Accounting for the intel pentium chip flaw case solution

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Research Associate Lisa Brem prepared this case under the supervision of Professors Gregory S. Miller and V.G. Narayanan. This case draws on material from “The Intel Pentium Chip Controversy (A) and (B), “HBS Nos. 196-091 and 196-092, prepared by Research Associate James Evans under the supervision of Professor V.G. Narayanan. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

Copyright © 2001 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

G R E G O R Y S . M I L L E R

V . G . N A R A Y A N A N

Accounting for the Intel Pentium Chip Flaw

What we view as an extremely minor technical problem has taken on a life of its own. —Andrew S. Grove, Chief Executive Officer, Intel Corp.1

In December 1994 IBM stopped shipping personal computers containing the Intel Pentium microprocessor. It supported this action with analysis provided by the IBM Research Division, which indicated that “common spreadsheet programs, recalculating for 15 minutes a day, could produce Pentium-related errors as often as once every 24 days. For a customer with 500 Pentium-based PCs, this could result in as many as 20 mistakes a day....”2

Andrew Grove, Intel’s president and CEO retorted quickly: “[b]ased on the work of our scientists analyzing real world applications, and the experience of millions of users of Pentium processor-based systems, we have no evidence of increased probability of encountering the flaw...You can always contrive situations that force this error. In other words, if you know where a meteor will land, you can go there and get hit.”3

Although Mr. Grove's opinion of the Pentium “bug” was clear, IBM's action forced Intel's top management to address a tough question: Should Intel undertake a broad recall of Pentium Chips?

History

Microprocessing chips are the “brains” of computers sold for both home and business use. Intel was the first, the biggest, and regarded by many as the best microprocessor-maker in the computer industry. Intel's 1993 gross margin of 63% and net margin of 26% were clear indications of the strength of the company (see Exhibit 1 for Intel's recent financial statements). Intel's success was based on constant innovation, huge spending in marketing, production and cycle-time improvement,

1Aaron Zitner, “Consumers get break on computer chip,” The Boston Globe, December 21, 1994, p. 1.

2Bart Ziegler, “IBM, Intel Continue Their Wrangling Over Liability for Pentium Repair Bill,” The Wall Street Journal, December 14, 1994, p .B6.

3[[Intel]] webmaster@www.intel.com, “Tell us what you think!,” Copyright (c) 1994, Intel Corporation. All rights reserved.

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and relentless challenging of copycat competitors by “pummeling rivals in court.”4 Intel’s first microprocessors for computers, the 8086 and 8088 (sold in the first IBM personal computer), were followed by its 80186 (used primarily in controllers), 80286, 80386, and 80486 editions, each with markedly more memory and processing speed than the previous generation (see Exhibit 2). By 1993, when the first Pentium was introduced, a number of competitors—including AMD, Cyrix, and NexGen—were already producing clones of Intel’s 486. These competitors were getting faster at cloning Intel's designs, and the 486 clones appeared on the market much faster than the clones of 386 and 286 chips.

The Pentium had been designed with more testing than any previously produced manufactured product.5 “They ran the hell out of all the software they could find,” said Joseph Costello, CEO of a chip-design software maker.6 A full year of testing involving trillions of random mathematical processes was performed to detect any problems with the chip before and soon after it went on the market; a quadrillion more were performed in the year after that. However, the rollout of any new microprocessor was unavoidably risky since chip-testing technology was a generation behind chip- making technology.

In addition to detailed testing, Intel had strategically prepared this new chip for market with the increased trademark protection available to a name, the “Pentium,” rather than using the 80586 moniker. Intel began to steer the market toward this newer, faster chip—and away from competitors’ clones of prior models—by attempting to convince personal and corporate computer users that the 486 was outmoded. With an advertising blitz estimated at $150 million, the company advertised the logo Intel Inside® and the name Pentium in every available type of media. By the end of September 1994, Intel had shipped nearly two million Pentium chips to computer producers (see Exhibit 3).

