In most industries, it's the end-user-facing manufacturers that suffer the highest levels of warranty costs, while their suppliers spend much less, and at far lower rates. But in the semiconductor business, the companies that make the very complex and expensive platforms that are used to manufacture the actual devices pay the most, while their customers spend much less, and at far lower rates.

Taking it a step further, as these integrated circuits and printed circuit boards are added into actual electronic products such as computers, they experience below-average warranty expense rates. But the computer OEMs and the makers of some types of telecom equipment experience much higher expense levels, meaning that the highest warranty costs in the high-tech sector are at the very beginning and the very end of the supply chain.

In order to tabulate the results for this week's microelectronics warranty report, we started with a list of 160 U.S.-based companies in the semiconductor and printed circuit board production industry. We separated them into two groups: 138 companies that make the actual chips and circuit boards, and 22 companies that make the production machinery and test equipment used to manufacture the devices.

Next we gathered some data on each company: their annual product sales, warranty claims payments, accruals made, and the ending balance in their warranty reserve funds. With these four metrics in hand, we calculated three more metrics: the claims rate (claims divided by sales), the accrual rate (accruals divided by sales), and the reserve capacity (reserves divided by claims).

Top Warranty Provider List

The list of 138 companies making the actual semiconductors and printed circuit boards was led by Advanced Micro Devices Inc.; Cree Inc.; FEI Co.; Nvidia Corp.; and Teradyne Inc. Companies that belong on the list but did not report any warranty expenses included Analog Devices Inc.; Intel Corp.; Micron Technology Inc.; and Texas Instruments Inc.

The list of 22 companies that sold the production and test equipment that was used to manufacture the semiconductor components were led by Applied Materials Inc.; Brooks Automation Inc.; KLA-Tencor Corp.; Lam Research Corp.; and in past years, by Novellus Systems Inc. (before it was acquired by Lam Research).

Although the two groups were vastly different in the number of members in each and in their annual sales totals, they were much more similar in terms of their warranty expense totals. In Figure 1 we have calculated the annual sums for claims paid by the two groups. In most of the past 13 years, roughly 60% of the expense has been paid by the 22 companies making the manufacturing equipment, while only about 40% has been paid by their customers: the companies making the actual components.

There were two years in which the pattern was reversed, where the companies making the actual components paid 60% and the companies making the machinery paid 40%. But that was due to the massive problems Nvidia had with its graphics boards, combined with the recession-related decline in sales of machinery (and claims payments) by the likes of Lam Research, Applied Materials, and KLA-Tencor.

In 2015, claims payments dropped by $24 million overall, with a steep drop of $32 million by the device makers and a slight $7 million gain by the production equipment makers. For the device makers, it was their smallest-ever annual total, while it was the smallest annual total for the manufacturing equipment companies since the recession.

Big drops in annual claims payments were reported by Advanced Energy Industries, Advanced Micro Devices, Brooks Automation, and KLA-Tencor, among others. Big annual increases in claims payments were reported by Lam Research, Nvidia, Cohu Inc., and Cree Inc.

Accrual Totals

In contrast to the trend in claims, the annual accrual totals for both groups were up in 2015. Accruals rose $38 million for the manufacturing equipment companies, and $8 million for the device makers. And it was the second straight year in which accruals rose for both groups, positioning 2013 as the post-recession year with the lowest totals.

Among the companies increasing their accruals, three were massive. Nvidia increased its annual accruals from $4.9 million in 2014 to $23 million in 2015. Sanmina Corp. increased its accruals from $4.9 million in 2014 to $18 million in 2015. And Cree increased its accruals from $7.1 million in 2014 to $16 million in 2015.

The reductions were much smaller, in terms of both size and relative impact. For instance, AMD reduced its accruals from $32 million to $28 million. Brooks Automation cut its accruals from $11 million to $9.3 million. And Teradyne reduced its accruals from $15 million to $12 million.

Warranty Expense Rates

The missing metric is product sales. If sales are rising, it's highly likely that expenses are as well. If they rise in proportion to one another, the results are neutral. For instance, although Lam Research saw a $13 million increase in claims and a $27 million increase in accruals in 2015, its product sales were up by 16% as well, blunting the effect of the increases in expenses.

Applied Materials saw no change in claims and only a slight increase in accruals, but its sales were flat so it didn't change the impact by much. AMD saw big drops in its claims and accruals, but its sales fell proportionally, so the percentage of revenue it spends on warranty didn't change by much.

We took the claims and accrual data from Figures 1 and 2 and divided them by product sales data to produce the two pairs of lines seen in Figure 3. These express the percentage of each group's sales revenue that's going towards paying warranty expenses: green is accruals and red is claims.

We want to point out two trends. First, in both 2009 and 2010, and for both groups, the expense rates rose significantly, though temporarily. But rather than being caused by rising expenses (Figures 1 and 2 showed the opposite), these spikes were caused by falling sales during the recession.

Second, over the past 13 years, the manufacturing equipment companies have significantly reduced their expense rates, from as high as 4.0% to a little below 1.5%. In fact, in early 2010 the group's claims rate was ever-so-briefly almost as low as the chip and PCB group. This group, meanwhile, has also reduced its expense rates, but not as noticeably, from a little over 0.5% to a little under 0.5% on average.

As a result, the gap in expense rates between the production machinery makers and their customers was reduced from roughly 2.3% to 2.5% from 2003 to 2007, to only 1.6% to 1.7% from 2011 to 2015. The gap was even smaller by the end of 2015.

Among the individual companies, there was no clear trend. Advanced Energy Industries saw a big drop in sales but an even bigger drop in its warranty expenses. The net effect was a reduction in its claims rate from 2.7% at the end of 2014 to only 0.3% at the end of 2015, and a reduction in its accrual rate over the same period from 2.4% to 0.3%.

