UNITED
      STATES


SECURITIES
      AND EXCHANGE COMMISSION


WASHINGTON,
      D.C.   20549


_____________________________________________





**FORM
      10-K**





xANNUAL
      REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE


SECURITIES
      EXCHANGE ACT OF 1934


for
      the
      fiscal year ended September 30, 2007





or





xTRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES
      EXCHANGE ACT OF 1934


For
      the
      transition period from ____ to ____ .


Commission
      File No. 0-21820


____________________________________________


**KEY
      TECHNOLOGY, INC.**


(Exact
      name of Registrant as specified in its charter)





**Oregon**
              (State
                or jurisdiction of incorporation or organization)
            **93-0822509**
              (I.R.S.
                Employer Identification No.)





**150
                Avery Street**
              **Walla
                Walla, Washington**
              (Address
                of Principal Executive Offices)
            **99362**
              (Zip
                Code)





Registrant’s
      telephone number, including area code:  **(509)
      529-2161**


_____________________________________________


Securities
      registered pursuant to Section 12(b) of the Act:


Title
                of each class
              Common
                Stock, no par value
            Name
                of each exchange on which registered
              Nasdaq
                Global Market





Securities
      registered pursuant to Section 12(g) of the Act:


None





Indicated
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act.    Yes o  No x





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Act    Yes o  No x





Indicate
      by check mark whether the Registrant (1) has filed all reports required to
      be
      filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the Registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.    Yes  ý No o





Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the best
      of Registrant's knowledge, in definitive proxy or information statements
      incorporated by reference in Part III of this Form 10-K or any amendment to
      this
      Form 10-K. [ ]





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer.  See definition of
“accelerated filer” and “large accelerated filer” in Rule 12b-2 of Exchange
      Act.  (Check one):


Large
      accelerated filer o                                                          Accelerated
      filer x                                          Non-accelerated
      filer o





Indicated
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).    Yes o  No x





The
      aggregate market value of the Registrant's common stock held by non-affiliates
      on March 31, 2007 (based on the last sale price of such shares) was
      approximately $77,689,216.





There
      were 5,552,697 shares of the Registrant's common stock outstanding on December
      7, 2007.





**DOCUMENTS
      INCORPORATED BY REFERENCE**


Parts
      of
      Registrant's Proxy Statement dated on or about January 4, 2008 prepared in
      connection with the Annual Meeting of Shareholders to be held on February 6,
      2008 are incorporated by reference into Part III of this
      Report.


Table
          of Contents




**KEY
      TECHNOLOGY, INC.**


**2007
      FORM 10-K**


**TABLE
      OF CONTENTS**





**PART
                I**
            
            **PAGE**Item
                1.
            BUSINESS
            1Item
                1A.
            RISK
                FACTORS
            9Item
                2.
            PROPERTIES
            11Item
                3.
            LEGAL
                PROCEEDINGS
            11Item
                4.
            SUBMISSION
                OF MATTERS TO A VOTE OF SECURITY
                HOLDERS
            11**PART
                II**Item
                5.
            MARKET
                FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER
                MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
            12Item
                6.
            SELECTED
                FINANCIAL DATA
            15Item
                7.
            MANAGEMENT'S
                DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                AND RESULTS OF OPERATIONS
            16Item
                7A.
            QUANTITATIVE
                AND QUALITATIVE DISCLOSURES ABOUT MARKET
                RISK
            27Item
                8.
            FINANCIAL
                STATEMENTS AND SUPPLEMENTARY
                DATA
            29Item
                9.
            CHANGES
                IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
                AND FINANCIAL DISCLOSURE
            56Item
                9A.
            CONTROLS
                AND PROCEDURES
            56**PART
                III**Item
                10.
            DIRECTORS,
                EXECUTIVE OFFICERS AND CORPORATE
                GOVERNANCE
            57Item
                11.
            EXECUTIVE
                COMPENSATION
            57Item
                12.
            SECURITY
                OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
                MANAGEMENT AND RELATED STOCKHOLDER MATTERS
            57Item
                13.
            CERTAIN
                RELATIONSHIPS AND RELATED TRANSACTIONS, AND
                DIRECTOR INDEPENDENCE
            58Item
                14.
            PRINCIPAL
                ACCOUNTANT FEES AND SERVICES
            58**PART
                IV**Item
                15.
            EXHIBITS
                AND FINANCIAL STATEMENT
                SCHEDULES
            58SIGNATURES
            
            61EXHIBIT INDEX
            
            62






Table
          of Contents


**PART
      I**





From
      time
      to time, Key Technology, Inc. (“Key” or the “Company”), through its management,
      may make forward-looking public statements with respect to the Company
      regarding, among other things, expected future revenues or earnings,
      projections, plans, future performance, product development and
      commercialization, and other estimates relating to the Company’s future
      operations.  Forward-looking statements may be included in reports
      filed under the Securities Exchange Act of 1934, as amended (the “Exchange
      Act”), in press releases or in oral statements made with the approval of an
      authorized executive officer of Key.  The words or phrases “will
      likely result,” “are expected to,” “intends,” “is anticipated,” “estimates,”
“believes,” “projects” or similar expressions are intended to identify
“forward-looking statements” within the meaning of Section 21E of the Exchange
      Act and Section 27A of the Securities Act of 1933, as amended, as enacted by
      the
      Private Securities Litigation Reform Act of 1995.





Forward-looking
      statements are subject to a number of risks and uncertainties.  The
      Company cautions investors not to place undue reliance on its forward-looking
      statements, which speak only as to the date on which they are
      made.  Key’s actual results may differ materially from those described
      in the forward-looking statements as a result of various factors, including
      those listed below:


·
            adverse
                economic conditions, particularly in the food processing industry,
                either
                globally or regionally, may adversely affect the Company's
                revenues;


·
            competition
                and advances in technology may adversely affect sales and
                prices;


·
            failure
                of the Company’s new products to compete successfully in either existing
                or new markets;


·
            the
                limited availability and possible cost fluctuations of materials
                used in
                the Company’s products could adversely affect the Company’s gross
                profits;


·
            the
                inability of the Company to protect its intellectual property, especially
                as the Company expands geographically, may adversely affect the Company’s
                competitive advantage; and


·
            intellectual
                property-related litigation expenses and other costs resulting from
                infringement claims asserted against the Company by third parties
                may
                adversely affect the Company’s results of operations and its customer
                relations.





Given
      these uncertainties, readers are cautioned not to place undue reliance on the
      forward-looking statements.  The Company disclaims any obligation
      subsequently to revise or update forward-looking statements to reflect events
      or
      circumstances after the date of such statements or to reflect the occurrence
      of
      anticipated or unanticipated events.








**ITEM
      1.                     BUSINESS.**





**General**





The
      Company was founded in 1948 as a local producer of vegetable processing
      equipment.  The Company has evolved into a worldwide supplier of
      process automation solutions to the food processing industry and other
      industries such as tobacco and pharmaceuticals. The present Company was
      incorporated in 1982 as a result of a management buyout of the predecessor
      organization.





The
      Company and its operating subsidiaries design, manufacture, sell and service
      process automation systems that process product streams of discrete pieces
      to
      improve safety and quality.  These systems integrate electro-optical
      automated inspection and sorting systems with process systems that include
      specialized conveying and preparation equipment. The Company provides parts
      and
      service for each of its product lines to customers throughout the
      world.





Sales
      for
      the year ended September 30, 2007 were $107.5 million compared with $84.8
      million for fiscal 2006.  The Company reported net earnings for fiscal
      2007 of $7.4 million, or $1.37 per diluted share, compared with a net loss
      of
      $793,000, or $0.15 per diluted share, for fiscal 2006.  Export and
      international sales for the fiscal years ended September 30, 2007, 2006 and
      2005
      accounted for 46%, 51% and 52% of net sales in each such year,
      respectively.


1
 Table
          of Contents


**Industry
      Background**





***Food
      Processing Industry***





The
      Company’s primary market is the food processing industry.  Food
      processors must process large quantities of raw product through different
      stages, including sorting to remove foreign material and defective pieces,
      and
      inspection for product quality and safety.  The frequency and severity
      of defects in the raw product is highly variable depending upon local factors
      affecting crops.  Historically, defect removal and quality control in
      the food processing industry have been labor intensive and dependent upon and
      limited by the variability of the work force.  The industry has sought
      to replace manual methods with automated systems that achieve higher yield,
      improve product quality and safety, and reduce costs.





The
      Company’s strategy is to solve processing industry problems of high labor costs,
      inadequate yields and inconsistent quality and safety by providing automated
      inspection systems and process systems.  The Company’s process
      automation systems use advanced optical inspection technology to improve product
      yield (more of the good product recovered) and quality (higher percentage of
      defective product and foreign material removed) over the manual sorting and
      defect removal methods historically used by food processors.  In more
      developed markets, such as those in North America and Western Europe, the
      substitution of automated inspection for manual inspection is well
      underway.  However, processors in these areas remain keenly interested
      in process yield and product quality and safety improvements.





The
      largest markets for the Company’s products have been processors of potatoes,
      vegetables, fruit and snack foods.  The Company believes many
      additional applications for its systems exist in both food and non-food
      markets.





The
      principal potato market served by the Company’s systems is french
      fries.  French fries comprise approximately 90% of the over eight
      billion pounds of frozen potato products processed annually in the United
      States.  The expansion of American-style fast food chains in other
      countries is beginning to result in development of the frozen french fry market
      overseas.  Current domestic investment in new french fry processing
      facilities has flattened relative to historical levels, largely in response
      to
      changing consumer preferences.  However, investments in process yield
      enhancement and in greater process throughputs from existing plants remain
      significant items for the Company and its customers in the potato
      market.  The Company’s recent diversification strategies have resulted
      in less dependence on this industry although it continues to be a strategically
      important market.





The
      Company’s products are used in the fruit and vegetable processing market where
      field-harvested products are cleaned, graded, automatically sorted, blanched
      and
      processed prior to freezing, canning or packaging for sale to institutional
      and
      retail markets.  Principal fruit and vegetable markets for the Company
      are green beans, corn, carrots, peas, onions, apples, pears, cranberries,
      peaches, pre-prepared, ready-to-eat salads and vegetables, dehydrated fruits
      and
      vegetables, and fresh-cut fruit products.





The
      global food processing industry has been in a consolidation period and market
      conditions suggest further consolidation in the future.  The Company
      believes the resulting food processing companies are financially stronger,
      yet
      are faced with the need to improve profitability while satisfying external
      pressures to hold constant or reduce prices for their own products and provide
      safer products to the consuming public.  Since the Company’s equipment
      results in higher process yields, improved product quality and safety, as well
      as reduced processing costs, the Company believes these surviving companies
      will
      have increased interest in the Company’s products to satisfy these needs,
      allowing for expanded sales into the food processing industry in future
      years.  Due to the seasonal nature of the food processing industry,
      the Company does experience some seasonality of orders and
      shipments.  Orders and shipments to this industry in the Company’s
      first fiscal quarter of the year tend to be lower than during the Company’s
      other fiscal quarters.  Demand for the Company’s products remained
      strong during fiscal 2007 due to positive market conditions and new product
      introductions by the Company.




2
 Table
          of Contents


***Non-food
      Industries – Tobacco, Pharmaceuticals and
      Nutraceuticals***





Processors
      in non-food industries also implement systems solutions to reduce costs,
      increase yields, and produce higher quality products.  The Company’s
      primary non-food markets are the tobacco industry and the
      pharmaceutical/nutraceutical industry.





In
      fiscal
      2007, the tobacco industry represented a small share of the Company’s
      sales.  The Company’s products provide tobacco companies sorting
      capability to remove foreign matter from a stream of stripped
      tobacco.





In
      fiscal
      2007, the pharmaceutical and nutraceutical industries represented a small share
      of the Company’s sales.  However, to further its growth strategy, the
      Company continued to expand its line of automation solutions, introducing three
      new product lines to provide more comprehensive solutions to its
      customers.





**Products**





The
      following table sets forth sales by product category for the periods
      indicated:





**Fiscal
                Year Ended September 30,****2007**
            
            
            **2006**
            
            
            **2005****(in
                thousands)**Automated
                inspection systems
            
            $
            46,858
            
            
            
            44
            %
            
            $
            30,264
            
            
            
            36
            %
            
            $
            27,284
            
            
            
            34
            %Process
                systems
            
            
            40,947
            
            
            
            38
            %
            
            
            34,925
            
            
            
            41
            %
            
            
            31,853
            
            
            
            40
            %Parts
                and service/contracts
            
            
            19,735
            
            
            
            18
            %
            
            
            19,651
            
            
            
            23
            %
            
            
            21,185
            
            
            
            26
            %Net
                sales
            
            $
            107,540
            
            
            
            100
            %
            
            $
            84,840
            
            
            
            100
            %
            
            $
            80,322
            
            
            
            100
            %





Service
      and maintenance contracts are less than 10% of total net sales and are therefore
      summarized with parts and service/contracts.





The
      following table sets forth the percent of the total gross margin contributed
      by
      each product category for the periods indicated:




**Fiscal
                Year Ended September 30,****2007**
            
            
            **2006**
            
            
            **2005**Automated
                inspection systems
            
            
            51
            %
            
            
            44
            %
            
            
            41
            %Process
                systems
            
            
            30
            %
            
            
            30
            %
            
            
            28
            %Parts
                and
                service/contracts
            
            
            19
            %
            
            
            26
            %
            
            
            31
            %Total
                gross
                margin
            
            
            100
            %
            
            
            100
            %
            
            
            100
            %





Upgrades
      of automated inspection systems are included with automated inspection
      systems.





***Automated
      Inspection Systems***





Automated
      inspection systems are used in various applications to detect and eliminate
      defects and foreign materials, most often during processing of raw and
      semi-finished products.  The Company’s product families within this
      group include the following:  ADR® automatic
      defect
      removal systems used in the french fry industry; Tobacco SorterTM ® ®


3
 Table
          of Contents


Nearly
      all systems in this group use proprietary linear array, charged coupled device
      ("CCD") monochromatic, color or multi-spectral cameras.  Each of the
      cameras scan the product-streams, which move at 5 to 20 feet per second, at
      the
      rate of 1,500 to 8,000 times per second and can identify defects as small as
      1/128 of an inch (0.17 mm) in diameter.  Systems with monochromatic
      cameras generally are sold at lower price levels and are most effective for
      product that has a marked disparity in shade between the defective and the
      good
      product.  Systems with color cameras are required when a variety of
      defect and product colors occur simultaneously, when the difference in shading
      between the defective and the good product is more subtle, and where shape
      sorting is required.  Multi-spectral systems can utilize infrared or
      ultraviolet technologies, individually or in combination with visible light,
      to
      identify defects that may not be detectable by using solely visible light
      spectra.





*Tegra
      System.*  Tegra is the Company’s highest capacity optical sorter
      and provides accurate in-air defect removal.   Tegra incorporates
      object-based sorting technology that recognizes not only color and size, but
      also shape characteristics.  This capability provides a solution to
      previously difficult sorting problems, such as differentiation between green
      beans and green bean stems.  Tegra, as with all sorters, incorporates
      KeyWare®
      software that substantially reduces operational complexity.  KeyWare
      consists of application packs, each specifically designed for a single product
      category that, together with the system’s computer hardware capability and
      networking software, support all standard factory control and automation
      interfaces.  These features allow Tegra to establish data connectivity
      and communication with a processing plant's computer network
      system.  Certain present and potential applications for Tegra systems
      include potato products, green beans, dried beans, corn, carrots, peas, spinach
      and other leafy vegetables, pears, nuts, grains, coffee, recycled commodities
      such as paper and plastic, and tobacco.





*Optyx
      System*.  The Optyx family of sorters provides a unique
      combination of on-belt and in-air sorting and offers multiple sensor
      capabilities with cameras, lasers, or a combination of cameras and
      lasers.  The lower cost Optyx 3000 series has the power and sorting
      capabilities of a larger sorter in an economical and compact
      machine.  It is ideal for smaller processors and lower volume
      processing lines which are unable to justify the expense of a larger
      sorter.





In
      2005,
      Key added laser-sensing technology to its optical inspection capabilities,
      enabling improved foreign material detection and removal based on differences
      in
      the optical properties of materials, regardless of color.  Raptor
      Laser Technology was first available in the Optyx 3000 Series Sorter, which
      combines Key’s proprietary state-of-the-art G6 color cameras and powerful G6
      sorting platform with laser technology.  In fiscal 2006, the Company
      introduced Raptor Laser Technology in the high-volume Optyx 6000 Series
      Sorter.  The larger Optyx 6000 series sorter provides customers with a
      mid-size sorting option with greater throughput.  Featuring a
      doublewide platform that uses Key’s G6 engine, Optyx 6000 Raptor detects the
      smallest defects and foreign material to optimize product quality and maximize
      food safety at double the throughput of an Optyx 3000.  As the first
      wide-belt laser sorter to maintain the high resolution of the finest narrow-belt
      laser sorters, it can sort fresh, frozen and dried fruits and vegetables,
      including frozen potato products, tree nuts, raisins and other food products
      at
      production rates of up to 40,000 pounds (approximately 18 metric tons) per
      hour,
      depending on the application.





In
      2007,
      FluoRaptorTM
      was added to the Optyx product family.  FluoRaptor, a
      fluorescence-sensing laser, is designed to maximize the detection and removal
      of
      defects, extraneous vegetable matter, and foreign material (FM) based on
      differing levels of chlorophyll, and is ideal for the fresh-cut and vegetable
      industries.





Optyx
      series sorters employ a novel broad-band illumination system and are designed
      to
      require minimal maintenance.  The Optyx line of sorters has gained
      strong acceptance in segments of the fruit, vegetable, processed potato, dried
      fruit and nut, and snack food markets. Additionally, Optyx has been placed
      in
      applications inspecting pharmaceuticals, nutraceuticals, plastics, tobacco,
      and
      paper.





*Tobacco
      Sorter 3.*  The tobacco industry has special requirements in the
      handling and sorting of its tobacco products, which vary in size and moisture
      content and other properties depending upon the type of product being produced
      and the point of handling and inspection.  Key’s Tobacco Sorter 3
      (TS3), utilizes a specially constructed frame, enclosure, and material handling
      arrangement to meet the specific product inspection requirements of this
      industry.  TS3 has been installed in North America, Latin America,
      Europe and Asia.


4
 Table
          of Contents


*ADR
      System.*  The Company’s ADR systems are used to transport, inspect
      and remove defects from French fries.  The Company believes its ADR
      system is the principal optical inspection and defect removal system used in
      the
      French fry processing industry.  The Company’s full-capacity ADR
      systems can process up to 27,000 pounds of product per hour.  The most
      recent version, introduced in fiscal 2006, is ADR®5, a combination
      of
      the well-proven conveying and fry alignment system of ADR® III with
      the G6
      engine, improved cutting subsystem and LED lighting including infrared. LED
      lighting provides a high level of output stability, both spectral and intensity,
      with extremely low maintenance cost.  The improved cutting subsystem
      enables the system to cut excessively long fries to control product length,
      a
      function especially valuable for fast-food products.  The ADR 5 system
      is available both as a new system as well as an upgrade to existing ADR® II and
      ADR III
      installations.





*Pharmaceutical
      and Nutraceutical Inspection Systems.*  In fiscal 2007, the
      Company introduced the OptyxSG/P and OptyxSG/N inspection systems, the
      ImpulseTM size
      grading system, and the PulseScrubberTM softgel
      polishing
      system.





Introduction
      of the OptyxSG/P enables the Company to offer a fully 21CFR11-compliant,
      high-volume inspection solution to solid dose pharmaceutical
      manufacturing.  Applicable to OTC (over the counter) and prescription
      drugs, the OptyxSG/P meets validation requirements pharmaceutical customers
      face
      when selecting automation for their FDA-regulated production
      lines.  The Company shipped the first OptyxSG/P in the third fiscal
      quarter.  Also introduced in 2007 was the OptyxSG/N, a replacement for
      the original OptyxSG, targeted at the nutraceutical market.  The /N
      version includes many of the features of the /P without the specific
      enhancements required for the regulated pharmaceutical market.  The
      Company shipped the first OptyxSG/N in the fourth quarter of fiscal
      2007.





With
      the
      introduction of the Impulse/P solid dose size grading product line, the Company
      continued to build toward a more comprehensive “full line”
solution.  The Impulse/P, derived from the Company’s Impulse vibratory
      conveyor technology, provides high-volume vibratory size grading that
      complements other automation solutions like the OptyxSG-series.  First
      shipments of the Impulse/P began in the third quarter of fiscal
      2007.





The
      PulseScrubber product, introduced in the fourth quarter of fiscal 2007, is
      targeted at the softgel manufacturing segment and provides a fully-automated,
      high-volume continuous-flow alternative to traditional batch-oriented softgel
      polishing.  The Company expects first shipments in early calendar
      2008.  Like the Impulse/P, the PulseScrubber complements other systems
      to provide customers the economic benefits of highly-integrated continuous
      automation.





The
      Company’s Vantyx® inspection
      system
      is a product developed for inspection of blister-packed solid dose
      pharmaceuticals.  Using patented spatial color analysis technology,
      this product line inspects solid-dose pharmaceuticals for broken or missing
      pieces, foreign products, discoloration or coating defects, as well as the
      integrity of capsules.  The pharmaceutical inspection system also
      verifies and detects color, size, location and shape defects at processing
      rates
      of over one million pieces per hour.





*Upgrades.*The Company has a large installed base of inspection and processing
      systems. This installed base generates potential business for the Company’s
      upgrade products.  In contrast to the acquisition of new inspection
      and processing systems products, upgrades can provide the customer with a less
      capital intensive alternative.





The
      Company believes that there is an opportunity for the sale of upgrade product
      offerings to its customers so that newer technology with advanced features,
      lower cost, greater reliability, and performance enhancements can benefit owners
      of Key systems.  The Company has increased its investment in
      development of specific upgrade products, particularly the G6 vision engine
      which creates upgrade opportunities for many customers in its installed base
      of
      sorting systems.