The Flaw Discovered

Early in the summer of 1994, mathematics professor Dr. Thomas Nicely of Lynchburg College in Virginia discovered inconsistencies in his calculations performed on his Pentium-driven PC. Nicely was trying to prove that PCs could do mathematical work heretofore only performed on larger systems and thus was involved in intense and continuous number crunching far beyond that of a typical user. Nicely discovered the division flaw occurred only with rare combinations of numbers, and was not in his software, but in the processor of his Pentium.7

The problem arose in the floating-point processing unit of the chip, which handled numbers expressed in scientific notation. At the end of October, Nicely published a note on the Internet querying other users about the Pentium flaw. A discussion soon emerged at the Internet news group “comp.sys.intel.” The tone quickly changed from a calm discussion of arcane technical tests to flaming accusations and threats aimed at Intel.

4Don Clark, “Intel Balks at Replacing Pentium Chip Without Asking Owners Any Questions,” The Wall Street Journal, December 14, 1994, p. A3.

5Jim Carlton and Stephen Kreider Yoder, “Computers: Humble Pie: Intel to Replace Its Pentium Chips,” The Wall Street Journal, December 21, 1994, p. B1.

6Robert D. Hof, “The ‘Lurking Time Bomb’ of Silicon Valley,” Business Week, December 19, 1994, p. 118.

7As one example of the flaw, the solution to the following calculation, 4,195,835—( (4,195,835 / 3,145,727)) x 3,145,727, should be zero, but a computer with the flawed Pentium chip provides an answer of 256: Walter S. Mossberg, “Intel Isn’t Serving Millions Who Bought Its Pentium Campaign,” The Wall Street Journal, December 15, 1994, p. B1.

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On November 7, 1994, an Electrical Engineering Times article by Alexander Wolfe, based on the Internet discussions, prompted Intel’s response that it had uncovered the flaw during tests the previous June. However, Intel had run a series of tests and concluded that an error would occur only once every nine billion random calculations, or every 27,000 years for most users. Further, Intel had remedied the problem for the next planned version of the Pentium, but had not informed customers who had purchased a flawed processor. Following the article, Intel offered to replace the flawed chips, but only on a limited basis: users first had to demonstrate that the flaw was likely to occur in the work they performed on their computer. The Internet discussion group continued to “flame” the company on-line and eventually attracted the attention of reporters. On November 22, 1994, CNN broadcasted a story that revealed the chip flaw for the first time to the general public, Intel’s own computer-making customers, and the rest of the media.

On November 24, the beginning of the Thanksgiving holiday weekend, the front-page of the New York Times Business Section headlined “Flaw undermines the accuracy of Intel’s Pentium.”8 The Boston Globe carried the same story on its front page, and the news continued to unfold over the next month. By November 25 Intel’s stock had dropped two percentage points from its high in late September.

The mounting consumer pressure to fix the Pentium flaw was hitting PC manufacturers as well as Intel. But who would take responsibility for fixing the flaw? Dell, a computer manufacturer, began advertising its Pentium with a built-in computer fix to remedy the latent flaw. On November 28, Sequent, a mainframe manufacturer, stopped shipping Pentium machines until a software solution could be installed.9 On November 30, IBM—a major Intel customer—announced that it would replace the Pentium processor in any of its machines at the customer’s request. IBM, however, did not have Intel’s support to fulfill such a promise and ran the risk of having to purchase replacements on its own account.

