. To remain competitive, merchant semiconductor companies consistently were offering some combination of price reductions and/or performance improvements, so that their products’ price / performance (price per unit of speed) halved every 1.5 years. Thus, for the SPx512 and for every CPU UKM developed and manufactured, Sarah believed the market would require similarly timed price / performance offerings. Sarah knew any price reductions would require offsetting cost reductions if UKM was to remain profitable and wondered what the manufacturing organisation was thinking.

As product development was no longer working on any SPx512 performance improvements, Sarah computed the essential price reductions on the SPx512 following the industry model. The SPx512 would continue at the £850 price through Q1 2023, then drop to £637.50 at the start of Q2 2023, drop to £425.00 at the start of Q1 2024 and to £318.75 at the start of Q4 2024. Sarah was troubled by these prices, as she knew AHS was requesting 150,000 units in FY2023, but only 75,000 in FY2024. AHS indicated it expected a customer shift away from workstations and into AHS’s new personal computer line.

Appendix One presents an overview of the semiconductor manufacturing process typically found in a microprocessor supplier such as UKM. Appendix Two presents an overview of the product costing process used by UKM.

 Product cost for the SPx512 had remained constant during FY2021 and FY2022 at approximately £665 (see Table 5). Sarah computed cost reductions of approximately

£166.25 per year (to £498.75 in FY2023 and £332.50 in 2024) would be necessary to maintain the SPx512‘s current gross margin of -22%. She wondered if manufacturing could achieve a cost reduction that steep.

Concurrent with the SPx512 pricing activities, Dr Khan, head of product development, sent an urgent request to English, Ahmad, Smith and White for £3m in funding. This funding would accelerate the completion of an integer-only microprocessor, the SPx256 and the follow-on CPU, the SPx384. The SPx256, a new product already under development, could be completed with £lm of the additional funding and made available for volume shipment by the beginning of FY2023. The remaining £2m would be spent during FY2023 and FY2024 to complete development and ready the SPx384 for volume shipment by the beginning of FY2024.

The SPx256, is a 256 MHz, 20 nanosecond CPU, manufactured like the SPx512, using the present 384-micron technology, but unlike the SPx512, the SPx256 does not have a floating-point processor. The elimination of the floating-point processor reduces the size and power requirements of the CPU. The SPx256 and SPx384 can be packaged in a 168-pin grid array (PGA) that costs £15, that is £35 less than the 339 PGA used by the SPx512. However, the testing parameters of the SPx256 and SPx384 are significantly different than for the SPx512 and require a Bonn tester, which MM&M does not currently own. This £2m tester, if purchased, will add £1.2m in annual depreciation and other direct operating costs, and £800,000 in incremental annual support costs to the present level of manufacturing spending.

The SPx256 and SPx384 are targeted as entry devices for AHS’s personal computer business. Top Telecommunication (TT) Plc, is the market leader in the 384 -micron integer-only microprocessors. Their TT256 CPU (also 256 MHz, 20 nanoseconds) sells for £500. The TT256 has just been announced with volume shipments to coincide with the beginning of UKM’s FY2023. UKM’s new marketing department estimates the demand for the SPx256 from AHS and potential new external customers could easily exceed 1,000 units per year. To break into this market, Sarah recommended heavy market promotion and a price / performance two times the competitions. Estimates for unit sales potential from advertising are 100,000 for the first £1,000, up to 500,000 for the second £1,000 and over £I, m for a third million-£ advertising expenditure.

With this increased pricing pressures from both AHS and the external marketplace, product cost reduction became critical. This fact, coupled with the request from product

development for additional funding, had John English very concerned. He knew it was important to bring out the SPx256 and SPx384 quickly, but the pricing pressures for their market entrance and the pricing pressures from AHS on the SPx512 seemed almost impossible to meet and still achieve a profit in FY2023 and 2024. He knew, however, if he didn’t maintain a profitable operation, his tenure would be short.

Reduced product costs leading to competitive manufacturing appeared to be the critical factor necessary to sustain UKM’s slim profit levels. English asked Smith, the director of operations, to formulate a series of recommendations for developing and manufacturing an expanded CPU product line in FY2023 and FY2024. He asked that the recommendations be completed by the annual two-year budget review, scheduled to commence in a month. English knew that soon after budget review he would have to present a credible business plan to UKM management. He worried how he could develop a viable plan in light of the obstacles.