***Process
      Systems***





Conveying
      and process systems are utilized worldwide throughout processing industries
      to
      move and process product within a production plant.  The Company’s
      conveying and process systems include the SmartShaker® vibratory
      solutions
      of Iso-Flo® and
      ImpulseTM
      branded conveyor systems, Farmco rotary grading systems, Turbo-


5
 Table
          of Contents


Flo®
      steam blanchers,
      FortéTM
      Process Control systems, Freshline product family for fresh-cut, and additional
      conveying and processing equipment.  The functions of these product
      lines include conveying, transferring, distributing, aligning, feeding,
      metering, separating and grading, as well as blanching, cooking, pasteurizing,
      cooling, cleaning, washing and drying.  The process systems group
      includes standard products as well as custom designed equipment.





*Iso-Flo
      Vibratory Conveying Systems.*  The Company’s principal specialized
      conveying system is its Iso-Flo vibratory conveyor system.  The
      Iso-Flo conveyor is a type of pan conveyor.  Pan conveyors are common
      throughout industries that process product streams of discrete pieces, including
      the food processing industry.  Pan conveyors move product pieces by
      vibrating the pan at high frequency along a diagonal axis, upward and
      forward.  This action propels the product ahead in small increments
      and distributes it evenly for close control of movement and
      presentation.





Iso-Flo
      systems are used in a variety of processing applications, including potato
      products, vegetables and fruits (green beans, peas, carrots, corn, peaches,
      pears, cranberries and apples), snack foods, cereals, fresh salads, cheese,
      poultry, and seafood.  Non-food processing applications include
      nutraceuticals, tobacco, pet food and plastics.





*Impulse*
      is a line of nearly silent electromagnetic vibratory conveyors which combine
      the
      advantage of quick start/stop with precise metering
      control.  Additionally, the Impulse conveyor drive systems are
      oil-free, which limits the potential for contamination and improves the safety
      of food products.  This conveyor system was developed for packaging
      applications in snack food, dry ingredient, chemical and pharmaceutical
      processing, but is seeing increased application in a wide variety of food and
      industrial processes.





*Rotary
      grading systems.*The mechanical sizing, sorting, separating, and grading
      products sold under the Farmco brand name are used in many food processing
      and
      fresh vegetable packing operations.  These rotary sizing and grading
      technologies optimize yield, increase packaging efficiency, and improve product
      quality by either removing oversized, undersized and small irregular-shaped
      pieces of product from the line or separating product into predetermined size
      categories.  In combination with other Company-provided equipment,
      these products increase overall line efficiency and systems
      capability.





*Turbo-Flo
      and Preparation Systems*.  The Company designs and manufactures
      preparation systems to prepare products prior to cooking, freezing, canning
      or
      other processing.  Products in this group include the Turbo-Flo
      Blancher/Cooker/Pasteurizer, air cleaners, air coolers, vegetable metering
      and
      blending systems, and bulk handling equipment.  These products
      represent the Company’s most mature product line.  Sales of these
      products over the years have formed a customer base for sales of other Company
      products and are also establishing a customer base in developing geographic
      markets.





Preparation
      system revenues may also include a variety of third-party supplied equipment
      and
      installation services which are sold as components of larger processing lines,
      for which the Company has assumed turn-key sales responsibility.  In
      addition, the process systems group includes other custom designed conveying
      and
      raw food sizing, grading, and preparation equipment.





*Forté
      Control Systems.* The Company’s primary offering in the area of process
      control for processing systems, Forté, provides a foundation for a wide range of
      control options for processing lines, from simple on/off commands to data
      logging and recipe entry.  This product is complementary to the
      Company’s primary equipment lines.





*Freshline
      products*.  The Company’s product line addresses the fresh-cut
      food industry and includes high volume automatic dryers, as well as a range
      of
      processing solutions from individual machines to large-scale production lines
      with automated control systems.





***Parts
      and Service/Contracts***





The
      Company has a large installed base of inspection and processing systems. This
      installed base generates potential business for the Company’s parts and service
      products.  The Company has made parts and service an
      area


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of
      strategic focus, and realigned its organization to leverage the large installed
      base and its strong customer support organization.





The
      Company provides spare parts and post-sale field and telephone-based repair
      services to support its customers’ routine maintenance requirements and seasonal
      equipment startup and winterization processes.  The Company considers
      its parts and maintenance service sales to be important potential sources of
      future revenue growth.  The Company continues to realign its service
      organization so that field service personnel are now geographically located
      closer to its customers throughout the world.  This strategy has
      contributed to revenue growth and improved gross margins in parts and
      service.  The Company also typically provides system installation
      support services which are included in the sales price of certain of its
      products, principally automated inspection systems, and customer
      training.





**Engineering,
      Research and Development**





At
      September 30, 2007, the Company’s research and development department had
      33 employees who conduct new product research and development and
      sustaining engineering for released products.  The Company’s technical
      staff includes electronic, optical, mechanical and software engineers,
      mathematicians and technical support personnel.





The
      Company’s project engineering department had 46 employees engaged in project
      engineering for custom systems.  The project engineering teams are
      responsible for engineering and designing the details of each custom
      order.  A document control team maintains and controls product
      documentation and the product modeling database for the development engineering
      and project engineering teams as well as the manufacturing
      department.





In
      fiscal
      2007, the Company’s research and development expenses, together with engineering
      expenses not applied to the manufacturing costs of products, were approximately
      $5.5 million, compared to $6.4 million and $5.1 million in 2006 and 2005,
      respectively.





**Manufacturing**





The
      Company maintains two domestic manufacturing facilities, one located in Walla
      Walla, Washington and one in Redmond, Oregon.  The Company also has a
      European manufacturing facility located in The Netherlands.  The
      Company’s current manufacturing facilities and its product design and
      manufacturing processes integrate Computer Aided Engineering (CAE), Finite
      Element Analysis (FEA), Computer Aided Design (CAD), Computer Aided
      Manufacturing (CAM) and Computer Integrated Manufacturing (CIM)
      technologies.  Manufacturing activities include process engineering;
      fabrication, welding, finishing, and assembly of custom designed stainless
      steel
      systems; camera and electronics assembly; subsystem assembly; and system test
      and integration.  The Company manufactures specific products in the
      following locations:





**Location**
            **Size
                in Square Feet**
            **Products/Services
                Produced**Walla
                Walla, Washington
            173,000
            Automated
                Inspection
              Process
                Systems
              Parts
                and ServiceRedmond,
                Oregon
            19,000
            Process
                Systems
              Parts
                and ServiceBeusichem,
                The Netherlands
            45,000
            Process
                Systems
              Parts
                and ServiceBeusichem,
                The Netherlands
            18,000
            Parts
                Warehouse
              Future
                Manufacturing Expansion





The
      Company manufactures certain of its products to Underwriters Laboratories and
      United States Department of Agriculture standards.  Certain of the
      Company’s products also comply with the Canadian Standards
      Association


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(CSA),
      European CE (Conformité Européene) and Electronic Testing Laboratory (ETL)
      safety standards.  The Company’s domestic facilities were recertified
      to the ISO 9001:2000 standard in 2006.





Certain
      components and subassemblies included in the Company’s products are obtained
      from limited-source or sole-source suppliers.  The Company attempts to
      ensure that adequate supplies are available to maintain manufacturing
      schedules.  Although the Company seeks to reduce its dependence on
      limited- and sole-source suppliers, the partial or complete loss of certain
      sources of supply could have an adverse effect on the Company’s results of
      operations and relations with customers.  During fiscal 2007 and 2006,
      the Company experienced higher component costs and reduced margins on certain
      product lines due to the worldwide shortage of stainless steel.





**Environmental**





The
      Company has not received notice of any material violations of environmental
      laws
      or regulations in on-going operations at any of its manufacturing
      locations.





**Sales
      and Marketing**





The
      Company markets its products directly and through independent sales
      representatives.  In North America, the Company operates sales offices
      in Walla Walla, Washington; Medford, Oregon; Redmond, Oregon; and Santiago
      de
      Querétaro, Mexico.  The Company’s subsidiary, Key Technology B.V.,
      provides sales and service to European and Middle Eastern and South African
      customers.  The Company’s subsidiary, Key Technology Australia Pty
      Ltd., provides sales and service to customers primarily in Australia and New
      Zealand.  The Company’s subsidiary Productos Key Mexicana S. de R.L.
      de C.V. provides sales and service to customers in Mexico, Central and South
      America.  The Company’s subsidiary, Key Technology (Shanghai) Trading
      Company Ltd., provides sales and service to customers in greater
      China.  The Company supplies products from both product groups -
      automated inspection systems and process systems - to customers in its primary
      markets through common sales and distribution channels.  In addition,
      the Company supplies parts and service through its worldwide service
      organization.





Most
      exports of products manufactured in the United States for shipment into
      international markets other than Europe and Australia have been denominated
      in
      U.S. dollars.  Sales into Europe of systems, spare parts and service,
      as well as products manufactured in Europe, are generally denominated in
      European currencies, most commonly Euros.  Sales into Australia are
      typically denominated in its local currency.  In its export and
      international sales, the Company is subject to the risks of conducting business
      internationally, including unexpected changes in regulatory requirements;
      fluctuations in the value of the U.S. dollar, which could increase or decrease
      the sales prices in local currencies of the Company’s products in international
      markets; tariffs and other barriers and restrictions; and the requirements
      of
      complying with a variety of international laws.  Additional
      information regarding export and international sales is set forth in Note 15
      to
      the Company’s Consolidated Financial Statements for the fiscal year ended
      September 30, 2007.





During
      fiscal 2007, 2006 and 2005, sales to our largest customer, McCain Foods,
      represented approximately 9%, 17% and 16% of total net sales,
      respectively.  While the Company believes that its relationship with
      McCain is satisfactory, the loss of this customer could have a material adverse
      effect on the Company’s revenues and results of operations.





**Backlog**





The
      Company’s backlog as of September 30, 2007 and September 30, 2006 was
      approximately $30.9 million and $22.8 million, respectively.  The
      Company schedules production based on firm customer commitments and forecasted
      requirements.  The Company includes in backlog only those customer
      orders for which it has accepted purchase orders.





**Competition**





The
      markets for automated inspection systems and process systems are highly
      competitive.  Important competitive factors include price,
      performance, reliability, and customer support and service.  The
      Company believes


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that
      it
      currently competes effectively with respect to these factors, although there
      can
      be no assurance that existing or future competitors will not introduce
      comparable or superior products at lower prices.  Certain of the
      Company’s competitors may have substantially greater financial, technical,
      marketing and other resources.  The Company’s principal competitors
      are believed to be FMC Technologies, Inc., Heat & Control, Inc. and its
      subsidiaries, BEST N.V., Sortex Ltd. and Kiremko B.V.  The Company has
      encountered additional small competitors entering its markets, including the
      introduction of potentially competing tobacco sorters into the Chinese market
      manufactured by Chinese companies.  As the Company enters new markets,
      it expects to encounter additional new competitors.





**Patents
      and Trademarks**





The
      Company currently holds forty-eight United States patents issued from 1989
      through 2007, and eleven other national patents issued by other
      countries.  The first of these patents expires in calendar 2008, and
      the Company believes that expiration will not have a significant effect on
      the
      Company.  As of December 7, 2007, nineteen other national patent
      applications have been filed and are pending in the United States and other
      countries and two international or regional applications have been filed that
      are awaiting the national phase.  The Company has thirty-three
      registered trademarks and eight pending applications for
      trademarks.





The
      Company also attempts to protect its trade secrets and other proprietary
      information through proprietary information agreements and security measures
      with employees, consultants and others.  The laws of certain countries
      in which the Company’s products are or may be manufactured or sold may not
      protect the Company’s products and intellectual property rights to the same
      extent as the laws of the United States.





**Employees**





At
      September 30, 2007, the Company had 532 full-time employees, including 263
      in
      manufacturing, 79 in engineering, research and development, 135 in marketing,
      sales and service, and 55 in general administration and finance.  A
      total of 143 employees are located outside the United States.  The
      Company utilizes temporary contract employees, which improves the Company’s
      ability to adjust manpower in response to changing demand for Company
      products.  Of the total employees at September 30, 2007, twenty-six
      were contract employees.  None of the Company’s employees in the
      United States are represented by a labor union.  The manufacturing
      employees located at the Company’s facility in Beusichem, The Netherlands are
      represented by the Small Metal Union.  The Company has never
      experienced a work stoppage, slowdown or strike.





**Available
      Information**





The
      Company’s annual and quarterly reports and other filings with the United States
      Securities and Exchange Commission (“SEC”) are made available free of charge
      through the Investor Relations section of the Company’s website at www.key.net
      as soon as reasonably practicable after the Company files such material with
      the
      SEC.  The information on or that can be accessed through the Company’s
      website is not a part of this Annual Report on Form 10-K.








**ITEM
      1A.                     RISK
      FACTORS.**





In
      addition to the other information in this Annual Report on Form 10-K, the
      following risk factors should be considered carefully in evaluating the Company
      and its business because such factors may have a significant effect on its
      operating results and financial condition.  As a result of the risk
      factors set forth below and the information presented elsewhere in this Annual
      Report on Form 10-K, actual results could differ materially from those included
      in any forward-looking statements.





**Adverse
      economic conditions in the food processing industry, either globally or
      regionally, may adversely affect the Company's
      revenues.**


The
      markets the Company serves, particularly the food processing industry, are
      experiencing variable economic conditions.  The U.S. and European
      markets in the food processing industry are not growing and are
      experiencing


9
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consolidation. 
      Additionally, varying consumer demand, product supply, and plant capacity,
      most
      notably in the potato market, could result in reduced or deferred capital
      equipment purchases for the Company’s product lines.  While the
      Company has reacted to these developments with applications directed to the
      growing fresh vegetable and fruit industries as well as the pharmaceutical
      and
      nutraceutical industries, loss of business, particularly in the potato industry,
      would have a negative effect on the Company’s sales and net
      earnings.





**Competition
      and advances in technology may adversely affect sales and
      prices.**





The
      markets for the Company’s products are highly competitive.  Advances
      in technology may remove some barriers to market entry, enabling additional
      competitors to enter the Company’s markets.  Such additional
      competition could force the Company to reduce prices to remain competitive,
      and
      decrease the Company’s profits, having a material adverse affect on the
      Company’s business and financial condition.  There can be no assurance
      that the Company will be able to continue to compete effectively in the
      future.





**The
      Company’s new products may not compete successfully in either existing or new
      markets.**





The
      future success and growth of the Company is dependent upon its ability to
      develop, market, and sell products and services in certain food processing
      markets as well as to introduce new products into other existing and potential
      markets.  There can be no assurance the Company can successfully
      penetrate these potential markets or expand into new international markets
      with
      its current or new products.





**The
      limited availability and possible cost fluctuations of materials used in the
      Company's products could adversely affect the Company's
      business.**





Certain
      of the components, subassemblies and materials for the Company’s products are
      obtained from single sources or a limited group of
      suppliers.  Although the Company seeks to reduce dependence on sole or
      limited source suppliers, the partial or complete loss of certain of these
      sources could have an adverse effect on the Company’s results of operations and
      customer relationships.  In addition, certain basic materials, such as
      stainless steel, are used extensively in the Company’s product fabrication
      processes.  Such basic materials may also be subject to worldwide
      shortages or price fluctuations related to the supply of or demand for raw
      materials, such as nickel, which are used in their production by the Company’s
      suppliers.  A significant increase in the price or decrease in the
      availability of one or more of these components, subassemblies or basic
      materials could also adversely affect the Company’s results of
      operations.  The high price of stainless steel worldwide in fiscal
      2006 and 2007 resulted in higher component costs and reduced margins on certain
      product lines.





**The
      inability to protect its intellectual property, especially as the Company
      expands geographically, may adversely affect the Company's competitive
      advantage.**





The
      Company’s competitive position may be affected by its ability to protect its
      proprietary technology.  The Company has obtained certain patents and
      has filed a number of patent applications.  The Company also
      anticipates filing applications for protection of its future products and
      technology.  There can be no assurance that any such patents will
      provide meaningful protection for the Company’s product innovations, or that the
      issuance of a patent will give the Company any material advantage over its
      competition in connection with any of its products.  The Company may
      experience additional intellectual property risks in international markets
      where
      it may lack patent protection.  The patent laws of other countries,
      such as China, may differ from those of the U.S. as to the patentability of
      the
      Company’s products and processes.  Moreover, the degree of protection
      afforded by foreign patents may be different from that of U.S.
      patents.





**Intellectual
      property-related litigation expenses and other costs resulting from infringement
      claims asserted against the Company by third parties may adversely affect the
      Company’s results of operations and its customer
      relations.**


The
      technologies used by the Company may infringe the patents or proprietary
      technology of others.  In the past, the Company has been required to
      initiate litigation to protect its patents.  The cost of enforcing the
      Company’s patent rights in lawsuits that it may bring against infringers or of
      defending itself against infringement charges by




10
 Table
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other
      patent holders or other third parties, including customers, may be high and
      could have an adverse effect on the Company’s results of operations and its
      customer relations.





**ITEM
      2.                    PROPERTIES.**





The
      Company owns or leases the following properties:





**Location**
            **Purpose**
            **Square
                Feet**
            **Owned
                or Leased**
            **Lease
                Expires**
            **Renewal
                Period**Walla
                Walla, Washington
            Corporate
                office, manufacturing, research and development, sales and marketing,
                administration
            173,000
            Leased
                with option to purchase within the lease term
            2020
            NoneRedmond,
                Oregon
            Manufacturing,
                research and development, sales, administration
            19,000
            Leased
            2012
            2017Beusichem,
                The Netherlands
            Manufacturing,
                sales and marketing, administration
            45,000
            Leased
            2008
            2013Beusichem,
                The Netherlands
            Parts
                warehouse, future manufacturing expansion
            18,000
            Owned
            n/a
            n/a





The
      Company also has leased office space for sales and service and other activities
      in Medford, Oregon, Dingley, Australia, Shanghai, China, Santiago de Querétaro,
      Mexico and Rotselaar, Belgium.





The
      Company considers all of its properties suitable for the purposes for which
      they
      are used.





**ITEM
      3.                      LEGAL
      PROCEEDINGS.**





From
      time-to-time, the Company is named as a defendant in legal proceedings arising
      out of the normal course of its business.  As of December 7, 2007, the
      Company was not a party to any material legal proceedings.





**ITEM
      4.                      SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY HOLDERS.**





None.




11
 Table
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**PART
      II**





**ITEM
                5.**
            **MARKET
                FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER
                MATTERS AND ISSUER PURCHASES OF EQUITY
                SECURITIES.**




*Common
      Stock*





Shares
      of
      the Company’s common stock are quoted on the Nasdaq Global Market under the
      symbol “KTEC”.  The following table shows the high and low bid prices
      per share of the Company’s common stock by quarter for the two most recent
      fiscal years ending with the month of July 2006 and shows the high and low
      sales
      prices per share of the Company’s common stock for August 2006 - September 30,
      2007:





Stock
                price by quarter
            
            High
            
            
            LowFiscal
                year ended September 30, 2007First
                Quarter
            
            $
            15.230
            
            
            $
            11.311Second
                Quarter
            
            
            16.870
            
            
            
            13.500Third
                Quarter
            
            
            23.100
            
            
            
            15.190Fourth
                Quarter
            
            
            30.950
            
            
            
            21.170Fiscal
                year ended September 30, 2006First
                Quarter
            
            $
            15.000
            
            
            $
            12.250Second
                Quarter
            
            
            13.175
            
            
            
            11.180Third
                Quarter
            
            
            12.860
            
            
            
            11.500Fourth
                Quarter
                (July)
            
            
            13.400
            
            
            
            12.050Fourth
                Quarter (August –
                September)
            
            
            13.330
            
            
            
            10.700





The
      source of these quotations for the Company’s common stock was the Nasdaq
      OnlineSMInternet
      site.





The
      Company had approximately 1,570 beneficial owners of its common stock, of which
      201 are of record, as of December 7, 2007.





The
      Company has not historically paid dividends on its common or preferred
      stock.  The Board of Directors presently intends to continue its
      policy of retaining earnings for reinvestment in the operations of the
      Company.  The current credit facility with the Company’s principal
      domestic bank restricts the payment of dividends.





Issuer
      Purchases of Equity Securities





The
      following table provides information about purchases made by or on behalf of
      the
      Company during the quarter ended September 30, 2007 of equity securities
      registered by the Company under Section 12 of the Securities Exchange Act of
      1934.




Stock
                  Repurchase Program (1)Period
              
              Total
                  Number of Shares Purchased
              
              Average
                  Price Paid per Share
              
              Total
                  Number of Shares Purchased as Part of Publicly Announced Plans
                  or
                     Programs
              
              Maximum
                  Number of Shares that May Yet Be Purchased Under the Plans or
                  ProgramsJuly
                  1 - 31, 2007
              
              
              0
              
              
              
              
              0August
                  1 - 31, 2007
              
              
              0
              
              
              
              
              0September
                  1 - 30, 2007
              
              
              0
              
              
              
              
              0Total
              
              
              0
              
              
              
              
              0
              
              411,748
  12
 Table
            of Contents


(1)           The
      Company initiated a stock repurchase program effective November 27,
      2006.  The Company may purchase up to 500,000 shares of its own common
      stock under the program.


13
 Table
          of Contents


STOCK
      PERFORMANCE GRAPH





COMPARISON
      OF FIVE-YEAR CUMULATIVE TOTAL RETURN


AMONG
      KEY
      TECHNOLOGY, INC., A PEER GROUP, AND THE RUSSELL MICROCAP INDEX









**TOTAL
                RETURN ANALYSIS**9/30/2002
            9/30/2003
            9/30/2004
            9/30/2005
            9/30/2006
            9/30/2007**Key
                Technology**
            **$   100.00**
            **$   236.91**
            **$   224.55**
            **$   283.43**
            **$   255.09**
            **$   600.80****Peer
                Group**
            **$   100.00**
            **$   148.70**
            **$   228.49**
            **$   262.75**
            **$   286.21**
            **$   512.40****Russell
                Microcap**
            **$   100.00**
            **$   154.27**
            **$   177.18**
            **$   207.28**
            **$   221.83**
            **$   243.31**





**PEER
      GROUP:  Cognex Corp., Perceptron, Inc., Flir Systems, Inc., Flow
      International Corp., Elbit Vision Systems Ltd., PPT Vision, Inc., Robotic Vision
      Systems, Inc., FMC Technologies, Inc.**




14
 Table
          of Contents


**ITEM
                6.**
            **SELECTED
                FINANCIAL DATA.**





The
      selected consolidated financial information set forth below for each of the
      five
      years in the period ended September 30, 2007 has been derived from the audited
      consolidated financial statements of the Company.  The information
      below should be read in conjunction with Management's Discussion and Analysis
      of
      Financial Condition and Results of Operations and the Company’s Consolidated
      Financial Statements and Notes thereto as provided in Item 7 and Item 8 of
      this
      Annual Report on Form 10-K, respectively.