As the second week of December passed, the media coverage began to abate and Pentium flaw stories lost their front-page status. December Pentium sales continued to increase as planned, but several thousand Pentium owners were calling Intel daily. Intel rallied over a thousand of its employees to respond to these calls and carefully assess whether the users were performing functions that would be at risk of engaging the flaw in the floating point unit.10

On December 12, 1994, IBM, without prior notice to Intel, dropped a bomb by halting shipments of their Pentium PCs. News coverage and consumer fears re-ignited. IBM claimed that further testing had revealed the bug to be more common than Intel had reported. On certain spreadsheet programs, IBM researchers claimed the problematic number combinations were not random and occurred much more frequently. Calculations for a continuous 15 minutes per day could produce an error once every 24 days. Intel’s stock plummeted $2.50 within an hour of IBM’s announcement. (see Exhibit 4).11

Intel had to decide how to respond to customer demands: should they offer to replace the defective Pentium chips of all concerned users with no-questions-asked. In the week following IBM’s announcement, an Intel crisis team assembled by Grove and made up of several dozen Intel 8John Markhoff, “Circuit Flaw Causes Pentium Chip to Miscalculate, Intel admits,” The New York Times, December 24, 1994, p. B1.

9Don Clark, “Technology and Health: Intel Finds Pumped-Up Image Offers a Juicy Target in Pentium Brouhaha,” The Wall Street Journal, December 5, 1994, p. B5.

10Robert D. Hof, “The Education of Andrew Grove,” Business Week, January 16, 1995, p. 31.

11Peter Lewis, “IBM Deals Blow to a Rival As It Suspends Pentium Sales,” The New York Times, December 13, 1994, p. A1.

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employees drawn from all parts of the company met before and after work each day to analyze and resolve the consumer crisis on their hands.12 An all-day meeting instigated by Grove on Monday, December 17, was “marked...by passionate discussion, the decision to change the policy on the Pentium replacements was adopted and rescinded several times.”13

Costs of Replacement

Clearly, Intel was faced with the prospect of replacing some of the defective chips. Questions remained as to how many of the chips would be replaced, how the replacement would be accomplished, and whether Intel would pay for the labor costs to replace the chips, in addition to the cost of the new chip itself.

Intel had to decide how wide a recall it would offer. It could continue its current policy of providing replacement chips only to customers that demonstrated a need (which one analyst estimated to be about 5% of chips sold),14 loosen these criteria but still require some demonstration of need, or bow to public pressure and unconditionally replace chips on-demand. Of the approximately six million flawed chips sold in 1993 and 1994, one-third were used in businesses.15 Presumably these users would have a higher rate of return than personal users under almost any recall plan.

The actual cost of producing the replacement chip and the accompanying heat sinks (the devices that release heat from operating chips) was estimated to be between $50 and $100 per chip. Other replacement costs, which included the actual labor and incidental costs, were estimated to range from $31 to $750 and average over $400 per chip replaced.16 The amount paid out by Intel depended on what method it used to implement the repair. Intel could pay for the entire cost of accessing the unit, the direct labor to replace the flawed chip, and any shipping or transportation costs incurred by customers. Alternatively, Intel could send the replacement chip to the customers, leaving them to decide how to replace the chip. Another possibility was to negotiate with computer manufacturers and sellers to offer discounted or free replacement service to end-user customers. In any case, the end user seeking replacement would have to bear some costs. One information technology consultancy estimated that “[t]he amount borne by companies in a typical scenario will be $289 per system, including administrative, labor, and downtime costs.”17

Other Potential Costs

Intel had other costs to account for as well. It had produced almost eight million flawed chips, so in addition to the six million chips currently in computers it would need to account for the two million chips in inventory.18

12John Markoff, “ Intel’s Crash Course on Consumers,” The New York Times, December 21, 1994, p. D1.

13Ibid.

14Aaron Zitner, “Pentium flaw not expected to damage Intel financially,” The Boston Globe, November 30, 1994, p. B1.

15Don Clark, “Intel Balks at Replacing Pentium Chip Without Asking Owners Any Questions,” The Wall Street Journal, December 14, 1994, p. A3.

16Brian Gillooly, “The Real Cost—Intel’s ‘free’ Pentium replacement plan may end up costing large users a bundle,” InformationWeek, January 9, 1995, p. 34.

17Ibid.

18Aaron Zitner, “Pentium flaw not expected to damage Intel financially,” The Boston Globe, November 30, 1994, p. B1.

