Vimicro International (VIMC)

Cost of Revenue and Gross Profit

Our cost of revenue primarily consists of costs associated with the fabrication of wafers, the assembly, testing and shipping of our multimedia processors, amortization of costs associated with production masks and tooling and costs of third-party products that we sell to our customers. As we do not have long-term, fixed supply agreements with third-party foundries and assembly and testing companies, our costs for wafer fabrication, assembly and testing are susceptible to changes based on conditions in the global semiconductor market.

Cost of revenue was $86.2 million, $64.3 million and $61.8 million in 2006, 2007 and 2008, respectively. Gross profit margin was 31.9%, 30.7% and 28.5% for the years ended December 31, 2006, 2007 and 2008, respectively.

Semiconductor products and electronic devices into which they are incorporated are typically sold in high volumes and are subject to rapid declines in average selling prices. We have reduced the prices of many of our products in the past to meet market demand, and expect that we will continue to face market driven pricing pressures on our products in the future. Therefore, there is no assurance that we will be able to maintain our gross profit margins in the future.

Cost of Revenue and Gross Profit

Our cost of revenue primarily consists of costs associated with the fabrication of wafers, the assembly, testing and shipping of our multimedia processors, amortization of costs associated with production masks and tooling and costs of third-party products that we sell to our customers. As we do not have long-term, fixed supply agreements with third-party foundries and assembly and testing companies, our costs for wafer fabrication, assembly and testing are susceptible to changes based on conditions in the global semiconductor market. We expect that our cost of revenue will increase as our sales volume increases, offset in part by reduced per-unit costs of wafer fabrication, assembly and testing over larger volume shipments.

Our gross profit margins decreased from 38.1% in 2005 to 31.9% in 2006 primarily due to the decline of the average selling price of our products and the increase in our product mix of the proportion of relatively lower margin products. Our sales of mobile phone multimedia processors, which have lower per-unit margins compared to our PC and embedded notebook camera multimedia processors, increased from 10.7 million units in 2005 to 18.6 million units in 2006. Our sales of third-party sensors increased from 13.6 million units in 2005 to 20.2 million units in 2006, and our gross profit margins on those sales increased in 2006 compared to 2005. This improvement was primarily due to increased sales of new products with greater margins. Our gross profit margins decreased from 31.9% in 2006 to 30.7% in 2007 primarily due to the decline of the average selling price of our products. However the decrease in gross profit margin has been partially offset by a decrease in our

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product mix of the relatively lower margin third-party sensor products. Our sales of third-party sensors decreased from 20.2 million units in 2006 to 16.3 million in 2007, and our sensor business accounted for 20.9% of revenues in 2007, a decrease from 32.4% in 2006.

Semiconductor products and electronic devices into which they are incorporated are typically sold in high volumes and are subject to rapid declines in average selling prices. We have reduced the prices of many of our products in the past to meet market demand, and expect that we will continue to face market driven pricing pressures on our products in the future. Therefore, there is no assurance that we will be able to maintain our gross profit margins in the future.

Cost of Revenue and Gross Profit

Our cost of revenue primarily consists of costs associated with the fabrication of wafers, the assembly, testing and shipping of our multimedia processors, amortization of costs associated with production masks and tooling, and costs of third-party products that we sell to our customers. As we do not have long-term, fixed supply agreements with third-party foundries and assembly and testing companies, our costs for wafer fabrication, assembly and testing are susceptible to changes based on conditions in the global semiconductor market. We expect that our cost of revenue will increase as our sales volume increases, offset in part by reduced per-unit costs of wafer fabrication, assembly and testing over larger volume shipments.