**Fiscal
                  Year Ended September 30,****2007**
              
              
              **2006**
              
              
              **2005**
              
              
              **2004**
              
              
              **2003****(in
                  thousands, except per share data)****Statement
                  of Operations Data:**Net
                  sales
              
              $
              107,540
              
              
              $
              84,840
              
              
              $
              80,322
              
              
              $
              80,610
              
              
              $
              82,622Cost
                  of
                  sales
              
              
              66,099
              
              
              
              53,041
              
              
              
              49,145
              
              
              
              46,887
              
              
              
              48,626Gross
                  profit
              
              
              41,441
              
              
              
              31,799
              
              
              
              31,177
              
              
              
              33,723
              
              
              
              33,996Operating
                  expenses
              
              
              32,839
              
              
              
              31,743
              
              
              
              27,193
              
              
              
              28,295
              
              
              
              25,221Gain
                  on sale of
                  assets
              
              
              23
              
              
              
              109
              
              
              
              28
              
              
              
              5
              
              
              
              4Income
                  from
                  operations
              
              
              8,625
              
              
              
              165
              
              
              
              4,012
              
              
              
              5,433
              
              
              
              8,779Other
                  income
                  (expense)
              
              
              1,961
              
              
              
              (980
              )
              
              
              (419
              )
              
              
              (132
              )
              
              
              (327
              )Earnings
                  (loss) from continuing operations before income taxes
              
              
              10,586
              
              
              
              (815
              )
              
              
              3,593
              
              
              
              5,301
              
              
              
              8,452Income
                  tax (benefit)
                  expense
              
              
              3,176
              
              
              
              (22
              )
              
              
              902
              
              
              
              1,617
              
              
              
              2,693Net
                  earnings
              
              
              7,410
              
              
              
              (793
              )
              
              
              2,691
              
              
              
              3,684
              
              
              
              5,759Assumed
                  dividends on mandatorily redeemable preferred stock
              
              
              --
              
              
              
              --
              
              
              
              (33
              )
              
              
              (69
              )
              
              
              (132
              )Accretion
                  of mandatorily redeemable preferred stock
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              --Net
                  earnings (loss) available to common shareholders
              
              $
              7,410
              
              
              $
              (793
              )
              
              $
              2,658
              
              
              $
              3,615
              
              
              $
              5,627Earnings
                  (loss) per
                  share                    –
                  basic
              
              $
              1.41
              
              
              $
              (0.15
              )
              
              $
              0.53
              
              
              $
              0.74
              
              
              $
              1.18– diluted
              
              $
              1.37
              
              
              $
              (0.15
              )
              
              $
              0.52
              
              
              $
              0.71
              
              
              $
              1.15Cash
                  dividends per share
              
              $
              --
              
              
              $
              --
              
              
              $
              --
              
              
              $
              --
              
              
              $
              --Shares
                  used in per share calculation – basic
              
              
              5,265
              
              
              
              5,205
              
              
              
              5,041
              
              
              
              4,909
              
              
              
              4,774–
                  diluted
              
              
              5,407
              
              
              
              5,205
              
              
              
              5,219
              
              
              
              5,222
              
              
              
              4,989**Balance
                  Sheet Data:**Cash
                  and cash equivalents and short-term investments
              
              $
              27,880
              
              
              $
              15,246
              
              
              $
              13,181
              
              
              $
              8,817
              
              
              $
              6,442Working
                  capital
              
              
              40,946
              
              
              
              30,057
              
              
              
              28,164
              
              
              
              20,991
              
              
              
              17,226Property,
                  plant and equipment, net.
              
              
              4,671
              
              
              
              4,275
              
              
              
              4,264
              
              
              
              5,046
              
              
              
              5,503Total
                  assets
              
              
              75,497
              
              
              
              57,938
              
              
              
              57,527
              
              
              
              52,514
              
              
              
              51,215Current
                  portion of long-term debt
              
              
              --
              
              
              
              1
              
              
              
              1,121
              
              
              
              1,210
              
              
              
              1,066Long-term
                  debt, less current portion
              
              
              --
              
              
              
              --
              
              
              
              1,199
              
              
              
              2,323
              
              
              
              3,249Mandatorily
                  redeemable preferred stock and warrants, including current
                  portion
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              1,595
              
              
              
              1,882Shareholders'
                  equity
              
              
              50,393
              
              
              
              41,252
              
              
              
              40,471
              
              
              
              36,044
              
              
              
              30,219
  Certain
      reclassifications have been made to prior year amounts to conform to the current
      year presentation.




15
 Table
          of Contents


**ITEM
                7.**
            **MANAGEMENT'S
                DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                OPERATIONS.**





**Introduction**





The
      Company and its wholly-owned subsidiaries design, manufacture and sell process
      automation systems, integrating electro-optical inspection, sorting and process
      systems.





The
      Company consists of Key Technology, Inc. which directly owns five
      subsidiaries:  Key Holdings USA LLC; Key Technology Australia Pty
      Ltd.; Productos Key Mexicana S. de R. L. de C.V.; Key Technology (Shanghai)
      Trading Co., Ltd.; and Key Technology AMVC LLC (inactive).  Key
      Holdings USA LLC owns Suplusco Holdings B.V., its European subsidiary, which
      owns Key Technology B.V.  Key Technology Australia Pty Ltd. owns
      Freshline Machines Pty Ltd. (inactive).  The Company manufactures
      products in Walla Walla, Washington; Redmond, Oregon; and Beusichem, The
      Netherlands.





**Overview**





Sales
      for
      the year ended September 30, 2007 were $107.5 million compared with $84.8
      million for fiscal 2006.  The Company reported net earnings for fiscal
      2007 of $7.4 million, or $1.37 per diluted share, compared with a net loss
      of
      $793,000, or $0.15 per diluted share, for fiscal 2006.  The principal
      reasons for the increase in net earnings for fiscal 2007 compared to fiscal
      2006
      were the 26.8% increase in sales volume, reflecting the 27.4% increase in orders
      for fiscal 2007, and the improvement of gross margins to 38.5% in fiscal 2007
      from 37.5% in fiscal 2006.  Automated inspection systems sales were up
      55%, process systems sales were up 17%, and parts and service sales remained
      on
      par with the prior fiscal year.  The primary market forces driving
      demand for our products are: the increased concerns about food safety and
      security, the inability of food and pharmaceutical processors to obtain cost
      effective labor, and the Company’s expansion into international
      markets.  Export and international sales for the fiscal years ended
      September 30, 2007, 2006 and 2005 accounted for 46%, 51% and 52% of net sales
      in
      each year, respectively.





In
      2007,
      the Company again focused efforts on three major initiatives to achieve its
      long-term revenue growth plan:





·
            Expand
                and grow its participation in the pharmaceutical and nutraceutical
                market;


·
            Strengthen
                and grow the level of business in China;
                and


·
            Continue
                to grow the Company’s aftermarket product
                lines.





Although
      the results from 2007 reflected some revenue progress from these initiatives,
      sales in our core businesses including upgrades accounted for the majority
      of
      the increased revenues.  The pharmaceutical initiative began in the
      fourth quarter of 2005 with the formation of the SYMETIXTM business
      unit.  This business unit was formed to dedicate a team of employees
      to develop and grow Key’s business in the pharmaceutical and nutraceutical
      market.  Anticipated penetration into this market will extend and
      advance the Company’s existing patented, high-resolution inspection technology
      and material handling platforms.  Revenue increased $1.4 million in
      fiscal 2007 to $2.1 million as efforts on the pharmaceutical initiative began
      to
      make progress.





The
      Company has historically been successful in selling tobacco sorters in
      China.  Larger opportunities exist there in the food processing
      business as well, and the Company invested in China during fiscal 2006 to
      enhance sales, service and applications support to build upon its established
      base.  In 2006, the Company opened offices and located personnel
      in-country.  In 2007, the Company experienced similar sales volumes
      into the Chinese market as in 2006, but with new traction in the food processing
      equipment market which was offset by lower fiscal 2007 tobacco
      volume.  Increased order volume in the last two quarters of fiscal
      2007 indicates that the Company’s expansion efforts into the Chinese food
      processing market is gaining traction.





The
      Company also focused on its aftermarket product lines (which include
      parts/service and upgrades) during 2007.  With the introduction of the
      G6 family of products in 2005, this enhanced vision engine technology provided
      additional product upgrade opportunities.  Upgrades are an important
      aspect of the aftermarket product lines, and the


16
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new
      modular G6 product family, which provides advanced image processing capability,
      has been well received by the Company’s current
      customers.  Aftermarket sales (including upgrades which are classified
      in automated inspection systems) increased in fiscal 2007 from fiscal 2006
      by
      24% to $32.7 million.  The Company believes a 42% increase in upgrade
      orders in fiscal 2007 over fiscal 2006 and the strong backlog at the end of
      fiscal 2007 bode well for the fiscal 2008 performance of the aftermarket
      business.





Other
      accomplishments during fiscal 2007 included completing the initial audit of
      the
      Company’s internal controls pursuant to Sarbanes-Oxley Section 404, completing
      the closure of the Company’s manufacturing facilities in Australia, reducing
      staff in the Medford, Oregon sales and engineering office, and selling the
      Company’s interest in the InspX joint venture.





The
      Company’s strategic initiatives for 2008 are to continue to build upon the
      direction and solid revenue base the Company developed during
      2007.  The focus for the coming year is to continue to grow sales in
      the Company’s core markets and invest in a market driven technology road map
      that provides the  new products required by our
      customers.  In addition, the Company will focus on four primary
      industries: potatoes, fresh cut produce, processed fruit and vegetables, and
      pharmaceutical/nutraceutical, and focus on four developing regions: China,
      Latin
      America, Eastern Europe and the Middle East.





The
      Company also plans to increase research and development expenditures and develop
      a global Enterprise Resource Planning, or ERP, system.  Efforts in
      research and development will continue to focus on customer solutions, providing
      new products that meet current needs as well as anticipated future functionality
      requirements.  The Company began preliminary work on developing a
      global ERP system in the third and fourth quarters of fiscal
      2007.  The Company has selected an ERP system and a business
      partner.  Implementation will be spread over a three-year period, with
      total costs of $5.5 million expected over the 2008-2010 period.  A
      significant portion of these ERP implementation costs will be
      capitalized.





**Application
      of Critical Accounting Policies**





The
      Company has identified its critical accounting policies, the application of
      which may materially affect the financial statements, either because of the
      significance of the financial statement item to which they relate, or because
      they require management judgment to make estimates and assumptions in measuring,
      at a specific point in time, events which will be settled in the
      future.  The critical accounting policies, judgments and estimates
      which management believes have the most significant effect on the financial
      statements are set forth below:





·
            Revenue
                recognition


·
            Allowances
                for doubtful accounts


·
            Valuation
                of inventories


·
            Long-lived
                assets


·
            Allowances
                for warranties


·
            Accounting
                for income taxes





Management
      has discussed the development, selection and related disclosures of these
      critical accounting estimates with the audit committee of the Company’s board of
      directors.





*Revenue
      Recognition.*  The Company recognizes revenue when persuasive
      evidence of an arrangement exists, delivery has occurred or services have been
      provided, the sale price is fixed or determinable, and collectibility is
      reasonably assured.  Additionally, the Company sells its goods on
      terms which transfer title and risk of loss at a specified location, typically
      shipping point, port of loading or port of discharge, depending on the final
      destination of the goods.  Accordingly, revenue recognition from
      product sales occurs when all criteria are met, including transfer of title
      and
      risk of loss, which occurs either upon shipment by the Company or upon receipt
      by customers at the location specified in the terms of sale.  Revenue
      earned from services (maintenance, installation support, and repairs) is
      recognized ratably over the contractual period or as the services are
      performed.  If any contract provides for both equipment and services
      (multiple deliverables), the sales price is allocated to the various elements
      based on objective evidence of fair value.  Each element is then
      evaluated for revenue recognition based on the previously
      described


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criteria.  The
      Company’s sales arrangements provide for no other significant post-shipment
      obligations.  If all conditions of revenue recognition are not met,
      the Company defers revenue recognition.  In the event of revenue
      deferral, the sale value is not recorded as revenue to the Company, accounts
      receivable are reduced by any amounts owed by the customer, and the cost of
      the
      goods or services deferred is carried in inventory.  In addition, the
      Company periodically evaluates whether an allowance for sales returns is
      necessary.  Historically, the Company has experienced few sales
      returns.  If the Company believes there are potential sales returns,
      the Company will provide any necessary provision against sales.  In
      accordance with the Financial Accounting Standard Board’s Emerging Issues Task
      Force Issue No. 01-9, *“Accounting for Consideration Given by a Vendor to a
      Customer or a Reseller of the Vendor’s Product,”* the Company accounts for
      cash consideration (such as sales incentives) that are given to customers or
      resellers as a reduction of revenue rather than as an operating expense unless
      an identified benefit is received for which fair value can be reasonably
      estimated.  The Company believes that revenue recognition is a
“critical accounting estimate” because the Company’s terms of sale vary
      significantly, and management exercises judgment in determining whether to
      recognize or defer revenue based on those terms.  Such judgments may
      materially affect net sales for any period.  Management exercises
      judgment within the parameters of accounting principles generally accepted
      in
      the United States of America (GAAP) in determining when contractual obligations
      are met, title and risk of loss are transferred, the sales price is fixed or
      determinable and collectibility is reasonably assured.  At September
      30, 2007, the Company had invoiced $2.3 million compared to $1.5 million at
      September 30, 2006 for which the Company has not recognized
      revenue.





*Allowances
      for doubtful accounts.*  The Company establishes allowances for
      doubtful accounts for specifically identified, as well as anticipated, doubtful
      accounts based on credit profiles of customers, current economic trends,
      contractual terms and conditions, and customers’ historical payment
      patterns.  Factors that affect collectibility of receivables include
      general economic or political factors in certain countries that affect the
      ability of customers to meet current obligations.  The Company
      actively manages its credit risk by utilizing an independent credit rating
      and
      reporting service, by requiring certain percentages of down payments, and by
      requiring secured forms of payment for customers with uncertain credit profiles
      or located in certain countries.  Forms of secured payment could
      include irrevocable letters of credit, bank guarantees, third-party leasing
      arrangements or EX-IM Bank guarantees, each utilizing Uniform Commercial Code
      filings, or the like, with governmental entities where possible.  The
      Company believes that the accounting estimate related to allowances for doubtful
      accounts is a “critical accounting estimate” because it requires management
      judgment in making assumptions relative to customer or general economic factors
      that are outside the Company’s control.  As of September 30, 2007, the
      balance sheet included allowances for doubtful accounts of
      $414,000.  Amounts charged to bad debt expense for fiscal 2007 and
      2006 were $16,000 and $29,000, respectively.  Actual charges to the
      allowance for doubtful accounts for fiscal 2007 and 2006 were $98,000 and
      $83,000, respectively.  If the Company experiences actual bad debt
      expense in excess of estimates, or if estimates are adversely adjusted in future
      periods, the carrying value of accounts receivable would decrease and charges
      for bad debts would increase, resulting in decreased net earnings.





*Valuation
      of inventories.*  Inventories are stated at the lower of cost or
      market. The Company’s inventory includes purchased raw materials, manufactured
      components, purchased components, work in process, finished goods and
      demonstration equipment.  Write downs for excess and obsolete
      inventories are made after periodic evaluation of historical sales, current
      economic trends, forecasted sales, estimated product lifecycles and estimated
      inventory levels.  The factors that contribute to inventory valuation
      risks are the Company’s purchasing practices, electronic component obsolescence,
      accuracy of sales and production forecasts, introduction of new products,
      product lifecycles and the associated product support.  The Company
      actively manages its exposure to inventory valuation risks by maintaining low
      safety stocks and minimum purchase lots, utilizing just in time purchasing
      practices, managing product end-of-life issues brought on by aging components
      or
      new product introductions, and by utilizing inventory minimization strategies
      such as vendor-managed inventories.  The Company believes that the
      accounting estimate related to valuation of inventories is a “critical
      accounting estimate” because it is susceptible to changes from period-to-period
      due to the requirement for management to make estimates relative to each of
      the
      underlying factors ranging from purchasing to sales to production to after-sale
      support.  At September 30, 2007, cumulative inventory adjustments to
      lower of cost or market totaled $1.8 million compared to $2.2 million as of
      September 30, 2006.  Amounts charged to expense to record inventory at
      lower of cost or market for fiscal 2007 and 2006 were $386,000 and $1.6 million,
      respectively.  Actual charges to the cumulative inventory adjustments
      upon disposition or sale of inventory were $903,000 and $2.3 million for fiscal
      2007 and 2006, respectively.  If actual demand, market conditions or
      product lifecycles are adversely different from those estimated by
      management,


18
 Table
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inventory
      adjustments to lower market values would result in a reduction to the carrying
      value of inventory, an increase in inventory write-offs, and a decrease to
      gross
      margins.





*Long-lived
      assets.*  The Company regularly reviews all of its long-lived
      assets, including property, plant and equipment, and amortizable intangible
      assets, for impairment whenever events or changes in circumstances indicate
      that
      the carrying value may not be recoverable.  If the total of projected
      future undiscounted cash flows is less than the carrying amount of these assets,
      an impairment loss based on the excess of the carrying amount over the fair
      value of the assets is recorded.  In addition, goodwill is reviewed
      based on its fair value at least annually.  As of September 30, 2007,
      the Company held $10.8 million of property, plant and equipment, goodwill and
      other intangible assets, net of depreciation and amortization.  There
      were no changes in the Company’s long-lived assets that would result in an
      adjustment of the carrying value for these assets.  Estimates of
      future cash flows arising from the utilization of these long-lived assets and
      estimated useful lives associated with the assets are critical to the assessment
      of recoverability and fair values.  The Company believes that the
      accounting estimate related to long-lived assets is a “critical accounting
      estimate” because:  (1) it is susceptible to change from period to
      period due to the requirement for management to make assumptions about future
      sales and cost of sales generated throughout the lives of several product lines
      over extended periods of time; and (2) the potential effect that recognizing
      an
      impairment could have on the assets reported on the Company’s balance sheet and
      the potential material adverse effect on reported earnings or
      loss.  Changes in these estimates could result in a determination of
      asset impairment, which would result in a reduction to the carrying value and
      a
      reduction to net earnings in the affected period.





*Allowances
      for warranties.*  The Company’s products are covered by standard
      warranty plans included in the price of the products ranging from 90 days to
      five years, depending upon the product and contractual terms of
      sale.  The majority of product warranties are for periods between one
      and two years.  The Company establishes allowances for warranties for
      specifically identified, as well as anticipated, warranty claims based on
      contractual terms, product conditions and actual warranty experience by product
      line.  Company products include both manufactured and purchased
      components and, therefore, warranty plans include third-party sourced parts
      which may not be covered by the third-party manufacturer’s
      warranty.  Ultimately, the warranty experience of the Company is
      directly attributable to the quality of its products.  The Company
      actively manages its quality program by using a structured product introduction
      plan, process monitoring techniques utilizing statistical process controls,
      vendor quality metrics, a quality training curriculum for every employee and
      feedback loops to communicate warranty claims to designers and engineers for
      remediation in future production.  The Company believes that the
      accounting estimate related to allowances for warranties is a “critical
      accounting estimate” because:  (1) it is susceptible to significant
      fluctuation period to period due to the requirement for management to make
      assumptions about future warranty claims relative to potential unknown issues
      arising in both existing and new products, which assumptions are derived from
      historical trends of known or resolved issues; and (2) risks associated with
      third-party supplied components being manufactured using processes that the
      Company does not control.  As of September 30, 2007, the balance sheet
      included warranty reserves of $1.4 million, while $2.1 million of warranty
      charges were incurred during the fiscal year then ended, compared to warranty
      reserves of $1.0 million as of September 30, 2006 and warranty charges of $2.0
      million for the fiscal year then ended.  If the Company’s actual
      warranty costs are higher than estimates, future warranty plan coverages are
      different, or estimates are adversely adjusted in future periods, reserves
      for
      warranty expense would need to increase, warranty expense would increase and
      gross margins would decrease.