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The potential of lawsuits from consumers, computer manufacturers, and shareholders loomed as an imminent threat. The Wall Street Journal reported that “at least 10 suits in three states” accusing Intel of securities fraud, false advertising, and violation of consumer protection laws, had been filed seeking “hundreds of millions of dollars in damages.” Some suits also looked to force Intel to replace the flawed chips. In addition, attorneys general of four states were in the process of filing suits against Intel on the grounds that the company violated unfair-trade-practices laws. 19

Intel also had to assess the impact on its brand name. The company had spent $500 million from 1992 through 1994 on the “Intel Inside” campaign, which was designed to make the Pentium a household name to personal computer consumers. The brand equity Intel had built through the years was estimated by advertising industry analysts to be worth $6.4 billion.20 Clearly the negative publicity surrounding the flaw had damaged Intel’s reputation, but the extensive coverage in the popular press had increased its name recognition substantially.21

Finally, Intel had projected 1995 Pentium sales of between 22 million and 25 million units,22 a large increase over 1994 projections. Intel claimed that it could replace any defective chips while continuing to meet demand for new orders. In fact, Intel’s new high production Fab 10 facility in Leixlip, Ireland, could produce an estimated 12.5 million Pentium chips per year,23 more than twice the approximately six million defective processors Intel sold in 1993 and 1994.24 Further, Intel had opened or expanded five semiconductor facilities internationally in 1994. Unfortunately the reality of Intel’s manufacturing and upgrading processes required some Intel plants to continue producing defective chips through the first quarter of 1995.25 Thus, it was unclear whether the company could change all production to the new chip and still meet the estimated demand.26

Accounting for the Loss Contingency

While Intel's management struggled to determine a return policy, financial analysts were already attempting to predict the impact on Intel's financial statements. One analyst put the estimated costs of a total recall at between $400 million and $800 million, assuming Intel replaced about 8 million chips, including products sold and chips still in inventory.27 Another analyst suggested that about one-quarter of Intel’s customers would respond to such a replacement-on-demand policy and that this would cost the company about $50 million, not including labor.28 The financial community was closely watching this issue, divided on its importance, and looking to Intel to provide some guidance on the magnitude of the charge. Further, Intel's management would have to determine whether this

19Richard B. Schmidt, “Flurry of Lawsuits Filed Against Intel Over Pentium Flaw,” The Wall Street Journal, December 16, 1994, p. B8.

20Bill Snyder, “The Big Bad Brand; Intel Corp’s $80 million marketing campaign,” PC Week, September 12, 1994, p. A1.

21Laurie Flynn, “The Executive Computer; Intel Looks Beyond the Pentium,” The New York Times, February 26, 1995, p. 15.

22J.J. Lazlo, “Intel Corporation—Company Report,” PaineWebber Inc., January 26, 1995, pp. 7-9; G. Christian Hill, “Computers: Despite Furor, Most Keep Their Pentium Chips,” The Wall Street Journal, April 13, 1995, p. B1.

23Fahnestock & Co. Inc., “Intel Corporation,” The Wall Street Journal Transcript, pp .113, 676.

24J.J. Lazlo, “Intel Corporation—Company Report,” PaineWebber Inc., January 26, 1995, pp. 7-9.

25Carlton and Kreider Yoder, The Wall Street Journal, December 21, 1994, p. B1

26Ibid.

27Aaron Zitner, “Pentium flaw not expected to damage Intel financially,” The Boston Globe, November 30, 1994, p. B1.

28Zitner, “Consumers get break on computer chip,” The Boston Globe, December 21, 1994, p. 62.