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Our gross profit margins increased from 35.5% in 2004 to 38.1% in 2005 primarily because a significant increase in our sales volume enabled us to obtain a substantial reduction in the per-unit costs for wafer fabrication, assembly and testing of PC and embedded notebook camera multimedia processors and mobile phone multimedia processors. These cost reductions were partially offset by a slight decline in the average selling prices of our products and a decrease in our gross profit margins resulting from a change in our products purchased by our customers. Our gross profit margins decreased from 38.1% in 2005 to 31.9% in 2006 primarily due to the decline of the average selling price of our products and the increase in our product mix of the proportion of relatively lower margin products. Our sales of mobile phone multimedia processors, which have lower per-unit margins compared to our PC and embedded notebook camera multimedia processors, increased from 10.7 million units in 2005 to 18.6 million units in 2006. As we continue to increase shipments of mobile phone multimedia processors, we expect that our average gross profit margins on our multimedia processors will decrease because the mobile phone multimedia processor market is characterized by higher unit shipment volumes but lower gross margins as compared with the PC and embedded notebook camera multimedia processor market. Our sales of third-party sensors increased from 13.6 million units in 2005 to 20.2 million units in 2006, and our gross profit margins on those sales increased in 2006 compared to 2005. This improvement was primarily due to the new products with greater margin.

Semiconductor products and electronic devices into which they are incorporated are typically sold in high volumes and are subject to rapid declines in average selling prices. We have reduced the prices of many of our products in the past to meet market demand, and expect that we will continue to face market driven pricing pressures on our products in the future. Therefore, there is no assurance that we will be able to maintain our gross profit margins in the future.

Cost of Revenue and Gross Profit

Our cost of revenue primarily consists of costs associated with the fabrication of wafers, the assembly, testing and shipping of our multimedia processors, amortization of costs associated with production masks and tooling, and costs of third-party products that we sell to our customers. As we do not have long-term, fixed supply agreements with third-party foundries and assembly and testing companies, our costs for wafer fabrication, assembly and testing are susceptible to changes based on conditions in the global semiconductor market. We expect that our cost of revenue will increase as our sales volume increases, offset in part by reduced per-unit costs of wafer fabrication, assembly and testing over larger volume shipments.

Our gross profit margins increased from 33.7% in 2003 to 35.5% in 2004 primarily due to a substantial increase in our sales of PC and embedded notebook camera multimedia processors from 3.9 million units in 2003 to 15.9 million units in 2004 and the increased revenue contribution from sales of PC and embedded notebook camera multimedia processors, as well as reduced per-unit costs for wafer fabrication, assembly and testing. Our gross profit margins increased from 35.5% in 2004 to 38.1% in 2005 primarily because a significant increase in our sales volume enabled us to obtain a substantial reduction in the per-unit costs for wafer fabrication, assembly and testing of PC and embedded notebook camera multimedia processors and mobile phone multimedia processors. These cost reductions were partially offset by a slight decline in the average selling prices of our products and a decrease in our gross profit margins resulting from a change in our products purchased by our customers. Our sales of mobile phone multimedia processors, which have lower per-unit margins compared to our PC and embedded notebook camera multimedia processors, increased from 845,000 units in 2004 to 10.7 million units in 2005 as a result of our further penetration of the mobile phone market. As we continue to increase shipments of mobile phone multimedia processors, we expect that our average gross profit margins on our multimedia processors will decrease because the mobile phone multimedia processor market is characterized by higher unit shipment volumes but lower gross margins as compared with the PC and embedded notebook camera multimedia processor market. Our sales of third-party sensors increased from 6.7 million units in 2004 to 13.6 million units in 2005, and our gross profit margins on those sales increased in 2005 compared to 2004. This improvement was primarily due to cost reductions we have achieved by working with sensor manufacturers to purchase dies based on our specifications that are designed to provide superior performance with our processors, and then processing these dies into finished products using an outsourced assembly vendor and our internal testing process.

Semiconductor products and electronic devices into which they are incorporated are typically sold in high volumes and are subject to rapid declines in average selling prices. We have reduced the prices of many of our products in the past to meet market demand, and expect that we will continue to face market driven pricing pressures on our products in the future. Therefore, there is no assurance that we will be able to maintain our gross profit margins in the future.