*Accounting
      for income taxes.*  The Company’s provision for income taxes and
      the determination of the resulting deferred tax assets and liabilities involves
      a significant amount of management judgment.  The quarterly provision
      for income taxes is based partially upon estimates of pre-tax financial
      accounting income for the full year and is affected by various differences
      between financial accounting income and taxable income.  Judgment is
      also applied in determining whether the deferred tax assets will be realized
      in
      full or in part.  In management’s judgment, when it is more likely
      than not that all or some portion of specific deferred tax assets, such as
      foreign tax credit carryovers, will not be realized, a valuation allowance
      must
      be established for the amount of the deferred tax assets that are determined
      not
      to be realizable.  At September 30, 2007, the Company had valuation
      reserves of approximately $510,000 consisting of $450,000 for deferred tax
      assets related to the sale of the investment in the InspX joint venture and
      the
      valuation reserve for notes receivable and contingent payments; and a net
      $60,000 for combined U.S., Australian and Chinese deferred tax assets and
      liabilities, primarily related to net operating loss carryforwards in those
      foreign jurisdictions.  There were no other valuation allowances at
      September 30, 2007 due to anticipated utilization of all the deferred tax assets
      as the Company believes it will have sufficient taxable income to utilize
      these


19
 Table
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assets.  The
      Company maintains reserves for estimated tax exposures in jurisdictions of
      operation.  These tax jurisdictions include federal, state and various
      international tax jurisdictions.  Potential income tax exposures
      include potential challenges of various tax credits, export-related tax
      benefits, and issues specific to state and local tax
      jurisdictions.  Exposures are typically settled primarily through
      audits within these tax jurisdictions, but can also be affected by changes
      in
      applicable tax law or other factors, which could cause management of the Company
      to believe a revision of past estimates is appropriate.  During fiscal
      2007 and 2006, there have been no significant changes in these
      estimates.  Management believes that an appropriate liability has been
      established for estimated exposures; however, actual results may differ
      materially from these estimates.  The Company believes that the
      accounting estimate related to income taxes is a “critical accounting estimate”
because it relies on significant management judgment in making assumptions
      relative to temporary and permanent timing differences of tax effects, estimates
      of future earnings, prospective application of changing tax laws in multiple
      jurisdictions, and the resulting ability to utilize tax assets at those future
      dates.  If the Company’s operating results were to fall short of
      expectations, thereby affecting the likelihood of realizing the deferred tax
      assets, judgment would have to be applied to determine the amount of the
      valuation allowance required to be included in the financial statements in
      any
      given period.  Establishing or increasing a valuation allowance would
      reduce the carrying value of the deferred tax asset, increase tax expense and
      reduce net earnings.





In
      October 2004, the American Jobs Creation Act of 2004 was
      enacted.  This legislation phases out the Extra Territorial Income
      Exclusion (“ETI”) beginning January 1, 2005 through December 31,
      2006.  The ETI exclusion reduced the Company’s effective tax rate by
      0.2%, 14.3% and 5.4% in 2007, 2006 and 2005, respectively.  The
      legislation also provides for a new deduction for manufacturing income, which
      phases in beginning in the Company’s 2006 fiscal year through
      2010.  The Company anticipates that this deduction will largely, if
      not completely, offset the loss of the ETI exclusion.  However, the
      effects in individual fiscal years during the phase-in periods may vary and
      increase the Company’s effective tax rate during these periods.  For
      fiscal 2007 and 2006, the deduction for manufacturing income reduced the
      Company’s effective tax rate by 0.8% and 0%, respectively.


20
 Table
          of Contents




**Summary
                of Financial Information****Fiscal
                Year Ended September 30,****2007**
            
            
            **2006**
            
            
            **Change
                $**
            
            
            **Change
                %****(in
                thousands)****Statement
                of Operations Data**Net
                sales
            
            $
            107,540
            
            
            $
            84,840
            
            
            $
            22,700
            
            
            
            26.8Gross
                profit
            
            
            41,441
            
            
            
            31,799
            
            
            
            9,642
            
            
            
            30.3Research
                and development
            
            
            5,520
            
            
            
            6,444
            
            
            
            (924
            )
            
            
            -14.3Sales
                and marketing
            
            
            17,191
            
            
            
            14,784
            
            
            
            2,407
            
            
            
            16.3General
                and administrative
            
            
            8,821
            
            
            
            9,185
            
            
            
            (364
            )
            
            
            -4.0Amortization
            
            
            1,307
            
            
            
            1,330
            
            
            
            (23
            )
            
            
            -1.7Total
                operating expense
            
            
            32,839
            
            
            
            31,743
            
            
            
            1,096
            
            
            
            3.5Gain
                on sale of assets
            
            
            23
            
            
            
            109
            
            
            
            (86
            )
            
            N/M*Income
                from operations
            
            
            8,625
            
            
            
            165
            
            
            
            8,460
            
            
            N/M*Other
                income and expense
            
            
            1,961
            
            
            
            (980
            )
            
            
            2,941
            
            
            N/M*Income
                tax expense (benefit)
            
            
            3,176
            
            
            
            (22
            )
            
            
            3,198
            
            
            N/M*Net
                income (loss)
            
            
            7,410
            
            
            
            (793
            )
            
            
            8,203
            
            
            N/M***Balance
                Sheet Data**Cash
                and cash equivalents
            
            
            27,880
            
            
            
            15,246
            
            
            
            12,634
            
            
            
            82.9Accounts
                receivable
            
            
            14,020
            
            
            
            10,381
            
            
            
            3,639
            
            
            
            35.1Inventories
            
            
            18,753
            
            
            
            16,035
            
            
            
            2,718
            
            
            
            17.0**Other
                Data *(unaudited)***Orders
            
            
            115,276
            
            
            
            90,500
            
            
            
            24,776
            
            
            
            27.4Backlog
            
            
            30,931
            
            
            
            22,756
            
            
            
            8,175
            
            
            
            35.9


* Not meaningful







21
 Table
            of Contents




**Results
      of Operations**





*Fiscal
      2007 compared to Fiscal 2006*





Net
      sales
      for the year ended September 30, 2007 were $107.5 million, a 27% increase over
      the $84.8 million reported for fiscal 2006.  The Company ended the
      year strongly with a record fourth quarter of $31.7 million in sales, a 31%
      increase over the corresponding period in fiscal 2006.





Sales
      in
      the Company’s automated inspection systems product line increased by 55% to
      $46.9 million in fiscal 2007, accounting for 44% of total revenues, compared
      to
      $30.3 million in fiscal 2006 and 36% of total revenues.  The most
      significant increase was in upgrade sales which increased $5.7 million or 81%
      to
      $12.7 million.   Sales increased in all automated inspection
      product lines except tobacco, which dropped $2.5 million to $0.7 million in
      fiscal 2007 as a result of a significant tobacco order from China that shipped
      in fiscal 2006.  Process systems sales in fiscal 2007 were $40.9
      million, a 17.2% increase over the $34.9 million reported for fiscal
      2006.  Sales of process systems accounted for 38% of total revenues in
      fiscal 2007 compared to 41% in fiscal 2006.  Shipments of process
      systems in fiscal 2007 from United States operating locations increased nearly
      27% and from the Netherlands increased by nearly 12%.  Parts and
      service sales remained on par with the prior year at $19.7 million and
      represented 18% of sales this year, down from 23% of sales in fiscal
      2006.





New
      orders increased 27%, or $24.8 million, to $115.3 million in fiscal 2007 over
      the $90.5 million in orders received in fiscal 2006.  Backlog at
      September 30, 2007 increased to $30.9 million compared to the $22.8 million
      reported at the end of fiscal 2006.  The order mix for the more recent
      year improved over fiscal 2006.  The Company’s higher margin automated
      inspection systems orders increased to almost 42% of order volume in fiscal
      2007
      compared to 40% in the prior year due in large part to an almost 42% increase
      in
      upgrade orders and a $3.0 million increase in SYMETIX orders.





Gross
      profits increased to $41.4 million for fiscal 2007 compared to $31.8 million
      in
      fiscal 2006, or 38.5% and 37.5% of sales, respectively.  The principle
      driver for the $9.6 million increase in gross profit relates to the nearly
      27%
      increase is sales volume.  The improvement in gross profit percentage
      relates to the increased mix of automated inspection systems sales as well
      as
      lower other cost of sales relating to improved manufacturing and overhead
      variances.  Gross profits were negatively affected by higher raw
      material cost increases driven by stainless steel pricing, as well as lower
      labor efficiencies relating to hiring and training over 40 new production
      employees in 2007.





Research
      and development spending decreased $924,000 to $5.5 million, or 5.1% of sales,
      in fiscal 2007 from $6.4 million and 7.6% of sales in fiscal
      2006.  The decrease was driven largely by focusing on fewer research
      and development projects, as well as the closure and the reduction in staffing
      of the Company’s Medford, Oregon facility.





Sales
      and
      marketing spending in fiscal 2007 was $17.2 million, a significant increase
      from
      the $14.8 million spent in fiscal 2006.  As a percent of sales, costs
      dropped 1.4% from the 17.4% of sales reported in fiscal 2006 to 16.0% of sales
      reported in fiscal 2007.  The primary drivers for the increase were
      the significantly higher sales volume, as well as continued investment in the
      Company’s China sales office and its SYMETIX initiative in the pharmaceutical
      and nutraceutical industry.





General
      and administrative spending in fiscal 2007 was $8.8 million and 8.2% of sales
      for the year, compared to $9.2 million and 10.8% of sales for fiscal
      2006.  The decrease in fiscal 2007 was due to the closure of the
      Company’s operations in Australia and reduced management consulting
      costs.  General and administrative costs incurred in 2006 included
      non-recurring costs related to information system upgrades.  General
      and administrative costs decreased in fiscal 2007 despite the $500,000 of
      external costs incurred to comply with Section 404 of the Sarbanes-Oxley
      Act.





Other
      income and expense was $2 million of income for fiscal 2007 compared to $1
      million of expense for fiscal 2006.  During fiscal 2007, the Company
      recognized a gain of $750,000 from the sale of the investment in the InspX
      joint
      venture.  In fiscal 2006, the Company booked a charge of $865,000
      related to the write-off of it’s investment in InspX.  During fiscal
      2006, the Company’s equity in the earnings of InspX was an additional loss of
      $389,000.


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Interest
      income increased to $726,000 in fiscal 2007 from the $391,000 reported for
      fiscal 2006 due to increased investment of cash generated by
      operations.  The Company also recognized exchange gains of $570,000 in
      fiscal 2007 compared with $86,000 in the prior year.





The
      effective tax rate for the Company was 30.2% in fiscal 2007 compared to 2.7%
      in
      fiscal 2006.  The effective tax rate for fiscal 2007 was primarily
      affected by the reversal of valuation reserves recorded in fiscal 2006 related
      to the Company’s valuation of its investment in the InspX joint
      venture.  Other items, such as permanent differences arising from
      extra-territorial income exclusions, domestic production deductions, research
      and development tax credits, tax exempt interest, and other permanent
      differences, caused the effective tax rate to vary from the 34% statutory rate
      in fiscal 2007.





Net
      earnings in fiscal 2007 were $7.4 million, or $1.37 per diluted share, compared
      to a net loss of $793,000, or $0.15 per diluted share, in fiscal
      2006.  The principal reasons for the increase in earnings for fiscal
      2007 compared to fiscal 2006 were increased sales volumes and improved gross
      profit margins.  In addition, earnings improved due to the effect of
      the InspX transactions in both years.





*Fiscal
      2006 compared to Fiscal 2005*





Net
      sales
      for the year ended September 30, 2006 were $84.8 million, a 5.6% increase over
      the $80.3 million reported for fiscal 2005.  The Company ended the
      year strongly with a record fourth quarter of $24.2 million in sales, a 12.1%
      increase over the corresponding period in fiscal 2005.





Sales
      in
      the Company’s automated inspection systems product line increased by 8.6% to
      $30.3 million in fiscal 2006, accounting for 36% of total revenues, compared
      to
      $27.9 million in fiscal 2005, and 34% of revenues.  The most
      significant increase was in tobacco sorters due to a shipment to China which
      was
      delayed from fiscal 2005 into the first quarter of fiscal
      2006.  Process systems sales in fiscal 2006 were $34.9 million, a 9.6%
      increase over the $31.9 million reported for fiscal 2005, and increased to
      41%
      of total revenue in fiscal 2006 compared to 40% in fiscal 2005.  Parts
      and service sales decreased by 7.2% to $19.7 million in fiscal 2006, compared
      to
      the $21.2 million reported for fiscal 2005, representing 23% and 26%
      respectively of total revenues.





Orders
      increased by $6.8 million to $90.5 million in fiscal 2006, an 8.1% increase
      over
      the $83.7 million in new orders received in fiscal 2005.  Backlog at
      September 30, 2006 increased to $22.8 million, compared to the $16.6 million
      reported at the end of fiscal 2005.  The order mix for the year
      improved over fiscal 2005, with the Company’s higher margin automated inspection
      systems orders increasing to almost 40% of order volume compared to 35% in
      the
      prior period due in large part to an almost 57% increase in upgrade orders
      and a
      39% increase in Tegra orders.





Gross
      profits increased to $31.8 million for fiscal 2006 compared to $31.2 million
      in
      fiscal 2005, or 37.5% and 38.8% of sales, respectively.  The principle
      drivers for the reduction in gross profit percentage were increased inventory
      reserves, including reserves related to the Freshline facility closure, raw
      material cost increases driven by stainless steel pricing, and costs associated
      with the consolidation of the Company’s Walla Walla facilities early in fiscal
      2006.





Research
      and development spending increased to $6.4 million and 7.6% of sales in fiscal
      2006 from $5.1 million and 6.4% of sales in fiscal 2005.  The increase
      was driven largely by increased spending for development of the Raptor 6000
      upgrade and products for the nutraceutical market.  In addition,
      $273,000 was charged to research and development during the fourth quarter
      related to the reduction in staffing in the Company’s Medford, Oregon
      facility.





Sales
      and
      marketing spending in fiscal 2006 was $14.8 million and 17.4% of sales, a
      significant increase from $12.6 million and 15.7% of sales for
      2005.  The primary drivers for the increase were the investment in the
      Company’s China office and related sales initiative, as well as the investment
      in SYMETIX, the Company’s initiative in the pharmaceutical and nutraceutical
      industry.


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General
      and administrative spending in fiscal 2006 was $9.2 million and 10.8% of sales
      for the year, compared to $8.1 million and 10.1% of sales for fiscal
      2005.  This increase was due to FAS 123R costs, contract and
      professional service costs, and recruiting and relocation costs.





Other
      income and expense was $980,000 of expense for fiscal 2006 compared to $419,000
      of expense for fiscal 2005.  During fiscal 2006, the Company booked a
      charge of $865,000 related to the write-off of it’s investment in InspX, its
      joint venture with Peco LLC.  During the year, the Company’s share of
      InspX performance was a loss of $389,000 compared to a loss in fiscal 2005
      of
      $659,000. Interest income increased to $391,000 in fiscal 2006 from the $229,000
      reported for fiscal 2005.





The
      effective tax rate for the Company was 2.7% in fiscal 2006 compared to 25.1%
      in
      fiscal 2005.  The most significant factor affecting the rate in fiscal
      2006 was the reduction in the value of deferred tax assets related to InpsX
      and
      Freshline.  Other items, such as permanent differences arising from
      extra-territorial income exclusions, research and development tax credits and
      other permanent differences, caused the effective tax rate to vary from the
      34%
      statutory rate.





The
      net
      loss from continuing operations in fiscal 2006 was $793,000, or $0.15 per
      diluted share, compared to net earnings of $2.7 million, or $0.52 per diluted
      share in fiscal 2005.  The principal reasons for the decrease in
      earnings for fiscal 2006 compared to fiscal 2005 were increased spending related
      to the investment in strategic initiatives in the pharmaceutical and
      nutraceutical market and in China, as well as the increased costs associated
      with the closure of the Freshline facility, the reduction in staffing in
      Medford, Oregon, and the charges related to the write-off of the InspX
      investment.





**Liquidity
      and Capital Resources**





*Fiscal
      2007*





For
      fiscal year 2007, net cash increased by $12.6  million, or nearly 83%,
      to $27.9 million on September 30, 2007.  The Company generated $12.4
      million in cash from operating activities and generated $575,000 from financing
      activities and consumed $749,000 in investing activities.





The
      net
      cash provided by operating activities during fiscal 2007 of $12.4 million
      included net earnings for the year of $7.4 million, non-cash expenses for
      depreciation and amortization of $2.6 million and non-cash share based payments
      and deferred income taxes of $987,000 and $721,000, respectively.  Net
      earnings also included the $750,000 gain on the sale of InspX.  This
      gain is not included in the cash provided by operations.  Non-cash
      working capital at September 30, 2007 declined from the same time last year,
      contributing $1.7 million to the cash provided by operating
      activities.  Increased business activity at the end of and during the
      fourth quarter of fiscal 2007 versus 2006, reflected by the record year-end
      backlog and the record fourth quarter revenues, resulted in increased inventory
      and receivables.  These increases were more than offset by increases
      in accounts payable, customer deposits, customer support and warranty accruals,
      as well as higher yearly incentive accruals.





Cash
      used
      in investing activities totaled $749,000 during fiscal 2007.  Capital
      expenditures during fiscal 2007 were approximately $1.6 million for the fiscal
      year, including $706,000 for software purchased for the global ERP
      implementation project.  These expenditures were partially offset by
      $750,000 of proceeds from the sale of InspX and $64,000 in proceeds from the
      sale of property.  Cash used  for investing activities in
      fiscal 2006 was $1.4 million.





Cash
      generated from financing activities totaled $575,000 in fiscal
      2007.  The Company initiated a stock repurchase program in fiscal 2007
      and repurchased 88,252 shares of stock during the fiscal year using $1.3 million
      of cash.  These applications of cash were more than offset by the $1.6
      million generated from the issuance of common stock related to option
      exercises.   Financing activities also benefited by the $320,000
      excess tax benefit from share based payments.  During the prior fiscal
      year, the Company used cash to payoff both the current and long term portion
      of
      long term debt in the amount of $2.3 million.  At the end of fiscal
      2006 and 2007, the Company had no long term debt outstanding.


24
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The
      Company’s domestic credit facility provides for a revolving credit line of up to
      $10 million and credit sub-facilities of $3.0 million each for sight commercial
      letters of credit and standby letters of credit.  The credit facility
      matures on June 30, 2008.  The credit facility bears interest, at the
      Company’s option, of either the bank prime rate minus 1.75% or LIBOR plus 1.0%
      per annum.  At September 30, 2007, the interest rate would have been
      6.0%.  The credit facility is secured by all U.S. accounts receivable,
      inventory and fixed assets.  The credit facility contains covenants
      which require the maintenance of a defined net worth ratio, a liquidity ratio
      and minimum profitability.  The credit facility also restricts the
      payment of dividends, mergers and acquisitions, incurrence of additional
      indebtedness, transactions, including purchases and retirements, in the
      Company’s own common stock, and places limitations on capital expenditures and
      lease expenditures, without the prior consent of the Lender.  At
      September 30, 2007, the Company had no borrowings outstanding under the credit
      facility and $530,000 in standby letters of credit.  At September 30,
      2007, the Company was in compliance with its loan covenants, and had received
      the consent of the lender for its stock repurchase program.





The
      Company’s credit accommodation with a commercial bank in The Netherlands
      provides a credit facility for its European subsidiary.  This credit
      accommodation totals $3.5 million and includes an operating line of the
      lesser of $2.1 million or the available borrowing base, which is based on
      varying percentages of eligible accounts receivable and inventories, and a
      bank
      guarantee facility of $1.4 million.  The operating line and bank
      guarantee facility are secured by all of the subsidiary’s personal
      property.  The credit facility bears interest at the bank’s prime
      rate, with a minimum of 3.00%, plus 1.75%.  At September 30, 2007, the
      interest rate was 6.8%.  At September 30, 2007, the Company had no
      borrowings under this facility and had received bank guarantees of $668,000
      under the bank guarantee facility.  The credit facility allows
      overages on the bank guarantee facility.  Any overages reduce the
      available borrowings from the operating line.





The
      Company anticipates that the ongoing cash flows from operations and borrowing
      capacity under currently available operating credit lines will be sufficient
      to
      fund the Company’s operating needs for the foreseeable future.  Cash
      provided by operating activities was $12.4 million, $5.5 million and $7.6
      million in each of the last three years, respectively.  This operating
      cash flow has allowed the Company to fund capital asset purchases and eliminate
      the long-term debt outstanding.  The Company anticipates that its cash
      needs will continued to be met from cash from operations as it embarks on its
      initiatives to grow the pharmaceutical, nutraceutical and aftermarket
      businesses, and expand its operation in China and other world-wide
      locations.  The Company also anticipates cash expenditures of $5.5
      million over the 2008-2010 fiscal years for development of a global ERP system,
      a significant portion of which will be capitalized.  In addition, due
      to the rate of growth, the Company is investigating opportunities for increased
      office and plant space, primarily through leased facilities in the Walla Walla
      area.  The Company had no material commitments for capital
      expenditures at September 30, 2007.





*Prior
      Years - Fiscal 2006 and 2005*





For
      fiscal year 2006, net cash increased by $2.1 million to $15.2 million on
      September 30, 2006.  The Company generated $5.5 million in cash from
      operating activities and consumed $1.4 million in investing activities and
      $2.0
      million in financing activities.





The
      net
      cash provided by operating activities during fiscal 2006 of $5.5 million
      included a net loss for the year which reduced cash by $0.8
      million.  This net loss included the non-cash loss of $1.3 million
      from the Company’s joint venture equity interest in InspX and non-cash expenses
      for depreciation and amortization of $3.0 million.  Higher business
      levels at the end of 2006 versus 2005 reflected by the increased order backlog
      resulted in increased payables and liabilities, as well as higher inventory
      levels.  These increases included higher accounts payable, $1.7
      million, higher customer deposits on orders in process, $2.2 million, and higher
      inventories, $1.0 million.  All other operating activities resulted in
      a use of cash in fiscal 2006 of $0.8 million.





Cash
      used
      in investing activities was for machinery and equipment purchases during fiscal
      2006 and amounted to $1.4 million for the fiscal year.  Cash used in
      investing activities in fiscal 2005 of $2.0 million was slightly higher than
      fiscal 2006 and included the Freshline acquisition in early fiscal 2005 of
      $1.1
      million.





Cash
      used
      in financing activities totaled $2.0 million in fiscal 2006.  During
      the fiscal year, the Company used cash to payoff both the current and long
      term
      portion of debt in the amount of $2.3 million.  Borrowings
      at


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September
      30, 2005 consisted of a term loan with a balance of $1.6 million, notes payable
      totaling $0.5 million and capital leases totaling $0.2 million.  At
      the end of fiscal 2006, the Company had no long term debt
      outstanding.  These applications of cash were partially offset by the
      receipt of $0.3 million due to the issuance of common stock pursuant to the
      exercise of stock options.





For
      fiscal year 2005, net cash increased $4.4 million, increasing from $8.8 million
      on September 30, 2004 to $13.2 million on September 30, 2005.  Net
      cash provided by operating activities during fiscal 2005 was $7.6
      million.  Net income generated $2.7 million and non-cash expenses for
      depreciation and amortization provided $3.2 million.  Net income also
      included the non-cash loss impact of the Company’s equity interest in InspX’s of
      $659,000.  Other changes in cash provided by operating activities were
      primarily due to changes in working capital relating to increased business
      activity at the end of fiscal 2005 over fiscal 2004 year-end.