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event was significant enough to warrant filing a form 8-K (frequently called a "current report") with the Securities and Exchange Commission.29

Intel's senior management would have to combine their knowledge regarding Intel's plans and expectations with the provisions in Statement of Financial Accounting Standards No. 5 (see Exhibit 5). This standard requires that a charge be recognized in the current financial statements if a loss is both probable and estimable based on the information available prior to a firm's financial year-end (December 31st for Intel). The true impact on Intel would depend not only on the size and implementation of any chip replacement plan, but also on the level at which customers would actually choose to participate in the replacement program. Thus, it could be quite some time before the final impact on Intel was known. Accordingly, even if Intel were to announce a replacement plan, the difficulty in estimating its costs could lead the company to delay financial statement recognition of its eventual costs. However, if Intel concluded the costs were not estimable, Statement No. 5 would still require a disclosure of the situation and discussion of its potential impact on Intel in the 1994 notes to the financial statements. Obviously, the determination of whether a liability exists, and if so, the magnitude of the related expense, would involve a large degree of managerial judgment. While such judgment provided an opportunity to communicate expectations to the financial markets, it also placed management in the difficult position of forecasting several future events. Once a decision was made, its accuracy could be judged only through the passage of time.

29 The 8-K or "current report" is a form filed with the Securities and Exchange Commission and used to publicly announce significant events in a more timely manner than the 10-Q (quarterly financials) or 10-K (annual financials). It is recommended for any significant event and required if there is a change in control of the company, a major purchase or sale of assets, a bankruptcy filing, a change in accountants or a director who has resigned due to a dispute with management. It is generally due with 15 days of the event occurrence (except for a change in auditors, which is due within five days). A voluntary 8-K (i.e., not related to one of the five required events) has no due date, but should be prompt. See "SEC Regulation of Public Companies," Allan B. Afterman, Prentice Hall 1995, for further discussion.

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Exhibit 1 Selected Intel Financial Information (all year's end as of December 31)

(In $ millions-except per share amounts) 1993 1992 1991

Consolidated Statements of Income Net revenues $8,782 $5,844 $4,779

Cost of sales 3,252 2,557 2,316 Gross profit 5,530 3,287 2463 Research and development 970 780 618

Marketing, general and administrative 1,168 1,017 765 Operating costs and expenses 5,390 4,354 3,699 Operating Income 3,392 1,490 1,080

Interest expense (50) (54) (82) Interest income and other, net 188 133 197 Income before taxes 3,530 1,569 1,195

Provision for taxes 1,235 502 376 Net income $2,295 $1,067 $819 Earnings per common and common equivalent share $ 5.20 $ 2.49 $ 1.96 Weighted average common and common equivalent shares outstanding

441 429 418

(In $ millions-except per share amounts) 1993 1992 1991

Balance Sheet Assets – Current Cash and cash equivalents 1,659 1,843 1,519 Other current assets 4,143 2,848 2,085

Total current assets 5,802 4,691 3,604 Property, plant and equipment, net 3,996 2,816 2,163 Long-term investments and other assets 1,546 582 525

Total Assets $11,344 $8,089 $6,292 Liabilities and Stockholders’ Equity Current liabilities 2,433 1,842 1,228

Long-term debt 426 249 363 Deferred tax liabilities and put warrants 297 180 144 Commitments and contingencies Stockholders’ equity: Preferred stock, $.001 par value, 50 shares authorized; none issued

- - -

Common Stock, $.001 par value, 1,400 shares authorized; 418 issued and outstanding in 1993 (419 in 1992) and Capital in excess of par value

2,194 1,776 -

Capital Surplus 1,640 Retained earnings 5,306 3,669 2,777 Other equity 688 373 140

Total stockholders’ equity 8,188 5,818 4,558 Total liabilities and stockholders’ equity $11,344 $8,089 $6,292

Source: Intel Corporation Annual Report, 1994, p. 15; , derived from Disclosure’s SEC Database, accessed January 24, 2001.

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Exhibit 2 Intel's Microprocessor Product History

Product Name Date

Introduced Clock Speed Number of Transistors

Addressable Memory Typical Use

4004 November 1971 108 kilohertz 2,300 640 bytes Arithmetic manipulation in calculator

8008 April 1972 200 kilohertz 3,500 16 kilobytes Dumb terminals, calculators, bottling machines

8080 April 1974 2 megahertz (MHz)

6,000 64 kilobytes Traffic light controller, first PC.

