Smaller Chips, Bigger Costs

The soaring prices of the latest technology is forcing more chipmakers to outsource their manufacturing

Over the years, chipmakers have become experts at preparing for rainy days. In the notoriously cyclical boom-to-bust semiconductor industry, storms are a given. Nevertheless, few expected the torrential weather they're enduring right now. Sales have tanked, inventories are rising, and chip prices are plunging. Meanwhile, companies are grappling with how much they must invest in new technologies aimed at reining in runaway manufacturing costs. Taken together, "this is the perfect storm," says Ashok K. Sinha, senior vice-president at equipment maker Applied Materials Inc. (AMAT )

Sounds melodramatic. But when the skies finally clear, expect to see an industry transformed. The key will be lowering costs. The most advanced chips are smaller than ever before, squeezing millions of transistors, each less than 1/1,000 the width of a human hair, into a space smaller than a thumbnail.

The new chips also pack twice the power of older generations, while costing 30% less to make. Companies hope to save even more by producing chips off 12-in. silicon wafers, which offer 240% more area than older 8-in. wafers. And, for the first time, companies such as Intel (INTC ), No. 56 on the Info Tech 100, Texas Instruments (TXN ), and Advanced Micro Devices (AMD ) are using copper wiring, instead of aluminum, to keep the chips from overheating while helping speed up the their function.

The payoff is big: One new factory can do the work of 2.3 older plants. On a per-chip basis, the new technologies reduce expenses "back to where you were 10 years ago," says Andy D. Bryant, chief financial officer at Intel Corp.

Sounds good. But those efficiencies don't come cheap. The cost of a chip plant has soared above $2 billion--20 times the $100 million investment required just 12 years ago. Add to that the cost of researching new technologies, which analysts estimate at $1.5 billion, and you're talking more than many chipmakers can afford--save Intel, IBM (IBM ) (No. 21), and TI. That puts a damper on the prospects for smaller rivals. "We don't make as much in revenue as Intel spends every year on R&D," says Hector de J. Ruiz, CEO of Advanced Micro Devices Inc.

In hopes of remaining competitive, one route many are taking is outsourcing manufacturing. Since 1987, the foundry business has helped small, specialty chipmakers, such as graphics-chip company ATI Technologies Inc. (ATYT ), defray production costs. Such foundries as Taiwan Semiconductor Manufacturing Co. (TSM ) and United Microelectronics Corp. (UMC ) invest in the latest technologies, then contract with chip suppliers, which buy time on their manufacturing lines. Motorola Inc. (MOT ) (No. 95), for instance, is shuttering 10 of its 18 plants and expects 25% of its manufacturing to be outsourced by yearend.

The tricky part is deciding just how much of the business should be off-loaded. Avoiding the cost of cutting-edge technologies provides short-term gains, says Thomas J. Engibous, CEO of Texas Instruments Inc. In the long term, though, that strategy could hasten a "fade into irrelevance," he argues. Engibous is investing in advanced technology for new chip plants.

To help stem costs, he also plans to boost outsourcing to as much as 20% of TI's total manufacturing in the next few years, up from 10% today. And when demand is at its peak, TI will farm out as much as half the production of its advanced processors for cell phones and other electronics.

Other chipmakers are grappling with the same decision. Those that make the wrong choice could drown as a tidal wave of technological change sweeps over the industry.

By Cliff Edwards in Santa Clara, Calif.

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