Cash
      used
      in investing activities was $2.0 million during fiscal 2005.  The
      acquisition of Freshline Machines Pty Ltd. used $1.1 million in cash and the
      purchase of machinery and equipment used $1.0 million.  The Company
      acquired $1.8 million in assets related to the Freshline purchase and assumed
      $0.8 million in liabilities.





Cash
      used
      in financing activities totaled $1.1 million in fiscal 2005.  Cash
      used for the redemption of Series B Preferred Stock and the redemption of
      warrants was $1.3 million and $0.2 million, respectively.  The Company
      also made debt payments which reduced the Company’s long-term debt by $1.2
      million.  These applications of cash were partially offset by the
      receipt of $1.5 million due to the issuance of common stock pursuant to the
      exercise of stock options.





*Contractual
      Obligations*





The
      Company’s continuing contractual obligations and commercial commitments existing
      on September 30, 2007 are as follows:





Payments
                due by period (in thousands)Contractual
                Obligations
            
            Total
            
            
            Less
                than 1 year
            
            
            1
–
                3 years
            
            
            4
–
                5 years
            
            
            After
                5 yearsOperating
                leases
            
            
            12,646
            
            
            
            1,268
            
            
            
            1,991
            
            
            
            2,045
            
            
            
            7,342Purchase
                obligations
            
            
            251
            
            
            
            251
            
            
            
            -
            
            
            
            -
            
            
            
            -Total
                contractual cash obligations
            
            $
            12,897
            
            
            $
            1,519
            
            
            $
            1,991
            
            
            $
            2,045
            
            
            $
            7,342





At
      September 30, 2007, the Company had standby letters of credit totaling $1.2
      million, which includes secured bank guarantees under the Company’s credit
      facility in Europe and letters of credit securing certain self-insurance
      contracts and lease commitments.  If the Company fails to meet its
      contractual obligations, these bank guarantees and letters of credit may become
      liabilities of the Company.  The Company has no off-balance sheet
      arrangements or transactions, arrangements or relationships with “special
      purpose entities.”





**Future
      Accounting Changes**




In
      June
      2006, the Financial Accounting Standards Board (“FASB”) issued FASB
      Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”),
      an interpretation of FASB Statement No. 109.  FIN 48 provides guidance
      for the recognition, derecognition and measurement in financial statements
      of
      tax positions taken in previously filed tax returns or tax positions expected
      to
      be taken in tax returns.  FIN 48 requires an entity to recognize the
      financial statement impact of a tax position when it is more likely than not
      that the position will be sustained upon examination.  If the tax
      position meets the more likely than not recognition threshold, the tax effect
      is
      recognized at the largest amount of the benefit that is greater than fifty
      percent likely of being realized upon ultimate settlement.  FIN 48
      also provides guidance on classification, interest and penalties, accounting
      in
      interim periods, disclosure and transition.  The Company was required to
      adopt FIN 48 as of October 1, 2007.  The Company has not fully
      completed its evaluation of the impact Interpretation 48 will have on its
      financial position and results of operations after adoption; however, the
      Company currently estimates that upon adoption the Company will record
      an


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estimated
      $250,000 increase in retained earnings.  The Company believes that the
      adoption of FIN 48 will not have a material ongoing effect on its financial
      position, results of operations, and cash flow.





In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      (“SFAS”) No. 157, “Fair Value Measurements,” which establishes guidelines
      for measuring fair value and expands disclosures regarding fair value
      measurements.  SFAS No. 157 does not require any new fair
      value measurements but rather it eliminates inconsistencies in the guidance
      found in various prior accounting
      pronouncements.  SFAS No. 157 is effective for fiscal years
      beginning after November 15, 2007.  The Company is evaluating the
      potential effects of this standard, although we do not expect the adoption
      of
      SFAS No. 157 to have a material effect on our financial position,
      results of operation, or cash flows.





In
      February 2007, the FASB issued Statement 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities”.  This Statement permits
      entities to elect to measure certain financial instruments and other items
      at
      fair value through earnings.  The fair value option may be applied on
      an instrument by instrument basis, is irrevocable and is applied only to entire
      instruments.  SFAS 159 requires additional financial statement
      presentation and disclosure requirements for those entities that elect to adopt
      the standard and is effective for fiscal years beginning after November 15,
      2007.  We do not anticipate any material impact on our financial
      condition or results of operations as a result of the adoption of SFAS
      159.





In
      September 2006, the SEC released Staff Accounting Bulletin No. 108, “Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements” (“SAB 108”). **SAB 108 provides
      guidance on how the effects of the carryover or reversal of prior year
      misstatements should be considered in quantifying a current year misstatement.
      **In some situations, companies will be required to record errors
      that occurred in prior years even though those errors were immaterial for each
      year in which they arose. **Companies may choose to either restate
      all previously presented financial statements or record the cumulative effect
      of
      such errors as an adjustment to retained earnings at the beginning of the period
      in which SAB 108 is applied.  SAB 108 is effective for fiscal years
      ending after November 15, 2006, and was adopted by the Company on October 1,
      2006.  The adoption of SAB 108 had no effect on the Company's
      financial statements.








**ITEM
                7A.**
            **QUANTITATIVE
                AND QUALITATIVE DISCLOSURES ABOUT MARKET
                RISK.**





The
      Company has assessed its exposure to market risks for its financial instruments
      and has determined that its exposures to such risks are generally limited to
      those affected by the value of the U.S. Dollar compared to the Euro and to
      a
      lesser extent the Australian Dollar, Mexican Peso and Chinese
      Renminbi.





The
      terms
      of sales to European customers are typically denominated in either Euros or
      U.S.
      Dollars.  The terms of sales to customers in Australia are typically
      denominated in their local currency. The Company expects that its standard
      terms
      of sale to international customers, other than those in Europe and Australia,
      will continue to be denominated in U.S. dollars, although as the Company expands
      its operations in Latin America and China, transactions denominated in these
      currencies may increase.  For sales transactions between international
      customers, including European customers, and the Company’s domestic operations,
      which are denominated in currencies other than U.S. dollars, the Company
      assesses its currency exchange risk and may enter into forward contracts to
      minimize such risk.  At September 30, 2007, the Company was not a
      party to any currency hedging transaction.  As of September 30, 2007,
      management estimates that a 10% change in foreign exchange rates would affect
      net earnings before taxes by approximately $519,000 on an annual basis as a
      result of converted cash, accounts receivable, loans to foreign subsidiaries,
      and sales or other contracts denominated in foreign currencies.





As
      of
      September 30, 2007, the Euro gained a net of 11% in value against the U.S.
      dollar compared to its value at September 30, 2006.  During the
      twelve-month period ended September 30, 2007, changes in the value of the Euro
      against the U.S. dollar ranged between a 1% gain and a 11%
      gain.  Other foreign currencies also gained in value against the U.S.
      Dollar.  The effect of these fluctuations on the operations and
      financial results of the Company were:





·
            Translation
                adjustments of $443,000, net of income tax, were recognized as a
                component
                of comprehensive income as a result of converting the Euro denominated
                balance sheets of Key Technology B.V. and
                Suplusco


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Holding
                B.V. into U.S. dollars, and to a lesser extent, the Australian dollar
                balance sheets of Key Technology Australia Pty Ltd. and Freshline
                Machines
                Pty Ltd., the RMB balance sheet of Key Technology (Shanghai) Trading
                Co.,
                Ltd., and the Peso balance sheet of Productos Key
                Mexicana.





·
            Foreign
                exchange gains of $570,000 were recognized in the other income and
                expense
                section of the consolidated statement of operations as a result of
                conversion of Euro and other foreign currency denominated receivables,
                intercompany loans, and cash carried on the balance sheet of the
                U.S.
                operations, as well as the result of the conversion of other
                non-functional currency receivables, payables and cash carried on
                the
                balance sheets of the European, Australian, Chinese, and Mexican
                operations.





The
      U.S.
      dollar weakened during the fiscal year and the U.S. dollar is still in a
      relatively weak position on the world markets.  A relatively weaker
      U.S. dollar on the world markets makes the Company’s U.S.-manufactured goods
      relatively less expensive to international customers when denominated in U.S.
      dollars or potentially more profitable to the Company when denominated in a
      foreign currency.  On the other hand, materials or components imported
      into the U.S. may be more expensive.  A relatively weaker U.S. dollar
      on the world markets, especially as measured against the Euro, may favorably
      affect the Company’s market and economic outlook for international
      sales.  The Company’s Netherlands-based subsidiary transacts business
      primarily in Euros and does not have significant exports to the
      U.S.





Under
      the
      Company’s current credit facilities, the Company may borrow at the lender’s
      prime rate between minus 150 and plus 175 basis points.  At September
      30, 2007, the Company had no borrowings which had variable interest
      rates.  During the year then ended, interest rates applicable to its
      variable rate credit facilities ranged from 5.75% to 6.8%.  At
      September 30, 2007, the rate was 6.0% on its domestic credit facility and 6.8%
      on its European credit facility.  As of September 30, 2007, management
      estimates that a 100 basis point change in these interest rates would not affect
      net income before taxes because the Company had no borrowings outstanding under
      its variable interest rate facilities.


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**ITEM
      8.                      FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA.**





Title
            **Page**Report
                of Independent Registered Public Accounting Firm
            30Report
                of Independent Registered Public Accounting Firm
            31Consolidated
                Balance Sheets at September 30, 2007 and 2006
            32Consolidated
                Statements of Operations for the three years ended September 30,
                2007
            34Consolidated
                Statements of Shareholders' Equity for the three years ended September
                30,
                2007
            35Consolidated
                Statements of Cash Flows for the three years ended September 30,
                2007
            36Notes
                to Consolidated Financial Statements
            38Supplementary
                Data
            55




29
 Table
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**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**








Board
      of
      Directors and Shareholders of Key Technology, Inc.





We
      have
      audited the accompanying consolidated balance sheets of Key Technology, Inc.
      (an
      Oregon corporation) as of September 30, 2007 and 2006, and the related
      consolidated statements of operations, shareholders' equity, and cash flows
      for
      each of the three years in the period ended September 30, 2007. These financial
      statements are the responsibility of the Company's management. Our
      responsibility is to express an opinion on these financial statements based
      on
      our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles used
      and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of Key Technology, Inc. as
      of
      September 30, 2007 and 2006, and the results of its operations and its cash
      flows for each of the three years in the period ended September 30, 2007 in
      conformity with accounting principles generally accepted in the United States
      of
      America.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the effectiveness of Key Technology Inc.’s
      internal control over financial reporting as of September 30, 2007, based on
      criteria established in Internal Control—Integrated Framework issued by the
      Committee of Sponsoring Organizations of the Treadway Commission (COSO) and
      our
      report dated December 7, 2007 expressed an unqualified opinion on the
      effectiveness of the Company’s internal control over financial
      reporting.








/s/
      GRANT
      THORNTON LLP








Seattle,
      Washington


December
      7, 2007




30
 Table
          of Contents





**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**






Board
      of
      Directors and Shareholders of Key Technology, Inc.





We
      have
      audited the internal control over financial reporting of Key Technology, Inc.
      (the Company) as of September 30, 2007, based on criteria established in
      Internal Control—Integrated Framework issued by the Committee of Sponsoring
      Organizations of the Treadway Commission (COSO). Key Technology, Inc.’s
      management is responsible for maintaining effective internal control over
      financial reporting and for its assessment of the effectiveness of internal
      control over financial reporting, included in the accompanying Management’s
      Annual Report on Internal Control Over Financial Reporting. Our responsibility
      is to express an opinion on the Company’s internal control over financial
      reporting based on our audit.





We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether effective
      internal control over financial reporting was maintained in all material
      respects. Our audit included obtaining an understanding of internal control
      over
      financial reporting, assessing the risk that a material weakness exists, testing
      and evaluating the design and operating effectiveness of internal control based
      on the assessed risk, and performing such other procedures as we considered
      necessary in the circumstances. We believe that our audit provides a reasonable
      basis for our opinion.





A
      company’s internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with generally accepted accounting principles. A company’s internal control over
      financial reporting includes those policies and procedures that (1) pertain
      to
      the maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the company; (2)
      provide reasonable assurance that transactions are recorded as necessary to
      permit preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the company are
      being made only in accordance with authorizations of management and directors
      of
      the company; and (3) provide reasonable assurance regarding prevention or timely
      detection of unauthorized acquisition, use, or disposition of the company’s
      assets that could have a material effect on the financial
      statements.





Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.





In
      our
      opinion, the Company maintained, in all material respects, effective internal
      control over financial reporting as of September 30, 2007, based on criteria
      established in Internal Control—Integrated Framework issued by
      COSO.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the accompanying consolidated balance sheets
      of
      Key Technology, Inc. as of September 30, 2007 and 2006, and the related
      consolidated statements of operations, stockholders' equity, and cash flows
      for
      each of the three years in the period ended September 30, 2007 and our report
      dated December 7, 2007 expressed an unqualified opinion on those financial
      statements.





/s/
      GRANT
      THORNTON LLP





Seattle,
      Washington


December
      7, 2007


31
 Table
            of Contents
  **KEY
                  TECHNOLOGY, INC. AND SUBSIDIARIES****CONSOLIDATED
                  BALANCE SHEETS****SEPTEMBER
                  30, 2007 AND 2006**(In
                  thousands)**2007**
              
              
              **2006****ASSETS**CURRENT
                  ASSETS:Cash
                  and cash equivalents
              
              $
              27,880
              
              
              $
              15,246Trade
                  accounts receivable, net
              
              
              14,020
              
              
              
              10,381Inventories
              
              
              18,753
              
              
              
              16,035Deferred
                  income taxes
              
              
              2,120
              
              
              
              2,145Prepaid
                  expenses and other assets
              
              
              1,954
              
              
              
              2,294Total
                  current assets
              
              
              64,727
              
              
              
              46,101PROPERTY,
                  PLANT, AND EQUIPMENT, Net
              
              
              4,671
              
              
              
              4,275DEFERRED
                  INCOME TAXES
              
              
              -
              
              
              
              160INTANGIBLES,
                  Net
              
              
              3,573
              
              
              
              4,876GOODWILL,
                  Net
              
              
              2,524
              
              
              
              2,524OTHER
                  ASSETS
              
              
              2
              
              
              
              2TOTAL
              
              $
              75,497
              
              
              $
              57,938See
                  notes to consolidated financial statements.
              
              
              
              
              
              (Continued)
  32
 Table
            of Contents
  **KEY
                  TECHNOLOGY, INC. AND SUBSIDIARIES****CONSOLIDATED
                  BALANCE SHEETS****SEPTEMBER
                  30, 2007 AND 2006**(In
                  thousands, except shares)**2007**
              
              
              **2006****LIABILITIES
                  AND SHAREHOLDERS’ EQUITY**CURRENT
                  LIABILITIES:Accounts
                  payable
              
              $
              5,692
              
              
              $
              3,983Accrued
                  payroll liabilities and commissions
              
              
              6,663
              
              
              
              4,400Accrued
                  customer support and warranty costs
              
              
              1,946
              
              
              
              1,137Income
                  tax payable
              
              
              181
              
              
              
              4Customer
                  purchase plans
              
              
              651
              
              
              
              393Other
                  accrued liabilities
              
              
              798
              
              
              
              866Customers’
                  deposits
              
              
              7,850
              
              
              
              5,260Current
                  portion of long-term debt
              
              
              -
              
              
              
              1Total
                  current liabilities
              
              
              23,781
              
              
              
              16,044DEFERRED
                  INCOME TAXES
              
              
              722
              
              
              
              46LONG-TERM
                  DEFERRED RENT
              
              
              601
              
              
              
              596COMMITMENTS
                  AND CONTINGENCIES
              
              
              -
              
              
              
              -SHAREHOLDERS’
                  EQUITY:Preferred
                  stock—no par value; 5,000,000 shares authorized;none
                  issued and outstanding
              
              
              -
              
              
              
              -Common
                  stock—no par value; 15,000,000 shares authorized; 5,508,658
                  and5,385,688
                  issued and outstanding at September 30, 2007 and 2006,
                  respectively
              
              
              17,105
              
              
              
              14,698Retained
                  earnings
              
              
              32,659
              
              
              
              26,311Accumulated
                  other comprehensive income
              
              
              629
              
              
              
              243Total
                  shareholders’ equity
              
              
              50,393
              
              
              
              41,252TOTAL
              
              $
              75,497
              
              
              $
              57,938See
                  notes to consolidated financial statements.
              
              
              
              
              
              (Concluded)
  33
 Table
            of Contents
  **KEY
                  TECHNOLOGY, INC. AND SUBSIDIARIES****CONSOLIDATED
                  STATEMENTS OF OPERATIONS****THREE
                  YEARS ENDED SEPTEMBER 30, 2007**(In
                  thousands, except per share data)**2007**
              
              
              **2006**
              
              
              **2005**NET
                  SALES
              
              $
              107,540
              
              
              $
              84,840
              
              
              $
              80,322COST
                  OF SALES
              
              
              66,099
              
              
              
              53,041
              
              
              
              49,145Gross
                  profit
              
              
              41,441
              
              
              
              31,799
              
              
              
              31,177OPERATING
                  EXPENSES:Selling
              
              
              17,191
              
              
              
              14,784
              
              
              
              12,639Research
                  and development
              
              
              5,520
              
              
              
              6,444
              
              
              
              5,134General
                  and administrative
              
              
              8,821
              
              
              
              9,185
              
              
              
              8,087Amortization
                  of intangibles
              
              
              1,307
              
              
              
              1,330
              
              
              
              1,333Total
                  operating expenses
              
              
              32,839
              
              
              
              31,743
              
              
              
              27,193GAIN
                  ON SALE OF ASSETS
              
              
              23
              
              
              
              109
              
              
              
              28INCOME
                  FROM OPERATIONS
              
              
              8,625
              
              
              
              165
              
              
              
              4,012OTHER
                  INCOME (EXPENSE):Royalty
                  income
              
              
              31
              
              
              
              17
              
              
              
              -Interest
                  income
              
              
              726
              
              
              
              391
              
              
              
              229Interest
                  expense
              
              
              (12
              )
              
              
              (36
              )
              
              
              (179
              )Equity
                  in earnings (loss) of joint venture
              
              
              -
              
              
              
              (389
              )
              
              
              (659
              )Gain
                  on sale of joint venture
              
              
              750
              
              
              
              -
              
              
              
              -Impairment
                  charge on investment in joint venture
              
              
              -
              
              
              
              (865
              )
              
              
              -Other,
                  net
              
              
              466
              
              
              
              (98
              )
              
              
              190Total
                  other income (expense)—net
              
              
              1,961
              
              
              
              (980
              )
              
              
              (419
              )Earnings
                  (loss) before income taxes
              
              
              10,586
              
              
              
              (815
              )
              
              
              3,593Income
                  tax expense (benefit)
              
              
              3,176
              
              
              
              (22
              )
              
              
              902Net
                  earnings (loss)
              
              
              7,410
              
              
              
              (793
              )
              
              
              2,691Assumed
                  dividends on mandatorily redeemable preferred stock
              
              
              -
              
              
              
              -
              
              
              
              (33
              )Net
                  earnings (loss) available to common shareholders
              
              $
              7,410
              
              
              $
              (793
              )
              
              $
              2,658EARNINGS
                  (LOSS) PER SHARE—Basic
              
              $
              1.41
              
              
              $
              (0.15
              )
              
              $
              0.53EARNINGS
                  (LOSS) PER SHARE—Diluted
              
              $
              1.37
              
              
              $
              (0.15
              )
              
              $
              0.52SHARES
                  USED IN PER SHARE CALCULATION—Basic
              
              
              5,265
              
              
              
              5,205
              
              
              
              5,041SHARES
                  USED IN PER SHARE CALCULATION—Diluted
              
              
              5,407
              
              
              
              5,205
              
              
              
              5,219See
                  notes to consolidated financial statements.
   34
 Table
            of Contents


**KEY
                  TECHNOLOGY, INC. AND SUBSIDIARIES****CONSOLIDATED
                  STATEMENTS OF SHAREHOLDERS’ EQUITY****THREE
                  YEARS ENDED SEPTEMBER 30, 2007**(Dollars
                  in thousands)
 
 **Deferred**
              
              
              
              
              
              **Accumulated****Common
                  Stock**
              
              
              **Stock-**
              
              
              
              
              
              **Other****Based**
              
              
              **Retained**
              
              
              **Comprehensive****Shares**
              
              
              **Amount**
              
              
              **Compensation**
              
              
              **Earnings**
              
              
              **Income
                  (Loss)**
              
              
              **Total**Balance
                  at September 30, 2004
              
              
              4,982,500
              
              
              $
              11,493
              
              
              $
              0
              
              
              $
              24,413
              
              
              $
              138
              
              
              $
              36,044Components
                  of comprehensive income:Net
                  earnings
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              2,691
              
              
              
              
              
              
              
              2,691Comprehensive
                  income—foreign currency translation adjustment, net of tax of
                  $8
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (15
              )
              
              
              (15
              )Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              2,676Tax
                  benefits from share-based payments
              
              
              
              
              
              
              30
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              30Shares
                  converted from mandatorily redeemable preferred stock
              
              
              52Shares
                  converted from warrants
              
              
              230
              
              
              
              6
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              6Reclass
                  expired warrants to equity
              
              
              
              
              
              
              127
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              127Issuance
                  of stock upon exercise of stock options
              
              
              191,858
              
              
              
              1,481
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,481Issuance
                  of stock for Employee Stock Purchase Plan
              
              
              3,644
              
              
              
              34
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              34Stock
                  grants - employment-based
              
              
              54,500
              
              
              
              751
              
              
              
              (751
              )Stock
                  grants - performance-based
              
              
              115,000
              
              
              
              1,379
              
              
              
              (1,379
              )Amortization
                  of deferred stock-based compensation
              
              
              
              
              
              
              
              
              
              
              73
              
              
              
              
              
              
              
              
              
              
              