KLA-Tencor increased its accruals in proportion to sales growth, so its accrual rate remained unchanged at 2.0%. But claims fell by $4 million so its claims rate declined from 1.9% to 1.3%.

Veeco Instruments Inc. saw its claims remain the same but sales grew by 21%, so its claims rate fell from 1.0% to 0.7%. But the company had to increase its accruals significantly, so its accrual rate rose from 0.9% to 1.7%.

Product sales grew by more than 5% on average for both groups, so the reasons behind the sales declines at individual companies such as Advanced Energy Industries, AMD, Cohu, and Brooks Automation cannot be generalized across the entire industry. Lam Research, Veeco Instruments, Cypress Semiconductor Corp., and Avago Technologies Ltd. were among those to report better-than-average sales growth in 2015. All four also reduced their claims rates, though Veeco's accrual rate rose.

Warranty Reserves

Our fourth metric is the balance in the warranty reserve funds of these 160 companies at the end of each of the last 13 years. For the device manufacturers, the balance has remained relatively stable over the past four years at a little over $200 million. For the 22 companies that supply them with manufacturing equipment, their combined balances have once again risen above $300 million after staying below that level for the three years before 2015.

Almost all the top warranty providers in both groups increased their warranty reserve fund balances in 2015, so the $41 million overall increase comes as no surprise. Lam Research raised its reserves by $18 million. Applied Materials raised its reserves by $13 million. Avago raised its reserves by $8 million. And Nvidia raised its reserves by $5.8 million.

Proportionally, the latter pair were the biggest of all: it was a doubling of the balance for Avago and an 80% increase for Nvidia. For Cree, its $5.2 million boost in reserves represented a two-thirds increase, while for Veeco, a $2.7 million rise in reserves represented better than a 50% increase.

But again, some of these companies are also seeing their sales increase, so it's inevitable that there should be a proportional increase in expenses. It's when some of these metrics are rising and others are falling that there's reason to worry.

Reserve Capacity

In Figure 5 we are measuring the relationship between claims and reserves, with the balance expressed as the number of months of claims that could be paid from the fund. In other words, if the balance is $12 million and the company is paying out $1 million a month in claims, its warranty reserve would last for 12 months. Of course, over the intervening 12 months additional claims would be paid and additional accruals would be made, so the funds would never truly run out. But at that moment, the fund would have a capacity of 12 months.

If the company's warranties were all exactly one year long, this would prove to be an ideal level, because the money that's there now, which was set aside to pay for the warranties on all products sold until now, would last until all those warranties expired a year from now. But of course, some products could turn out to be more or less reliable than was predicted, and some warranties could expire because of heavy usage, resale of the equipment, misuse or abuse, or other factors.

In the chart below, there seems to be a clear preference among these companies to keep the ratio between claims and reserves between 9 and 15 months, with 12 months as a midpoint. For all companies in all industries, the average was just over 19 months, so the semiconductor industry is below average in this measure.

Meanwhile, the average accrual rate, as measured along the horizontal axis, was just under 1.3%. The manufacturing equipment makers are decidedly above this average, while their customers the device makers are decidedly below it.

This entire industry is composed of supplier companies, in the sense that all of the products these 160 companies manufacture are used by another manufacturer. The makers of the manufacturing equipment are supplying the makers of the chips and boards. Those chips and boards are then sold to the computer manufacturers we covered in the April 21 newsletter, the medical equipment manufacturers we covered in the April 28 newsletter, and the telecom equipment makers we covered in the May 5 newsletter.

Looking back at those newsletters, it's no surprise to find that most of their warranty reserve capacities were also in that 9-to-15-month range (with the notable exception of the broadcast and cable TV equipment makers). In other words, these suppliers are generally matching their customers in terms of the amount of reserves they keep, given what they pay per month in claims.

However, the data in Figures 3 and 5 demonstrates that the suppliers' suppliers -- the manufacturing equipment makers -- suffer from relatively higher accrual rates than most of their customers, and all of their customers' customers except perhaps the computer OEMs. So in the high-tech electronics industry, it's the beginning and the end of the supply chain that has the highest accrual rates.

Calculated Risks

Among the individual semiconductor companies, there's quite a bit of difference in the reserve capacities, reflecting perhaps the outlook of the financial planners themselves. Advanced Energy Industries, Applied Materials, and KLA-Tencor tend to keep the ratio between claims and reserves well above 15 months, though they've occasionally allowed it to dip below that threshold.

Meanwhile, companies such as Teradyne, Brooks Automation, Nanometrics Inc., and Electro Scientific Industries Inc. are content to operate with the thinnest of cushions in their warranty reserve fund, keeping the ratio between 6 and 8 months on average. In the middle are companies such as Cree, AMD, Lam Research, and Cohu, which keep their reserve capacities in that average range of 9 to 15 months.

This suggests that there's an element of risk-taking that's measured by this warranty reserve capacity metric. Companies close to the industry average are taking a small risk that their reserves may someday turn out to be insufficient to cover the cost of a crisis. Companies well above the industry average are taking no risk, and are therefore protecting their investors well.

Companies at the low end, meaning in this case below 9 months, are exposing their shareholders to a high risk that someday something could go wrong, erasing net income and then some. This is exactly what happened to Nvidia back in 2009 and 2010.

And guess what? It could happen again. Nvidia ended its latest fiscal year with a warranty reserve balance of $11 million, paying claims at a rate of $2 million a month, for a reserve capacity of only 5.5 months. But that's actually an improvement. Back at the end of its third quarter, its reserve capacity was only 2.6 months.