The Smith’s plan

Simon Smith started his preparation by reviewing the detailed SPx512 product cost (see TABLES below 1, 2 and 3). He immediately assembled a team comprising White from finance, T.Q. Marcel from quality and Dian Ruby from training. The team, led by Mark Spencer, manager of wafer fabrication, conducted a cost review by activity. Simon, like John English, believed significant cost reductions would be necessary to maintain profitability. He had recently taken an executive development course in activity-based costing and knew it was a proven method for better understanding cost structures and cost drivers, and highlighting non-value-added work. Smith was excited, given the size of the assignment and his belief there were both cost reduction opportunities in manufacturing and necessary improvements in the current standard cost system. He felt the current standard cost system did not properly capture the complexity of UKM’s production process. He felt an ABC analysis could provide the insight necessary to reduce the SPx512 product cost by the £166 marketing had requested. The team mapped the processes of the entire operation and then reassigned costs to the newly defined activities. The manufacturing support organisations were also better understood. Their key activities were costed, and then each was aligned to the manufacturing operation it supported. UKM’s ABC team reset the SPx512 product cost in line with the true practical capacity of the manufacturing process. The team saw capacity utilisation as a major driver of product cost. The old product costing methodology was based on the planned utilisation of each manufacturing process with underutilised manufacturing costs absorbed into product costs.

The revised SPx512 product cost was pleasing, but not very surprising to Smith. It confirmed his belief in the inaccuracies of the old costing method. The new SPx512 product cost of £437.50 was £227.61 lower than the £665.11 original cost shown by the old system. It did not make sense to charge the SPx512 for the costs of resources it did not consume. Smith felt he could commit immediately to Sarah’s 2023 product cost reduction request of £166.

To achieve the 2024 product cost goal of £332.50, Smith and his team looked further into the activity-based costing results. The study clearly showed that wafer fabrication was the largest area of manufacturing cost. Smith computed that if the SPx512 wafer cost was reduced from the 2023 level of £3,000/wafer to £1,866/wafer, the SPx512 total product cost would be lowered by £105, achieving the desired £332.50. To obtain a wafer cost of £1,866, spending reductions of -£25.5m or 38 per cent in wafer

fabrication would have to be achieved (see Table 1). Smith again asked Spencer to review the fabrication area for further cost reduction opportunities. He asked Spencer to formulate a plan that could reduce direct wafer fabrication spending by -£25.5m (from £67.4m to £41.9m).

Spencer returned in two weeks with an alternative plan (see Table 2). His team found nominal spending opportunities by:

(l) Reducing monitor wafer usage,

• Redesigning wafer lot handling procedures and
• Better placement of inspection

Spencer’s most significant discovery was the 64 per cent increase in capacity attained by increasing equipment uptime (the time equipment is not undergoing repair or preventive maintenance).

Higher uptime, however, required an annual investment of £1.8m in additional equipment engineers. While this investment would increase wafer fabrication spending to £69.2m, wafer fabrication capacity would increase from 26,000 to 42,700 in annual wafer starts. The increased capacity actually decreased the cost / wafer to

£1,845, which was £21 lower than Pound had requested

Simon Smith dismissed Spencer’s alternative plan outright. ‘Spending needed to decrease, not increase!’ Smith exclaimed and reiterated his request to reduce fabrication spending by 38 per cent. Smith then focused his team’s cost reduction efforts on packaging costs, another major cost component of the SPx512. (UKM had spent close to £8.8m annually on chip packages.) He asked UKM’s purchasing manager, Zoe, to pressure UKM’s 339 PGA supplier to lower their £50 price. Zoe told Smith she had already made this request and was reminded by the vendor that the 339 PGA was a unique design, used only by UKM for the SPx512. With order volumes declining by 50 per cent in a year, Zoe said it would be difficult to keep the

£50 package price from increasing.

The final area of review was the SPx256 proposal. Smith and the team reviewed its product cost, necessary manufacturing process and spending requirements (see TABLES 14 & 15 below). Smith compared the SPx256 product cost (computed assuming all production capacity was used to manufacture the SPx256) with the product cost of the SPx512 and noted a few significant cost differences.

The reduced size of the SPx256 (no floating-point processor) increased the number of dies able to be placed on each wafer, thus reducing the fabrication cost/die 67 per cent from the SPx512 (£61.00 for the SPx512; £20.33 for the SPx256). The increase in the number of dies on each wafer increased the probe time, however, and increased the probe cost per wafer by 25 per cent (£500 for the SPx512; £625 for the SPx256). He was pleased with the doubling of assembly capacity resulting from the smaller package required by the SPx256 (202,500 annual assembly starts for the SPx512 405,000 for the SPx256). The increase in assembly throughput reduced the SPx256 assembly costs by 50 per cent. Smith was pleasantly surprised at the SPx256‘s lower test costs. Even though the SPx256 required a new tester, the lower annual operating costs versus the SPx512, along with the reduced testing time from the elimination of the floating-point unit, resulted in a per unit test cost of only £5 versus £40 for the SPx512.

With the SPx256‘s cost structure now soundly understood, Smith could better appreciate the high but achievable profit margins of the SPx256. The margins ranged from 75 per cent during Q1-Q3 2023 to -67 per cent in Q4 2024 when the marketing- required price reduction took effect (see Table 3). If Spencer could achieve the £1,866 wafer cost by the start of 2023, the SPx256 could obtain a very respectable margin of 59 per cent in the second half of 2023 at the required price of £125. Using the capacity available in 2023 and 2024 to produce 50,000 and 215,000 units, respectively, easily convinced Smith to fund the SPx256 development effort and purchase the new tester.