              73Balance
                  at September 30, 2005
              
              
              5,347,784
              
              
              
              15,301
              
              
              
              (2,057
              )
              
              
              27,104
              
              
              
              123
              
              
              
              40,471Components
                  of comprehensive income:Net
                  loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (793
              )
              
              
              
              
              
              
              (793
              )Comprehensive
                  income—foreign currency translation adjustment, net of tax of
                  $62
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              120
              
              
              
              120Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (673
              )Tax
                  benefits from share-based payments
              
              
              
              
              
              
              262
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              262Share
                  based payments
              
              
              
              
              
              
              910
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              910Issuance
                  of stock upon exercise of stock options
              
              
              40,412
              
              
              
              220
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              220Issuance
                  of stock for Employee Stock Purchase Plan
              
              
              5,765
              
              
              
              62
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              62Stock
                  grants - employment-based
              
              
              25,926Stock
                  grants - performance-based
              
              
              (34,199
              )Reversal
                  of deferred stock compensation on adoption of FASB 123(R)
              
              
              
              
              
              
              (2,057
              )
              
              
              2,057Balance
                  at September 30, 2006
              
              
              5,385,688
              
              
              
              14,698
              
              
              
              0
              
              
              
              26,311
              
              
              
              243
              
              
              
              41,252Components
                  of comprehensive income:Net
                  earnings
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              7,410
              
              
              
              
              
              
              
              7,410Comprehensive
                  income—foreign currency translation adjustment, net of tax of
                  $228
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              443
              
              
              
              443Less:
                  Reclassification to net earnings (net of tax benefit of
                  $29)
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (57
              )
              
              
              (57
              )Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              7,796Tax
                  benefits from share-based payments
              
              
              
              
              
              
              58
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              58Share
                  based payments
              
              
              
              
              
              
              1,031
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,031Issuance
                  of stock upon exercise of stock options
              
              
              174,184
              
              
              
              1,495
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,495Issuance
                  of stock for Employee Stock Purchase Plan
              
              
              4,176
              
              
              
              64
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              64Stock
                  buyback
              
              
              (88,252
              )
              
              
              (241
              )
              
              
              
              
              
              
              (1,062
              )
              
              
              
              
              
              
              (1,303
              )Stock
                  grants - employment-based
              
              
              70,736Stock
                  forfeitures and retirements
              
              
              (37,874
              )Balance
                  at September 30, 2007
              
              
              5,508,658
              
              
              $
              17,105
              
              
              $
              0
              
              
              $
              32,659
              
              
              $
              629
              
              
              $
              50,393See
                  notes to consolidated financial statements.
 35
 Table
              of Contents
 **KEY
                  TECHNOLOGY, INC. AND SUBSIDIARIES****CONSOLIDATED
                  STATEMENTS OF CASH FLOWS****THREE
                  YEARS ENDED SEPTEMBER 30, 2007**(In
                  thousands)
 
 **2007**
              
              
              **2006**
              
              
              **2005**CASH
                  FLOWS FROM OPERATING ACTIVITIES:Net
                  earnings (loss)
              
              $
              7,410
              
              
              $
              (793
              )
              
              $
              2,691Adjustments
                  to reconcile net earnings (loss) to net cashprovided
                  by operating activities:Equity
                  in (earnings) loss of joint venture
              
              
              -
              
              
              
              389
              
              
              
              659Gain
                  on sale of investment in joint venture
              
              
              (750
              )
              
              
              -
              
              
              
              -Impairment
                  charge for investment in joint venture
              
              
              -
              
              
              
              865
              
              
              
              -Gain
                  on sale of assets
              
              
              (23
              )
              
              
              (109
              )
              
              
              (28
              )Foreign
                  currency exchange (gain) loss
              
              
              (570
              )
              
              
              (86
              )
              
              
              165Depreciation
                  and amortization
              
              
              2,596
              
              
              
              2,950
              
              
              
              3,153Share
                  based payments
              
              
              987
              
              
              
              910
              
              
              
              73Tax
                  savings from share-based payments
              
              
              -
              
              
              
              -
              
              
              
              197Excess
                  tax benefit from share based payments
              
              
              (320
              )Deferred
                  income taxes
              
              
              721
              
              
              
              (218
              )
              
              
              235Deferred
                  rent
              
              
              (57
              )
              
              
              (65
              )
              
              
              (79
              )Bad
                  debt expense
              
              
              16
              
              
              
              29
              
              
              
              (43
              )Changes
                  in assets and liabilities:Trade
                  accounts receivable
              
              
              (3,283
              )
              
              
              598
              
              
              
              (1,054
              )Inventories
              
              
              (1,929
              )
              
              
              (995
              )
              
              
              (980
              )Prepaid
                  expenses and other current assets
              
              
              129
              
              
              
              (468
              )
              
              
              613Income
                  taxes receivable
              
              
              225
              
              
              
              124
              
              
              
              (255
              )Accounts
                  payable
              
              
              1,592
              
              
              
              1,651
              
              
              
              563Accrued
                  payroll liabilities and commissions
              
              
              2,106
              
              
              
              402
              
              
              
              (96
              )Accrued
                  customer support and warranty costs
              
              
              733
              
              
              
              (649
              )
              
              
              495Income
                  taxes payable
              
              
              194
              
              
              
              (83
              )
              
              
              (116
              )Other
                  accrued liabilities
              
              
              247
              
              
              
              (1,171
              )
              
              
              1,151Customers’
                  deposits
              
              
              2,348
              
              
              
              2,217
              
              
              
              152Other
              
              
              -
              
              
              
              35
              
              
              
              83Cash
                  provided by operating activities
              
              
              12,372
              
              
              
              5,533
              
              
              
              7,579CASH
                  FLOWS FROM INVESTING ACTIVITIES:Proceeds
                  from sale of property
              
              
              64
              
              
              
              143
              
              
              
              28Purchases
                  of property, plant, and equipment
              
              
              (1,563
              )
              
              
              (1,560
              )
              
              
              (977
              )Sale
                  of investment in joint venture
              
              
              750
              
              
              
              -
              
              
              
              -Acquisition
                  of Freshline Machines, Pty. Ltd., net of cash acquired
              
              
              -
              
              
              
              -
              
              
              
              (1,059
              )Cash
                  used in investing activities
              
              
              (749
              )
              
              
              (1,417
              )
              
              
              (2,008
              )See
                  notes to consolidated financial statements.
              
              
              
              
              
              
              
              
              
              (Continued)
   36
 Table
            of Contents
  **KEY
                  TECHNOLOGY, INC. AND SUBSIDIARIES****CONSOLIDATED
                  STATEMENTS OF CASH FLOWS****THREE
                  YEARS ENDED SEPTEMBER 30, 2007**(In
                  thousands)
 **2007**
              
              
              **2006**
              
              
              **2005**CASH
                  FLOWS FROM FINANCING ACTIVITIES:Payments
                  on long-term debt
              
              $
              (1
              )
              
              $
              (2,311
              )
              
              $
              (1,199
              )Redemption
                  of warrants
              
              
              -
              
              
              
              -
              
              
              
              (185
              )Redemption
                  of mandatorily redeemable preferred stock
              
              
              -
              
              
              
              -
              
              
              
              (1,278
              )Proceeds
                  from issuance of common stock
              
              
              1,559
              
              
              
              282
              
              
              
              1,512Stock
                  buyback
              
              
              (1,303
              )
              
              
              -
              
              
              
              -Excess
                  tax benefits from share based payments
              
              
              320
              
              
              
              -
              
              
              
              -Proceeds
                  from exercise of warrants
              
              
              -
              
              
              
              -
              
              
              
              6Cash
                  provided by (used in) financing activities
              
              
              575
              
              
              
              (2,029
              )
              
              
              (1,144
              )EFFECT
                  OF EXCHANGE RATE CHANGES ON CASH
              
              
              436
              
              
              
              (22
              )
              
              
              (63
              )NET
                  INCREASE  IN CASH AND CASH EQUIVALENTS
              
              
              12,634
              
              
              
              2,065
              
              
              
              4,364CASH
                  AND CASH EQUIVALENTS, BEGINNING OF YEAR
              
              
              15,246
              
              
              
              13,181
              
              
              
              8,817CASH
                  AND CASH EQUIVALENTS, END OF YEAR
              
              $
              27,880
              
              
              $
              15,246
              
              
              $
              13,181SUPPLEMENTAL
                  DISCLOSURES OF CASH FLOWINFORMATION:Cash
                  paid during the year for interest
              
              $
              12
              
              
              $
              61
              
              
              $
              178Cash
                  paid during the year for income taxes
              
              
              2,018
              
              
              
              99
              
              
              
              850See
                  notes to consolidated financial statements.
              
              
              
              
              
              
              
              
              
              (Concluded)
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**KEY
      TECHNOLOGY, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**THREE
        YEARS ENDED SEPTEMBER 30, 2007**


**1.**
            **THE
                COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING
                POLICIES**




Key
      Technology, Inc. and its wholly-owned subsidiaries (the “Company”) design,
      manufacture, and sell process automation systems, integrating electro-optical
      inspection and sorting, specialized conveying and product preparation
      equipment.  The consolidated financial statements include the accounts
      of Key Technology, Inc. and its wholly-owned subsidiaries:  Key
      Technology Holdings USA LLC; Key Technology AMVC LLC; Productos Key Mexicana
      S.
      de R. L. de C.V.; Key Technology (Shanghai) Trading Co. Ltd.; and Key Technology
      Australia Pty Ltd.  Suplusco Holding B.V. is a wholly-owned European
      subsidiary of Key Technology Holdings USA LLC that includes the accounts of
      Key
      Technology B.V.  Key Technology Australia Pty Ltd. includes the
      accounts of Freshline Machines Pty Ltd. (inactive).  All significant
      intercompany accounts and transactions have been eliminated.  The
      financial statements also include the Company’s investment in InspX LLC, a 50%
      owned joint venture accounted for by the equity method (See Note
      7).




***Revenue
      Recognition***—The Company recognizes revenue when persuasive
      evidence of an arrangement exists, delivery has occurred or services have been
      provided, the sale price is fixed or determinable, and collectibility is
      reasonably assured.  Additionally, the Company sells its goods on
      terms which transfer title and risk of loss at a specified location, typically
      shipping point, port of loading or port of discharge, depending on the final
      destination of the goods.  Accordingly, revenue recognition from
      product sales occurs when all factors are met, including transfer of title
      and
      risk of loss, which occurs either upon shipment by the Company or upon receipt
      by customers at the location specified in the terms of sale.  Revenue
      earned from services (maintenance, installation support, and repairs) is
      recognized ratably over the contractual period or as the services are
      performed.  If any contract provides for both equipment and services
      (multiple deliverables), the sales price is allocated to the various elements
      based on objective evidence of fair value.  Each element is then
      evaluated for revenue recognition based on the previously described
      criteria.  The Company’s sales arrangements provide for no other
      significant post shipment obligations.  If all conditions of revenue
      recognition are not met, the Company defers revenue recognition.  In
      the event of revenue deferral, the sale value is not recorded as revenue to
      the
      Company, accounts receivable are reduced by any amounts owed by the customer,
      and the cost of the goods or services deferred is carried in
      inventory.  In addition, the Company periodically evaluates whether an
      allowance for sales returns is necessary.  Historically, the Company
      has experienced little, if any, sales returns.  If the Company
      believes there are potential sales returns, the Company would provide any
      necessary provision against sales.  Upon receipt of an order, the
      Company generally receives a deposit which is recorded as customers’
deposits.  The Company makes periodic evaluations of the
      creditworthiness of its customers and generally does not require
      collateral.  An allowance for credit losses is provided based upon
      historical experience and anticipated losses.  The Company records
      revenues net of any taxes, such as sales tax, which are passed through to the
      customer.




In
      accordance with the Financial Accounting Standard Board’s Emerging Issues Task
      Force Issue (“EITF”) No. 01-9, *“Accounting for Consideration Given by a
      Vendor to a Customer or a Reseller of the Vendor’s Product,”* the Company
      accounts for cash consideration (such as sales incentives) that are given to
      customers or resellers as a reduction of revenue rather than as an operating
      expense unless an identified benefit is received for which fair value can be
      reasonably estimated.




***Cash
      and Cash Equivalents***—The Company considers all highly liquid
      investments with original maturities of 90 days or less at date of acquisition
      to be cash equivalents.




***Inventories***
      are stated at the lower of cost (first-in, first-out method) or
      market.




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***Property,
      Plant, and Equipment*** are recorded at cost and depreciated over
      estimated useful lives on the straight-line basis, and depreciation commences
      at
      the time assets are placed in service.  Leasehold improvements are
      amortized over the lesser of useful life or the term of the applicable lease
      using the straight-line method.  The range of useful lives for fixed
      assets is as follows:




**Years**Buildings
                  and improvements
              7
                  to 40Manufacturing
                  equipment
              5
                  to 10Office
                  equipment, furniture, and fixtures
              3
                  to 7




***Goodwill
      and Other Intangibles***—The Company accounts for goodwill in
      accordance with Statement of Financial Accounting Standards (“SFAS”)
      No. 142, *Goodwill and Other Intangible Assets*.  Goodwill
      is not amortized, but an assessment of potential goodwill impairment is
      performed by the Company on an annual basis, or sooner, if
      necessary.




Other
      intangibles, which consist of patents, developed technologies, trademarks and
      trade names, and customer related intangible assets, are amortized over the
      estimated useful lives of the related assets, which are 10 years for the
      majority of the assets.  Management periodically evaluates the
      recoverability of other intangibles based upon current and anticipated results
      of operations and undiscounted future cash flows.  Amortization of
      other intangibles was $1,307,000, $1,330,000and $1,333,000 for the years ended
      September 30, 2007, 2006, and 2005, respectively (see
      Note 3).




***Accrued
      Customer Support and Warranty Costs***—The Company provides customer
      support services consisting of start-up assistance and evaluation and training
      to its customers.  The Company also provides a warranty on its
      products ranging from ninety days to five years following the date of
      shipment.  The majority of product warranties are for periods between
      one and two years.  Management establishes allowances for customer
      support and warranty costs based upon the types of products shipped, customer
      support and product warranty experience.  The provision of customer
      support and warranty costs is charged to cost of sales at the point of sale,
      and
      it is periodically assessed for adequacy based on changes in these
      factors.




A
      reconciliation of the changes in the Company’s allowances for warranties is as
      follows (in thousands):




**2007**
              
              
              **2006**Beginning
                  balance
              
              $
              979
              
              
              $
              1,191Warranty
                  costs incurred
              
              
              (2,122
              )
              
              
              (2,048
              )Warranty
                  expense accrued
              
              
              2,518
              
              
              
              1,821Translation
                  adjustments
              
              
              58
              
              
              
              15Ending
                  balance
              
              $
              1,433
              
              
              $
              979


***Income
      Taxes***—Deferred income taxes are provided for the effects of
      temporary differences arising from differences in the reporting of revenues
      and
      expenses for financial statement and for income tax purposes under the asset
      and
      liability method using currently enacted tax rates.




***Research
      and Development***—Expenditures for research and development are
      expensed when incurred.




***Foreign
      Currency Translation***—Assets and liabilities denominated in a
      foreign currency are translated to U.S. dollars at the exchange rate on the
      balance sheet date.  Translation adjustments are shown as part of
      accumulated other comprehensive income (loss).  Revenues, costs, and
      expenses are translated using an average rate.  Realized and
      unrealized foreign currency transaction gains and losses are included in the
      consolidated statement of operations.




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***Impairment
      of Long-Lived Assets***—The Company
      regularly reviews
      all of its long-lived assets, including property, plant and equipment, and
      amortizable intangible assets, for impairment whenever events or changes in
      circumstances indicate that the carrying value may not be
      recoverable.  If the total of future undiscounted cash flows is less
      than the carrying amount of these assets, an impairment loss, if any, based
      on
      the excess of the carrying amount over the fair value of the assets, is
      recorded.  In addition, goodwill is reviewed based on its implied fair
      value at least annually.




***One-Time
      Termination Costs***—In September
      2006, the
      Company announced plans to consolidate a portion of its Medford, Oregon office
      and its manufacturing operations in Australia into its primary operating
      facility in Walla Walla.  These reductions in its work force were
      completed in early calendar year 2007.  As a result, the Company
      incurred approximately $479,000 in costs associated with net one-time
      termination benefits, including retention bonuses.  Of this amount,
      approximately $372,000 was expensed in fiscal 2006 as part of operating
      expenses, with the remainder expensed as part of operating expenses in the
      first
      quarter of fiscal 2007.  As of March 31, 2007, all amounts accrued had
      been paid.




***Estimates***—The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect the reported amounts of assets and
      liabilities and disclosure of contingent assets and liabilities at the date
      of
      the financial statements and reported amounts of revenues and expenses during
      the reporting period.  Actual results could differ from those
      estimates.




***Financial
      Instruments***—The carrying value of the Company’s cash and cash
      equivalents, accounts and notes receivable, accounts payable, accrued payroll
      liabilities and commissions, accrued customer support and warranty costs, and
      other accrued liabilities approximates their estimated fair values due to the
      short maturities of those instruments.




***Earnings
      Per Share***—Basic earnings (loss) per share (“EPS”) is computed by
      dividing net earnings (loss) available to common shareholders by the weighted
      average number of shares outstanding for the period.  Diluted EPS is
      computed by dividing net earnings (loss) available to common shareholders by
      the
      weighted average common stock and common stock equivalent shares outstanding
      during each period using the treasury stock method for employee stock option
      plans and service-based stock awards and warrants, and the if-converted method
      for mandatorily redeemable preferred stock, if the common equivalent shares
      were
      not anti-dilutive.  If the mandatorily redeemable preferred stock is
      not anti-dilutive, assumed dividends on these securities is added back into
      net
      earnings available to common shareholders for the computation of diluted
      EPS.  The calculation of the basic and diluted EPS from continuing
      operations is as follows (in thousands except per share data):





**For
                the year ended September 30, 2007****Earnings**
            
            
            **Shares**
            
            
            **Per-Share
                Amount**Basic
                EPS:Net
                earnings available to common shareholders
            
            $
            7,410
            
            
            
            5,265
            
            
            $
            1.41Effect
                of dilutive securities:Common
                stock options
            
            
            -
            
            
            
            97Common
                stock awards
            
            
            -
            
            
            
            45Diluted
                EPS:Net
                earnings available to common shareholders plus assumed
                conversions
            
            $
            7,410
            
            
            
            5,407
            
            
            $
            1.37




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**For
                the year ended September 30, 2006****Loss**
            
            
            **Shares**
            
            
            **Per-Share
                Amount**Basic
                EPS:Net
                loss available to common shareholders
            
            $
            (793
            )
            
            
            5,205
            
            
            $
            (0.15
            )Effect
                of dilutive securities:None
            
            
            -
            
            
            
            -Diluted
                EPS:Net
                loss available to common shareholders plus assumed
                conversions
            
            $
            (793
            )
            
            
            5,205
            
            
            $
            (0.15
            )








**For
                the year ended September 30, 2005****Earnings**
            
            
            **Shares**
            
            
            **Per-Share
                Amount**Net
                earnings from continuing operations
            
            $
            2,691Less:   Assumed
                dividends on mandatorily redeemable preferred stock
            
            
            (33
            )Basic
                EPS:Net
                earnings available to common shareholders
            
            
            2,658
            
            
            
            5,041
            
            
            $
            0.53Effect
                of dilutive securities:Common
                stock options
            
            
            -
            
            
            
            115Mandatorily
                redeemable preferred stock
            
            
            33
            
            
            
            63Diluted
                EPS:Income
                available to common shareholders plus assumed conversions
            
            $
            2,691
            
            
            
            5,219
            
            
            $
            0.52








The
      weighted average number of diluted shares does not include potential common
      shares which are anti-dilutive, nor does it include performance-based restricted
      stock awards if the performance measurement has not been met.  The
      following potential common shares were not included in the calculation of
      diluted EPS as they were anti-dilutive:




**For
                the year ended September 30****2007**
            
            
            **2006**
            
            
            **2005**Common
                shares from:Assumed
                exercise of stock options
            
            
            -
            
            
            
            389,702
            
            
            
            249,100Assumed
                exercise of:-  employment
                based stock grants
            
            
            -
            
            
            
            70,926
            
            
            
            52,500-  performance
                based stock grants
            
            
            -
            
            
            
            88,301
            
            
            
            115,000-  non-employee
                stock grants
            
            
            -
            
            
            
            2,000
            
            
            
            2,000




The
      options expire on dates beginning in February 2008 through February
      2015.  The restrictions on stock grants may lapse between December
      2007 and March 2010.




In
      2004,
      the Financial Accounting Standards Board’s Emerging Issues Task Force reached
      consensus on issue No. 03-6, “*Participating Securities and the Two-Class
      Method**under FASB Statement No. 128”*.  Issue No. 03-6
      determined that for participating securities, the two-class method of computing
      basic earnings per share




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is
      required.  Dividends must be calculated for the participating security
      on undistributed earnings and are a reduction in the net income available to
      common shareholders.  The Company’s Series B preferred stock was a
      participating security as it had the right to dividends should dividends be
      declared on common stock.  Assumed dividends on undistributed earnings
      are allocated as if the entire net income were distributed and are based on
      the
      relationship of the weighted average of common shares outstanding and the
      weighted average of common shares outstanding if the preferred stock were
      converted into common.




***Accounting
                for Stock-Based Compensation***—Effective October 1, 2005, the
                Company adopted the fair value recognition provisions of FASB Statement
                No. 123(R), *Share-Based
                Payment*, using the modified-prospective-transition
                method.  Under that transition method, compensation cost
                recognized in fiscal 2006 includes: (a) compensation cost for all
                share-based payments granted prior to, but not yet vested as of October
                1,
                2005, based on the grant date fair value estimated in accordance
                with the
                original provisions of Statement 123, and (b) compensation cost for
                all
                share-based payments granted subsequent to October 1, 2005, based
                on the
                grant-date fair value estimated in accordance with the provisions
                of
                Statement 123(R).  Prior to the adoption of Statement 123(R),
                the Company accounted for stock-based awards to employees and directors
                using the intrinsic value method in accordance with APB 25 as allowed
                under Statement No. 123, “Accounting for Stock-Based
                Compensation.”  In accordance with the modified prospective
                transition method, the Company’s Consolidated Financial Statements for
                prior periods have not been restated to reflect, and do not include,
                the
                effect of Statement 123(R).