8086/8088 June 1978/June 1979

5 MHz 29,000 1 megabyte Portable computing/IBM PCs and PC clones

80286 February 1982 6 MHz 134,000 16 megabyte PC and PC clones Intel386 DX October 1985 16 MHz 275,000 4 gigabytes Desktop computing Intel486 DX April 1989 25 MHz 1,200,000 4 gigabytes Desktop computing and

servers Pentium March 1993 60 MHz 3,100,000 4 gigabytes Desktops Pentium October 1994 75 MHz 3,200,000 4 gigabytes Desktops and notebooks

Source: , accessed January 24, 2001.

Exhibit 3 Pentium Chip Sales

1993 1994 1995 (Estimated)

Unitsa ASPb Salesc Unitsa ASPb Salesc Unitsa ASPb Salesc

1Q 0.00 0 $0 0.40 625 $250 4.00 341 $1,365 2Q 0.00 0 0 0.80 528 422 5.00 326 1,630 3Q 0.05 660 33 1.50 483 725 6.00 283 1,700 4Q 0.20 665 133 3.00 375 1,125 7.01 268 1,879 Year 0.25 664 166 5.71 442 2,522 21.99 299 6,574

Source: J.J. Laslo, “Intel Corporation Company Report,” PaineWebber Inc., January 26, 1995, pp. 7-9. a Units in millions b Average selling price c Total sales in millions of dollars

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Exhibit 4 Intel's Stock Price Throughout the Controversy

45

50

55

60

65

70

75

10 /1

4

10 /2

1

10 /2

8

11 /4

11 /1

1

11 /1

8

11 /2

5

12 /2

12 /9

12 /1

6

A B C

A/ Octobe r 31: Dr. Nice ly has pos te d inform ation about the flaw on the Inte rne t and s tarte d an active dis cus s ion group. B/ Nove m be r 25: Article in Electri cal Engi neering Ti mes has appe are d, a s tory has be e n broadcas t on CNN and article s have appeare d in the New York Ti mes and Boston Globe . C/ De ce m be r 12: IBM announce s that it has s toppe d s hipm e nts of its com pute rs w ith the flaw e d Pe ntium chip.

Intel Daily Closing Stock Price (1994)

Data Source: Datastream International

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Exhibit 5 Excerpts from Statement of Financial Accounting Standards No. 5; Accounting for Contingencies

For the purpose of this Statement, a contingency is defined as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (hereinafter a "gain contingency") or loss (hereinafter a "loss contingency") to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.

When a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability can range from probable to remote. This Statement uses the terms probable, reasonably possible, and remote to identify three areas within that range, as follows:

a. Probable. The future event or events are likely to occur.

b. Reasonably possible. The chance of the future event or events occurring is more than remote but less than likely.

c. Remote. The chance of the future event or events occurring is slight.

An estimated loss from a loss contingency (as defined in paragraph 1) shall be accrued by a charge to income if both of the following conditions are met:

a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements.a It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.

b. The amount of loss can be reasonably estimated.

If no accrual is made for a loss contingency because one or both of the conditions in paragraph 8 are not met, or if an exposure to loss exists in excess of the amount accrued pursuant to the provisions of paragraph 8, disclosure of the contingency shall be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred. The disclosure shall indicate the nature of the contingency and shall give an estimate of the possible loss or range of loss or state that such estimate cannot be made.

Source: Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, issued March 1975. FASB Statement No. 5, Accounting for Contingencies, is copyrighted by the Financial Accounting Standards Board, 401 Merritt 7, P.O. Box 5116, Norwalk Connecticut 06856-5116, U.S.A. These paragraphs are reprinted with permission. Complete copies of this document are available from the FASB.

aDate of the financial statements means the end of the most recent accounting period for which financial statements are being presented.

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