While the product specifications for the SPx384 were not yet available, he also agreed to fund its development effort. He felt the SPx384 would achieve the same product margins the SPx256 demonstrated

Appendix One: Overview of the semiconductor manufacturing process Semiconductor devices are made from silicon, which is material refined from quartz. Silicon is first melted and grown into long crystals (ingots). The purified silicon is sliced into wafers on which integrated circuits will be patterns. As the size of an integrated circuit is extremely small, hundreds, even, of circuits can be formed on a wafer at the same time. Integrated circuits (typically referred to as ‘chips’ or ‘dies’) are an array of transistors made up of various connected layers, designed to perform specific operations. A glass plate (called a reticle) is used to pattern layer on the wafer during the fabrication process.

1. Fabrication process: blank wafers are first insulated with a film of oxide, then coated with a soft, light-sensitive plastic called photoresist. The wafers are marked by a reticle and flooded with ultraviolet light, exposing the reticle’s specific circuit pattern on the unmasked portion of the wafer. Exposed photoresist hardens into the proper circuit layer outline. More photoresist is placed on the wafer, masked and stripped, then implanted with chemical impurities, or dopants, that form negative and positive conducting zones. Repeating these steps builds the necessary layers required for the integrated circuit design to be completed on the
2. Probe process: an electrical performance test of the functions of each of the completed integrated circuits is performed while each die is still on the wafer. The non-functioning dies are marked with ink; the functioning dies are left unmarked and moved to
3. Assembly process: each die is cut from the wafer. The good dies are placed in the cavity of a ceramic The bonding pads from the dies are connected by very thin aluminium wires into the leads of the package, creating the necessary electrical connection from the chip to the package.
4. Test: the devise is tested to ensure all electrical specifications of the integrated circuit are met. The completed, packaged semiconductor devise is now ready to be soldered to a printed circuit board (PCB), which in turn will be installed into a computer

 Appendix Two: overview of the product costing service

Semiconductor of the product costing is a multi-step process in which manufacturing costs measure value added to raw material as it is processed through each stage of production:

1. First, the costs of raw materials used and the unit costs of each stage of manufacturing are
2. Next, raw wafer and wafer production costs are converted to die In wafer fabrication and probe, manufactured material is in wafer form.
3. Costs of the raw wafer and manufacturing in these stages are captured initially as cost/wafer. In assembly, where the wafer is cut into dies, the unit of measures also changes to dies. Thus, to complete the costing of the final product, which is in die form, cost/wafer must be converted to cost/die.
4. Finally, the unit of die costs are accumulated in the sequence of the manufacturing process and yielded at each Yield refers to the production units successfully manufactured in each stage. The semiconductor manufacturing process typically loses much of it production due to misprocessing or non-functioning dies. Yielding the accumulated unit cost at each manufacturing stage applies to the cost of lost production units to the cost of good production units.

At UKM, the unit production cost of each major manufacturing stage (wafer, fabrication, probe, assembly, test) has been determined by applying that stage’s annual spending to the annual volume of production (see Tables 5 and Table 6) or capacity (see Tables 12 and Table 13).

Tables 6 and 7 highlight the computation of unit cost at each stage of manufacturing. In wafer, fabrication and probe, the production unit is a wafer. Unit cost through these two stages in computed as a wafer cost. In assembly and test, the wafer has been diced to remove the dies. The good dies continue through assembly; the non- functioning dies are discarded. Unit cost through these two manufacturing stages is computed as die cost.

At each stage of production, production loss (or yield) is experienced. Yield loss is typically greatest during probe, when each die on the wafer is first tested to determine if it is functioning as designed. At probe, the effectiveness and quality of the wafer fabrication process, through which the multiple circuit layers have been placed on the wafer, is revealed. In wafer fabrication, the wafers used solely for engineering testing (to ensure equipment is properly calibrated and not used for production) are also eliminated (treated similar to production yield loss) in the calculation of wafer cost.

Table 5 and Table 12 highlight the computation of product cost. The unit cost of each manufacturing stage is listed. For the raw wafer, wafer fabrication and probe, the unit cost (wafer) is converted to die cost. The material cost is reflected at the manufacturing stage at which it is introduced. To determine a final or complete product cost, the cost per die is accumulated through each manufacturing stage and yielded for the production loss experienced in that stage. Yielding the accumulated die cost has the effect of placing the total cost of manufacturing on the good production units (or expected good production units if the total production capacity costing method id used).

Table 5 highlights the accumulation of costs the SPx512 incurs during manufacturing. The cost and application of raw material can be seen at the start of wafer fabrication and assembly. Wafer to die conversion, based on the SPx512’s specification of 50 die on each wafer, is used to compute the equivalent die cost from the raw wafer and at wafer fabrication and probe. Finally, the treatment of production loss (yield) can be seen throughout the costing process, as the accumulated cost at each stage of production is increased by the planned or expected yield at that stage of production is increased by the planned or expected yield at that stage, resulting in an accumulated cost that reflects the total cost of production applied to the good dies produced or expected after each stage.

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