Upon
      adoption of Statement 123(R), the $2.1 million increase in common stock and
      the
      offsetting amount in deferred stock-based compensation, that are both reflected
      in shareholders’ equity at September 30, 2005, have been reversed as required by
      Statement 123(R).  The net effect has no change in total shareholders’
equity.  Prior to the adoption of Statement 123(R), the Company
      presented all tax benefits of deductions resulting from the exercise of stock
      options as operating cash flows in the Statement of Cash
      Flows.  Statement 123(R) requires the cash flows resulting from the
      tax benefits resulting from tax deductions in excess of the compensation cost
      recognized for those options (excess tax benefits) to be classified as financing
      cash flows.




If
      the
      Company had accounted for stock compensation in accordance with
      Statement No. 123(R) for fiscal 2005, the Company’s net earnings and
      earnings per share would approximate the pro forma disclosures below (in
      thousands, except per share amounts):


**Year
                  Ended September 2005**Net
                  earnings, as reported
              
              $
              2,691Deduct:
                  Total stock-based employee compensation expense determined under
                  fair
                  value based method for all awards, net of related tax
                  effects
              
              
              (361
              )Plus:
                  Stock-based employee compensation expense already included in the
                  determination of net earnings, net of related tax effects
              
              
              47Pro
                  forma net earnings
              
              $
              2,377Earnings
                  per shareBasic
                  - as reported
              
              $
              0.53Basic
                  - pro forma
              
              $
              0.47Diluted
                  - as reported
              
              $
              0.52Diluted
                  - pro forma
              
              $
              0.46


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***Future
      Accounting
      Changes***— In June 2006, the Financial Accounting Standards
      Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in
      Income Taxes” (“FIN 48”), an interpretation of FASB Statement No.
      109.  FIN 48 provides guidance for the recognition, derecognition and
      measurement in financial statements of tax positions taken in previously filed
      tax returns or tax positions expected to be taken in tax returns.  FIN
      48 requires an entity to recognize the financial statement impact of a tax
      position when it is more likely than not that the position will be sustained
      upon examination.  If the tax position meets the more likely than not
      recognition threshold, the tax effect is recognized at the largest amount of
      the
      benefit that is greater than fifty percent likely of being realized upon
      ultimate settlement.  FIN 48 also provides guidance on classification,
      interest and penalties, accounting in interim periods, disclosure and
      transition.  The Company will be required to adopt FIN 48 as of October 1,
      2007.  The Company has not fully completed its evaluation of the
      impact Interpretation 48 will have on its financial position and results of
      operations when adopted; however, the Company currently estimates that upon
      adoption the Company will record an estimated $250,000 increase in retained
      earnings.  The Company believes that the adoption of FIN 48 will not
      have a material ongoing effect on its financial position, results of operations,
      and cash flow.




In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      (“SFAS”) No. 157, “Fair Value Measurements,” which establishes guidelines
      for measuring fair value and expands disclosures regarding fair value
      measurements.  SFAS No. 157 does not require any new fair
      value measurements but rather it eliminates inconsistencies in the guidance
      found in various prior accounting
      pronouncements.  SFAS No. 157 is effective for fiscal years
      beginning after November 15, 2007.  The Company is evaluating the
      potential effects of this standard, although we do not expect the adoption
      of
      SFAS No. 157 to have a material effect on our financial position,
      results of operation, or cash flows.




In
      February 2007, the FASB issued Statement 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities”.  This Statement permits
      entities to elect to measure certain financial instruments and other items
      at
      fair value through earnings.  The fair value option may be applied on
      an instrument by instrument basis, is irrevocable and is applied only to entire
      instruments.  SFAS 159 requires additional financial statement
      presentation and disclosure requirements for those entities that elect to adopt
      the standard and is effective for fiscal years beginning after November 15,
      2007.  We do not anticipate any material impact on our financial
      condition or results of operations as a result of the adoption of SFAS
      159.





In
      September 2006, the SEC released Staff Accounting Bulletin No. 108, “Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements” (“SAB 108”). **SAB 108 provides
      guidance on how the effects of the carryover or reversal of prior year
      misstatements should be considered in quantifying a current year misstatement.
      **In some situations, companies will be required to record errors
      that occurred in prior years even though those errors were immaterial for each
      year in which they arose. **Companies may choose to either restate
      all previously presented financial statements or record the cumulative effect
      of
      such errors as an adjustment to retained earnings at the beginning of the period
      in which SAB 108 is applied.  SAB 108 is effective for fiscal years
      ending after November 15, 2006, and was adopted by the Company on October 1,
      2006.  The adoption of SAB 108 had no effect on the Company's
      financial statements.




***Reclassifications***— Certain reclassifications have been made to prior year amounts
        to conform to the current year presentation.


**2.**
            **ACQUISITIONS**




Effective
      February 10, 2005, the Company acquired all the outstanding stock of Freshline
      Machines Pty Ltd. (“Freshline”).  The purchase price, including
      acquisition costs, was approximately $1,477,000.  The purchase
      agreement also provided for contingent payments if Freshline’s gross revenues in
      the twelve-month period subsequent
      to acquisition exceeded specific targets.  The maximum contingent
      purchase price under these contingencies was $700,000.  The specified
      targets were not met and there was no contingent purchase price
      payment.  The Company paid the cash purchase price from cash on
      hand.




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The
      acquisition was accounted for as a purchase and Freshline’s results of operation
      for the period subsequent to the acquisition have been included in the Company’s
      Consolidated Statements of Operations.  The purchase price has been
      allocated to the assets and liabilities of Freshline based on their estimated
      fair values.  Based on the estimates, the Company recorded
      approximately $152,000 of patents / developed technologies, which is being
      amortized on a straight-line basis over 10 years, as the product lines
      associated with these assets are expected to continue to generate revenues
      for
      an extended period of time.  Assets and liabilities acquired were as
      follows (in thousands):




Fair
                  value of assets acquiredTangible
                  assets
              
              $
              1,041Note
                  receivable from previous owner
              
              
              672Patents
                  / developed technologies
              
              
              152Liabilities
                  assumed
              
              
              (806
              )Cash
                  paid for common stock, less cash acquired of $418
              
              $
              1,059
  In
      September 2006, the Company announced plans to close its facility at Freshline
      and move manufacturing operations to its primary operating facility in Walla
      Walla.  This was completed early in calendar year
      2007.  (See Note 1 – One-Time Termination Costs)




The
      note
      receivable from Freshline’s previous owner was re-paid in March
      2005.  In addition, the Company entered into the following two
      agreements with the previous owner: (1) a one year rental, with a one-year
      renewal option, of the building where Freshline is currently operating, and
      (2)
      a two-year consulting agreement.  Both agreements expired early in
      calendar year 2007.




**3.**
            **GOODWILL
                AND OTHER INTANGIBLE
                ASSETS**




As
      of
      September 30, 2007, the Company had the following intangible assets (in
      thousands):




**Cost**
            
            
            **Net
                Book Value**Patents
                and developed technologies
            
            $
            11,085
            
            
            $
            2,857Purchased
                trademarks and trade names
            
            
            1,700
            
            
            
            468Customer
                related intangibles
            
            
            900
            
            
            
            248$
            13,685
            
            
            $
            3,573





The
      significant majority of these assets are being amortized over 10
      years.  Amortization expense for the next five fiscal years is
      expected to be approximately:




**Year
                ended September 30**
              **(in
                thousands)**2009
            
            $
            1,3072009
            
            
            1,2692010
            
            
            9292011
            
            
            152012
            
            
            15Thereafter
            
            
            38Total
            
            $
            3,573





As
      of
      September 30, 2007, the Company had $2.5 million of goodwill which is
      not being amortized.  There was no change to goodwill during the
      fiscal years ended September 30, 2007 and 2006.




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**4.**
            **TRADE
                ACCOUNTS RECEIVABLE**




Trade
      accounts receivable consist of the following (in thousands):




**September
                  30,****2007**
              
              
              **2006**Trade
                  accounts receivable
              
              $
              14,434
              
              
              $
              10,842Allowance
                  for doubtful accounts
              
              
              (414
              )
              
              
              (461
              )Total
                  trade accounts receivable, net
              
              $
              14,020
              
              
              $
              10,381
  Amounts
      charged to bad debt expense for fiscal 2007, 2006, and 2005 were $16,000,
      $29,000, and ($43,000), respectively.  Actual charges to the allowance
      for doubtful accounts for fiscal 2007, 2006, and 2005 were $98,000, $83,000,
      and
      $79,000, respectively.




**5.**
            **INVENTORIES**




Inventories
      consist of the following (in thousands):




**September
                  30,****2007**
              
              
              **2006**Purchased
                  components and raw materials
              
              $
              7,104
              
              
              $
              6,811Sub-assemblies
              
              
              1,722
              
              
              
              1,395Work-in-process
              
              
              5,081
              
              
              
              3,936Finished
                  goods
              
              
              4,846
              
              
              
              3,893Total
                  inventories
              
              $
              18,753
              
              
              $
              16,035
  At
      September 30, 2007 and 2006, respectively, cumulative inventory adjustments
      to
      lower of cost or market totaled $1.8 million and $2.2
      million.  Amounts charged to expense to record inventory at lower of
      cost or market for fiscal 2007 were $386,000, $1.6 million for fiscal 2006,
      and
      $728,000 for fiscal 2005.  Amounts charged to expense in fiscal 2006
      included charges of approximately $160,000 related to the Company’s operation at
      Freshline Machines Pty Ltd.  Actual charges to the cumulative
      inventory adjustments upon disposition or sale of inventory were $903,000,
      $2.3
      million and $863,000 for fiscal 2007, 2006, and 2005,
      respectively.


**6.         PROPERTY,
      PLANT, AND EQUIPMENT**




Property,
      plant, and equipment consist of the following (in thousands):




**September
                  30,****2007**
              
              
              **2006**Land
              
              $
              306
              
              
              $
              273Buildings
                  and improvements
              
              
              2,944
              
              
              
              2,894Manufacturing
                  equipment
              
              
              12,243
              
              
              
              11,326Office
                  equipment, furniture, and fixtures
              
              
              7,353
              
              
              
              10,49122,846
              
              
              
              24,984Accumulated
                  depreciation
              
              
              (18,175
              )
              
              
              (20,709
              )Total
                  property, plant, and equipment, net
              
              $
              4,671
              
              
              $
              4,275


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Depreciation
      expense was $1.3 million, $1.6 million and $1.8 million for fiscal 2007, 2006
      and 2005, respectively.




**7.**
            **INVESTMENT
                IN JOINT VENTURE**




In
      July
      2004, the Company entered into a joint venture with Peco LLC to form InspX
      LLC
      for the product development, manufacturing and sales of x-ray inspection
      systems.  The Company invested $2.0 million cash in the joint venture
      plus approximately $0.1 million in capitalized acquisition costs for a 50%
      equity interest in the joint venture and was be subject to additional voluntary
      capital calls if necessary to finance the joint venture
      operations.  At the third anniversary of formation, if certain sales
      objectives were not achieved, $1.5 million of the Company’s capital contribution
      would have converted to debt.  The Company also had a purchase option
      to acquire the remaining 50% interest in the joint venture at any time after
      June 30, 2008 and, subject to certain provisions, not prior to June 30, 2009,
      at
      prices determined under valuation formulas provided for in the operating
      agreement.




The
      investment in the joint venture was being accounted for under the equity method
      of accounting.  The Company shared equally (50%) in the earnings or
      loss of the joint venture.  For the periods ending September 30, 2006
      and 2005, the Company’s equity in earnings of the joint venture was a loss of
      approximately $389,000 and $659,000, respectively.   During
      fiscal 2006, the Company also earned approximately $33,000 on sales commissions
      from InspX for sales of InspX equipment.  During fiscal 2006, the
      Company purchased $676,000 of equipment from the InspX joint
      venture.





The
      Company reached an agreement with its joint venture partner in December 2006
      pursuant to which the Company sold its interest in InspX to the InspX joint
      venture.  Under the agreement, InspX redeemed the Company’s 50%
      interest in the joint venture in exchange for $1,500,000 plus a contingent
      payment.  The $1,500,000 portion of the sale price consists
      of  $750,000 in cash that was paid to the Company in December 2006 and
      a $750,000 term note payable on September 30, 2009 bearing interest at 5% per
      annum payable quarterly until the note is paid in full.  The note is
      unsecured and, due to uncertainty related to the ultimate collectibility of
      the
      note, the Company has established an allowance for the doubtful note receivable
      for the full amount of the note.  The contingent portion of the sale
      price consists of an additional $500,000, which is payable in the event (1)
      InspX revenues for the year ended December 31, 2008 are $9,000,000 or higher,
      or
      (2) of the sale prior to December 31, 2008 by InspX or any existing owner of
      InspX of equity in InspX for $2,000,000 or more at an enterprise value for
      InspX
      of $10,000,000 or more.  The contingent payment is payable to the
      Company at InspX’s election either within 45 days after the event giving rise to
      the payment or in four equal annual installments (plus interest) beginning
      one
      year after the event giving rise to the payment.  As the contingent
      event has not occurred, and as the Company believes the likelihood of the
      contingent event occurring is remote, there has been no value recorded related
      to the contingent amount.  The cash payment received with respect to
      the Company’s sale of its interest in the InspX joint venture added
      approximately $750,000
      to pre- and after-tax income to the Company’s net earnings in the first quarter
      of fiscal 2007.  The Company and its former joint venture partner have
      agreed not to compete in the development or sale of certain x-ray based products
      for 18 months from the date of the agreement and agreed informally to cooperate
      regarding future sales of the products sold by the former joint
      venture.




**8.**
            **FINANCING
                AGREEMENTS**




The
      Company’s domestic credit facility provides for a revolving credit line of up to
      $10 million and credit sub-facilities of $3.0 million each for sight commercial
      letters of credit and standby letters of credit.  The credit facility
      matures on June 30, 2008.  The credit facility bears interest, at the
      Company’s option, of either the bank prime rate minus 1.75% or LIBOR plus 1.0%
      per annum.  At September 30, 2007, the interest rate would have been
      6.0%.  The credit facility is secured by all U.S. accounts receivable,
      inventory and fixed assets.  The credit facility contains covenants
      which require the maintenance of a defined net worth ratio, a liquidity ratio
      and minimum profitability.  The credit facility also restricts the
      payment of dividends, mergers and acquisitions, incurrence of additional
      indebtedness, transactions, including purchases and retirements, in the
      Company’s own common stock, and places limitations on capital expenditures and
      lease expenditures,




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without
      the prior consent of the Lender.  At September 30, 2007, the Company
      had no borrowings outstanding under the credit facility and $530,000 in standby
      letters of credit.  At September 30, 2007, the Company was in
      compliance with its loan covenants, and had received the consent of the lender
      for its stock repurchase program.  At September 30, 2006, the Company
      had no borrowings outstanding under the credit facility and $530,000 in standby
      letters of credit.  At September 30, 2006, the Company was not in
      compliance with its covenant related to minimum profitability.  The
      bank waived non-compliance with this covenant.





The
      Company’s credit accommodation with a commercial bank in The Netherlands
      provides a credit facility for its European subsidiary.  This credit
      accommodation totals $3.5 million and includes an operating line of the
      lesser of $2.1 million or the available borrowing base, which is based on
      varying percentages of eligible accounts receivable and inventories, and a
      bank
      guarantee facility of $1.4 million.  The operating line and bank
      guarantee facility are secured by all of the subsidiary’s personal
      property.  The credit facility bears interest at the bank’s prime
      rate, with a minimum of 3.00%, plus 1.75%.  At September 30, 2007, the
      interest rate was 6.8%.  At September 30, 2007, the Company had no
      borrowings under this facility and had received bank guarantees of $668,000
      under the bank guarantee facility.  At September 30, 2006, the Company
      had no borrowings under this facility and had received bank guarantees of
      $855,000 under the bank guarantee facility.  The credit facility
      allows overages on the bank guarantee facility.  Any overages reduce
      the available borrowings from the operating line.





At
      September 30, 2006, the Company had $1,000 in the current portion of long term
      debt related to capital leases.  The leases were due in installments
      through March 2007, at an interest rate of 8.5% and secured by certain office
      equipment.  At September 30, 2007, the Company had no capital lease
      obligations outstanding.




**9.**
            **LEASES**




The
      Company has an agreement with the Port of Walla Walla to lease its primary
      operating facility in Walla Walla.  The Company amended its lease
      agreement on its primary operating facility in June 2005, which extended the
      lease term to 2020 and added approximately 23,000 square feet of manufacturing
      and office space under the lease in 2006.  The Company currently has
      the option to purchase the land and plant under the agreement.  The
      purchase price of the primary facility is determined by reducing the original
      plant construction costs and plant expansion costs of approximately $11,600,000
      by one thirty-fifth for each lease year prior to the exercise of the option
      and
      adding $600,000 for the land, subject to further reductions if exercised after
      the fifteenth year of the lease.  The Company also has a leased
      operating facility in Oregon which expires in 2012 and has a five-year renewal
      option.  The Company has leased an operating facility in The
      Netherlands under a lease that expires in 2008, with a five-year renewal
      option.  The Company also has leased office space for sales and
      service and other activities in Oregon, Australia, Mexico, Belgium and
      China.




Rental
      expense is recognized on a straight-line basis over the term of the
      lease.  Rental expense for the Company’s operating leases referred to
      above was $1,431,000 for the year ended September 30, 2007, $1,519,000 for
      the year ended September 30, 2006, and $1,476,000 for the year ended
      September 30, 2005.




The
      following is a schedule of future minimum rental payments required under
      operating leases and future rental expense (in thousands):




**Year
                  Ending September 30**
              
              **Rental
                  Payments**
              
              
              **Rental
                  Expense**2008
              
              $
              1,268
              
              
              $
              1,2732009
              
              
              1,005
              
              
              
              1,0092010
              
              
              986
              
              
              
              9912011
              
              
              1,043
              
              
              
              9922012
              
              
              1,002
              
              
              
              951Thereafter
              
              
              7,342
              
              
              
              6,834Total
              
              $
              12,646
              
              
              $
              12,050




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**10.**
            **CONTRACTUAL
                GUARANTEES AND INDEMNITIES**




*Intellectual
      property and general contractual indemnities*




The
      Company, in the normal course of business, provides specific, limited
      indemnification to its customers for liability and damages related to
      intellectual property rights.  In addition, the Company may enter into
      contracts with customers where it has agreed to indemnify the customer for
      personal injury or property damage caused by the Company’s products and
      services. Indemnification is typically limited to replacement of the items
      or
      the actual price of the products and services.  The Company maintains
      product liability insurance as well as errors and omissions insurance, which
      may
      provide a source of recovery in the event of an indemnification claim, but
      does
      not maintain insurance coverage for claims related to intellectual property
      rights.




Historically,
      any amounts payable under these indemnifications have not had a material effect
      on the Company’s business, financial condition, results of operations, or cash
      flows. The Company has not recorded any provision for future obligations under
      these indemnifications.  If the Company determines it is probable that
      a loss has occurred under these indemnifications, then any such reasonably
      estimable loss would be recognized.




*Director
      and officer indemnities*




The
      Company has entered into indemnification agreements with its directors and
      certain executive officers which require the Company to indemnify such
      individuals against certain expenses, judgments and fines in third-party and
      derivative proceedings.  The Company may recover some of the expenses
      and liabilities that arise in connection with such indemnifications under the
      terms of its directors’ and officers’ insurance policies.  The Company
      has not recorded any provision for future obligations under these
      indemnification agreements.




*Bank
      guarantees and letters of credit*




At
      September 30, 2007, the Company had standby letters of credit totaling $1.2
      million, which includes secured bank guarantees under the Company’s credit
      facility in Europe and letters of credit securing certain self-insurance
      contracts and lease commitments.  If the Company fails to meet its
      contractual obligations, these bank guarantees and letters of credit may become
      liabilities of the Company.  This amount is comprised of approximately
      $668,000 of outstanding performance guarantees secured by bank guarantees under
      the Company’s European subsidiaries credit facility in Europe, a standby letter
      of credit for $300,000 securing certain self-insurance contracts related to
      workers compensation and a standby letter of credit for $230,000 securing
      payments under a lease contract for a domestic production
      facility.  Bank guarantees arise when the European subsidiary collects
      customer deposits prior to order fulfillment.  The customer deposits
      received are recorded
      as current liabilities on the Company’s balance sheet.  The bank
      guarantees repayment of the customer deposit in the event an order is not
      completed.  The bank guarantee is canceled upon shipment and transfer
      of title.  These bank guarantees arise in the normal course of the
      Company’s European business and are not deemed to expose the Company to any
      significant risks since they are satisfied as part of the design and
      manufacturing process.




*Purchase
      obligations*




The
      Company has contractual obligations to purchase certain materials and supplies
      aggregating $686,000 by December 31, 2008.  As of September 30, 2007,
      the Company had purchased $435,000 of materials under contract.  The
      Company anticipates it will purchase the remaining $251,000 of obligations
      in
      the next twelve months.




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**11.**
            **INCOME
                TAXES**




The
      provision for income taxes from continuing operations consists of the following
      (in thousands):




**Year
                  Ended September 30,****2007**
              
              
              **2006**
              
              
              **2005**Current:Federal
              
              $
              2,253
              
              
              $
              -
              
              
              $
              372Foreign
              
              
              187
              
              
              
              173
              
              
              
              31State
              
              
              210
              
              
              
              40
              
              
              
              672,650
              
              
              
              213
              
              
              
              470Deferred:Federal
              
              
              1,041
              
              
              
              (365
              )
              
              
              481Foreign
              
              
              (281
              )
              
              
              (276
              )
              
              
              (25
              )State
              
              
              37
              
              
              
              (49
              )
              
              
              (24
              )797
              
              
              
              (690
              )
              
              
              432Valuation
                  reserves:Federal
              
              
              (529
              )
              
              
              56
              
              
              
              -Foreign
              
              
              281
              
              
              
              366
              
              
              
              -State
              
              
              (23
              )
              
              
              33
              
              
              
              -(271
              )
              
              
              455
              
              
              
              -Total
                  income tax expense (benefit)
              
              $
              3,176
              
              
              $
              (22
              )
              
              $
              902
  The
      Company accounts for its deferred tax assets and liabilities, including excess
      tax benefits of share-based payments, based on the tax ordering of deductions
      to
      be used on its tax returns.  The tax effects of temporary differences
      that give rise to significant portions of deferred tax assets and deferred
      tax
      liabilities are as follows (in thousands):


**September
                  30,****2007**
              
              
              **2006**Deferred
                  tax asset:Reserves
                  and accruals
              
              $
              2,165
              
              
              $
              2,155Net
                  operating loss and other tax credit carryforwards
              
              
              -
              
              
              
              1,212Tax
                  benefits of share-based payments
              
              
              629
              
              
              
              308Translation
                  adjustment to equity
              
              
              (324
              )
              
              
              (126
              )Deferred
                  tax liability:Accumulated
                  depreciation
              
              
              178
              
              
              
              261Intangible
                  assets
              
              
              (1,250
              )
              
              
              (1,551
              )Net
                  deferred tax asset
              
              $
              1,398
              
              
              $
              2,259Deferred
                  tax:Current
                  asset
              
              $
              2,120
              
              
              $
              2,145Long-term
                  asset
              
              
              -
              
              
              
              160Long-term
                  liability
              
              
              (722
              )
              
              
              (46
              )Net
                  deferred tax asset
              
              $
              1,398
              
              
              $
              2,259




At
      September 30, 2007, the Company had valuation reserves of approximately $510,000
      consisting of $450,000 for deferred tax assets related to the sale of the
      investment in the InspX joint venture and the valuation reserve for notes
      receivable and contingent payments; and a net $60,000 for combined U.S.,
      Australian and Chinese deferred tax assets and liabilities, primarily related
      to
      net operating loss carryforwards in those foreign
      jurisdictions.  There were no other valuation allowances at September
      30, 2007 due to




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anticipated
      utilization of all the deferred tax assets as the Company believes it will
      have
      sufficient taxable income to utilize these assets.





During
      fiscal 2007, the Company recorded $281,000 of valuation reserves for deferred
      tax assets related to Australian and Chinese net operating losses which were
      offset by an equal amount of U.S. deferred tax liabilities related to these
      operating losses.  The Company believes these amounts will not be
      realized due to the closure of operations in Australia and the likelihood of
      the
      Company’s ability to fully utilize net operating losses in China during the
      carryforward period.  The Company also reversed valuation reserves of
      a net $271,000 for deferred tax assets related to the Company’s valuation of its
      investment in the InspX joint venture and the subsequent sale of its investment
      in the first quarter of fiscal 2007.





During
      fiscal 2006, the Company recorded valuation reserves of $58,000 for the net
      U.S.
      and Australian deferred tax assets and liabilities that would not be realized
      once the Company completed its closure of operations at Freshline Machines
      Pty
      Ltd.  In addition, the Company recorded valuation reserves of $397,000
      for deferred tax assets related to its investment in, and valuation reserve
      for,
      the InspX joint venture.





Income
      tax expense (benefit) is computed at rates different than statutory
      rates.  The reconciliation between effective and statutory rates is as
      follows:




**Year
                  Ended September 30,****2007**
              
              
              **2006**
              
              
              **2005**Statutory
                  rates
              
              
              34.0
              %
              
              
              (34.0
              )%
              
              
              34.0
              %Increase
                  (reduction) in income taxes resulting from:Extraterratorial
                  income exclusion
              
              
              (0.2
              )
              
              
              (14.3
              )
              
              
              (5.4
              )Domestic
                  production deduction
              
              
              (0.8
              )
              
              
              -
              
              
              
              -Foreign
                  tax credit effects of acquisition
              
              
              -
              
              
              
              -
              
              
              
              (2.2
              )Research
                  and development credit
              
              
              (0.7
              )
              
              
              (7.2
              )
              
              
              (1.7
              )State
                  income taxes, net of federal benefit
              
              
              1.4
              
              
              
              1.9
              
              
              
              0.6Tax
                  exempt interest
              
              
              (2.1
              )
              
              
              (14.3
              )
              
              
              (0.5
              )Valuation
                  reserve - InspX
              
              
              (2.4
              )
              
              
              48.7
              
              
              
              -Valuation
                  reserve - Freshline
              
              
              -
              
              
              
              7.1
              
              
              
              -Meals
                  and entertainment deduction limitation
              
              
              0.6
              
              
              
              7.2
              
              
              
              1.5Non-deductible
                  stock compensation
              
              
              0.3
              
              
              
              7.4
              
              
              
              -Other
                  permanent differences
              
              
              0.1
              
              
              
              (5.2
              )
              
              
              (1.2
              )Income
                  tax combined effective rate
              
              
              30.2
              %
              
              
              (2.7
              )%
              
              
              25.1
              %


**12.**
            **STOCK
                COMPENSATION PLANS**




At
      September 30, 2007, the Company had two stock-based compensation plans, which
      are shareholder-approved, as described below.  The Company has also
      awarded shares to non-employees.  The Company issues new shares of
      common stock for exercises and awards under these plans and non-employee
      awards.  Effective October 1, 2005, the Company began accounting for
      stock-based compensation under SFAS No. 123(R) (see Note 1).




Stock
      compensation costs charged against income are as follows:




**Fiscal
                  year ended September 30, 2007**
              
              
              **Fiscal
                  year ended September 30, 2006**Cost
                  of goods sold
              
              $
              197
              
              
              $
              100Operating
                  expenses
              
              
              790
              
              
              
              800Total
                  share-based compensation expense
              
              
              987
              
              
              
              900Income
                  tax benefit
              
              
              326
              
              
              
              260
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Approximately
      $54,000 and $10,000 of share-based compensation expense remained capitalized
      in
      inventory as of September 30, 2007 and September 30, 2006,
      respectively.





As
      of
      September 30, 2007, the total unrecognized compensation cost related to these
      plans was $1.0 million and was comprised of:  $7,000 related to stock
      options granted under the Stock Incentive Plan that is expected to be recognized
      over a weighted-average period of ten months, $870,000 related to service-based
      stock awards that is expected to be recognized over a weighted-average period
      of
      1.44 years, and $148,000 related to performance-based stock awards that is
      expected to be recognized over a period of .62 years.





**Employees’
      Stock Incentive Plan**—Under the Restated Employees’ Stock Incentive Plan
      (the “Incentive Plan”), eligible employees may receive either incentive stock
      options or non-qualified stock options and such options may be exercised only
      after an employee has remained in continuous employment for one year after
      the
      date of grant.  Thereafter, the options become exercisable as
      stipulated by the individual option agreements, generally 25% per year on the
      anniversary date of the grant for incentive stock options and 100% on the one
      year anniversary for non-qualified stock options.  The contractual
      term for these options varies from 5-10 years.  The option exercise
      price is the fair market value of the underlying stock at the date of
      grant.  In addition, under the Incentive Plan, eligible employees may
      be granted restricted stock awards which vest either on employment-based or
      performance-based measures.  At September 30, 2007, the total number
      of shares
      reserved for issuance under the Incentive Plan was 594,127, of which 290,901
      were available for grant.  The fair value of each option award is
      estimated on the date of grant using a Black-Scholes option valuation
      model.  Expected volatilities are based on historical volatility of
      the Company’s stock, and other factors.  The Company uses historical
      data to estimate option exercise and employee termination within the valuation
      model:  separate groups of employees that have similar historical
      exercise behavior are considered separately for valuation
      purposes.  The expected term of options granted is derived from the
      output of the option valuation model and represents the period of time that
      options granted are expected to be outstanding.  The risk-free rate
      for periods within the contractual life of the option is based on the U.S.
      Treasury Note five-year rate in effect at the time of grant.





The
      following weighted average assumptions were used for options granted in the
      year
      ended September 30, 2005 (there were no options granted in fiscal 2006 or
      2007):




**2005**Risk-free
                    interest rate
                
                4.24%Expected
                    dividend yield
                
                0%Expected
                    lives
                
                5
                    yearsExpected
                    volatility
                
                62%


Incentive
      Stock Options





A
      summary
      of option activity under the Incentive Plan as of September 30, 2007 and the
      year then ended is presented below:




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**Options**
              
              **Number
                  of Shares**
              
              
              **Weighted-Average
                  Exercise Price**
              
              
              **Weighted-Average
                  Remaining Contractual Term**
              
              
              **Aggregate
                  Intrinsic Value ($000)**Outstanding
                  at October 1, 2006
              
              
              389,702
              
              
              $
              10.54Granted
              
              
              0
              
              
              
              -
              
              
              
              -
              
              
              
              -Exercised
              
              
              (235,539
              )
              
              $
              10.59Forfeited
                  or expired
              
              
              (17,925
              )
              
              $
              18.32Outstanding
                  at September 30, 2007
              
              
              136,238
              
              
              $
              9.43
              
              
              
              3.63
              
              
              $
              2,816Exercisable
                  at September 30, 2007
              
              
              134,988
              
              
              $
              9.42
              
              
              
              3.60
              
              
              $
              2,792
  The
      weighted average grant date fair value of options granted during fiscal 2005
      was
      $5.43 per share.  The total intrinsic value of options exercised
      during the years ended September 30, 2007, 2006 and 2005 was $1.6 million,
      $295,000 and $808,000, respectively.  The fair value of shares vested
      during fiscal 2007, 2006 and 2005 was $562,000, $344,000 and $524,000,
      respectively.





As
      of
      September 30, 2007, there was $7,000 of total unrecognized compensation cost
      related to stock options granted under the Incentive Plan.  That cost
      is expected to be recognized over a weighted-average period of ten
      months.





Service-Based
      Stock Awards—Under the Incentive Plan, the Company may award service-based
      stock grants to selected executives and other key employees whose vesting is
      contingent upon meeting the required service period, generally three years,
      or
      in the case of members of the Board of Directors, one year.  The fair
      value of these grants is based on the closing fair market value at the grant
      date.  The restrictions on the grants lapse at the
      end
      of the required service period.  Stock compensation expense is
      recognized based on the grant date fair value of the stock over the vesting
      period.





The
      summary of activity for service-based stock awards as of September 30, 2007,
      and
      changes during the year then ended, is presented below:




**Service-Based
                  Stock Awards**
              
              **Number
                  of Shares**
              
              
              **Weighted-Average
                  Grant Date Fair Value**Non-vested
                  balance at October 1, 2006
              
              
              70,926
              
              
              $
              13.18Granted
              
              
              70,736
              
              
              $
              14.92Vested
              
              
              (27,492
              )
              
              $
              12.66Forfeited
              
              
              (5,983
              )
              
              $
              14.22Non-vested
                  balance at September 30, 2007
              
              
              108,187
              
              
              $
              14.39
  The
      number of shares granted in fiscal 2007 that vest in one year was 10,486, 12,500
      vest in 1.33 years and 47,750 vest in three years.  As of September
      30, 2007, there was $870,000 of total unrecognized compensation cost related
      to
      service-based stock awards that is expected to be recognized over a
      weighted-average period of 1.44 years.





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Employee
      Performance-Based Stock Awards—In fiscal 2007, the Company did not award any
      performance-based stock.  In fiscal 2006, the Company awarded
      performance-based stock grants to the Company’s Chief Executive Officer, the
      lapse of restrictions on which is contingent on performance objectives to be
      determined by the Compensation Committee over a three-year period ending
      September 30, 2009.  The Company awarded performance-based stock
      grants in fiscal 2005 to selected executive and other key employees, the lapse
      of the restrictions on which is contingent upon the increase in the Company’s
      net earnings over a three-year period beginning with fiscal 2005.  If
      the Company’s net income from continuing operations has a compound annual growth
      rate of 7.5%, the restrictions on 50% of the shares lapse; at 10%, the
      restrictions on 80% of the shares lapse; and at 25%, the restrictions on 100%
      of
      the shares lapse.  The lapse of the restrictions on the shares is
      linear between the stated levels.  No restrictions lapse if the
      compound annual growth rate is less than 7.5%, and 10% of the shares may be
      forfeited if net income in any one year does not equal at least 90% of the
      prior
      year’s net income from continuing operations, although up to 25% of the
      forfeited shares may be reinstated at the discretion of the Board of
      Directors.  In addition, recipients must be in continued employment
      with the Company through December 2007 for the restrictions on the awards to
      lapse.





Compensation
      expense is recognized over the period the employee performs related services
      based on the estimated number of shares expected to vest at the grant date
      fair
      value and assumes that 74% of the performance goal will be achieved for awards
      granted in fiscal 2005 and 85% for awards granted in fiscal 2006.  If
      the performance goals are not met or the service period is not fulfilled, no
      compensation cost is recognized and any recognized compensation cost will be
      reversed.





A
      summary
      of the activity for performance-based stock awards as of September 30, 2007,
      and
      changes during the year then ended, is presented below:




**Performance-Based
                  Stock Awards**
              
              **Number
                  of Shares**
              
              
              **Weighted-Average
                  Grant Date Fair Value**Non-vested
                  balance at October 1, 2006
              
              
              88,301
              
              
              $
              13.680Granted
              
              
              -
              
              
              
              -Vested
              
              
              -
              
              
              
              -Forfeited
              
              
              (29,500
              )
              
              $
              13.785Non-vested
                  balance at September 30, 2007
              
              
              58,801
              
              
              $
              13.630
  As
      of
      September 30, 2007, there was $148,000 of total unrecognized compensation cost
      related to performance-based stock awards that is expected to be recognized
      over
      a period of .62 years.





***Employee
      Stock Purchase Plan***—Most employees are eligible to participate in
      the Company’s Employee Stock Purchase Plan (the “Purchase
      Plan”).  Shares are not available to employees who already own 5% or
      more of the Company’s stock.  Employees can withhold, by payroll
      deductions, up to 5% of their regular compensation to purchase shares at a
      purchase price of 85% of the fair market value of the common stock on the
      purchase date.  There were 500,000 shares reserved for purchase under
      the Purchase Plan of which 403,713 remained available at September 30,
      2007.





During
      the year ended September 30, 2007, the Company issued 4,176 shares under the
      Purchase Plan and recorded compensation cost based on the 15% discount from
      market price paid by the employees.





***Non-Employee
      Service-Based Stock Awards***—The Company may award shares of
      service-based stock grants to non-employees.  At September 30, 2007,
      there were no shares outstanding.  There were 2,000 shares granted in
      previous years on which the restrictions have lapsed.  Under the terms
      of the award, 50% of the




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shares
      vested when the non-employees performed services through May 31, 2006 and the
      remaining 50% vested when services were performed through May 31,
      2007.  In accordance with EITF 96-18 *“Accounting for Equity
      Instruments That Are Issued to Other Than Employees for Acquiring, or in
      Conjunction with Selling, Goods or Services”*, the value of the instrument
      is amortized to expense over the vesting period with final valuation measured
      on
      the vesting date.  The weighted-average fair value of these shares was
      $13.785 at the grant date, and at the vesting dates the aggregate intrinsic
      value of these shares was $33,000.





Cash
      received from option and employee stock purchase plan exercises was $1.6
      million, $282,000 and $1.5 million for the year ended September 30, 2007, 2006
      and 2005, respectively.  The tax benefit to be realized for the tax
      deductions from option exercises under the share-based payment arrangements
      was
      $613,000, $71,000 and $240,000 for the years ended September 30, 2007, 2006
      and
      2005, respectively.




**13.**
            **STOCK
                REPURCHASE PROGRAM**




The
      Company initiated a stock repurchase program effective November 27,
      2006.  The Company may purchase up to 500,000 shares of its common
      stock under the program.  The Company intends to retire the shares
      upon repurchase.  In the period ended September 30, 2007, the Company
      repurchased and retired 88,252 shares of common stock at an average purchase
      price of $14.77 per share.  The aggregate purchase price of the
      repurchased shares has been reflected as a reduction in shareholders’
equity.




**14.**
            **EMPLOYEE
                BENEFIT PLANS**




The
      Company has a 401(k) profit sharing plan which covers substantially all
      employees.  The Company is required to match 50% of employee
      contributions for a maximum match of 2% in fiscal 2006 and 2005, 3% in fiscal
      2007 and 4% in fiscal 2008 of each participating employee’s
      compensation.  The Company contributed $470,000,
      $291,000, and $281,000 in matching funds to the plan for the years ended
      September 30, 2007, 2006, and 2005, respectively.




The
      401(k) plan also permits the Company to make discretionary profit sharing
      contributions to all employees.  Discretionary profit sharing
      contributions are determined annually by the Board of
      Directors.  Profit sharing plan expense was $443,000, $0, and $248,000
      for the years ended September 30, 2007, 2006, and 2005,
      respectively.




**15.**
            **SEGMENT
                INFORMATION**




The
      Company’s business units serve customers in its primary market—the food
      processing and agricultural products industry—through common sales and
      distribution channels.  Therefore, the Company reports on one
      segment.  The following table summarizes information about products
      and services (in thousands).




**Year
                  Ended September 30,****2007**
              
              
              **2006**
              
              
              **2005**Net
                  sales by product category:Automated
                  inspection systems
              
              $
              46,858
              
              
              $
              30,264
              
              
              $
              27,284Process
                  systems
              
              
              40,947
              
              
              
              34,925
              
              
              
              31,853Parts
                  and service/contracts
              
              
              19,735
              
              
              
              19,651
              
              
              
              21,185Total
                  net sales by product category
              
              $
              107,540
              
              
              $
              84,840
              
              
              $
              80,322




Net
      sales
      for service/contracts were less than 10% of total net sales for the years ended
      September 30, 2007, 2006, and 2005, respectively, and are therefore
      summarized with parts and service/contracts.  Upgrades of automated
      inspection systems are included with automated inspection systems.




54
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The
      following table summarizes information about geographic areas:




**Year
                  Ended September 30,****2007**
              
              
              **2006**
              
              
              **2005**Net
                  sales:Domestic
              
              $
              58,351
              
              
              $
              41,665
              
              
              $
              38,475International
              
              
              49,189
              
              
              
              43,175
              
              
              
              41,847Total
                  net sales
              
              $
              107,540
              
              
              $
              84,840
              
              
              $
              80,322Long-lived
                  assets:Domestic
              
              $
              8,286
              
              
              $
              9,109
              
              
              $
              11,658International
              
              
              2,484
              
              
              
              2,568
              
              
              
              2,593Total
                  long-lived assets
              
              $
              10,770
              
              
              $
              11,677
              
              
              $
              14,251




There
      was
      no customer that accounted for greater than 10% of net sales during fiscal
      2007.  There was one customer that accounted for approximately 17% and
      16% of net sales during fiscal 2006 and 2005, respectively.




No
      single
      country outside the United States accounted for more than 10% of net sales
      in
      2007, 2006 or 2005.  Location of the customer is the basis for the
      categorization of net sales.




*
      * * * *
      *




**SUPPLEMENTARY
      DATA**




**QUARTERLY
        FINANCIAL INFORMATION***(Unaudited)*




The
      following is a summary of operating results by quarter for the years ended
      September 30, 2007 and 2006 (in thousands, except per share
      data):


**2007
                  Quarter Ended**
              
              **December
                  31**
              
              
              **March
                  31**
              
              
              **June
                  30**
              
              
              **September
                  30**
              
              
              **Total**Net
                  sales
              
              $
              22,609
              
              
              $
              22,165
              
              
              $
              31,019
              
              
              $
              31,747
              
              
              $
              107,540Gross
                  profit
              
              
              8,720
              
              
              
              8,343
              
              
              
              12,473
              
              
              
              11,906
              
              
              
              41,441Net
                  earnings
              
              
              1,566
              
              
              
              608
              
              
              
              2,939
              
              
              
              2,297
              
              
              
              7,410Net
                  earnings per share—basic
              
              $
              0.30
              
              
              $
              0.12
              
              
              $
              0.56
              
              
              $
              0.43
              
              
              $
              1.41Net
                  earnings per share—diluted
              
              $
              0.29
              
              
              $
              0.11
              
              
              $
              0.54
              
              
              $
              0.42
              
              
              $
              1.37**2006
                  Quarter Ended**
              
              **December
                  31**
              
              
              **March
                  31**
              
              
              **June
                  30**
              
              
              **September
                  30**
              
              
              **Total**Net
                  sales
              
              $
              19,195
              
              
              $
              19,956
              
              
              $
              21,510
              
              
              $
              24,178
              
              
              $
              84,840Gross
                  profit
              
              
              6,971
              
              
              
              7,508
              
              
              
              8,230
              
              
              
              9,090
              
              
              
              31,799Net
                  earnings (loss)
              
              
              (510
              )
              
              
              (61
              )
              
              
              359
              
              
              
              (581
              )
              
              
              (793
              )Net
                  earnings (loss) per share—basic
              
              $
              (0.10
              )
              
              $
              (0.01
              )
              
              $
              0.07
              
              
              $
              (0.11
              )
              
              $
              (0.15
              )Net
                  earnings (loss) per share—diluted
              
              $
              (0.10
              )
              
              $
              (0.01
              )
              
              $
              0.07
              
              
              $
              (0.11
              )
              
              $
              (0.15
              )




Note:  Annual
      totals may not agree to the summarization of quarterly information due to
      insignificant rounding and the required calculation conventions.





*
      * * * *
      *




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**ITEM9.**
            **CHANGES
                IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
                DISCLOSURE.**





None.





**ITEM
                9A.**
            **CONTROLS
                AND PROCEDURES.**





Evaluation
      of Disclosure Controls and Procedures





The
      Company’s management, with the participation of its Chief Executive Officer and
      Corporate Controller, conducted an evaluation of the effectiveness of the design
      and operation of the Company’s disclosure controls and procedures, as required
      by Exchange Act Rule 13a-15.  Based on that evaluation, the Chief
      Executive Officer and Corporate Controller have concluded that, as of the end
      of
      the period covered by this report, the Company’s disclosure controls and
      procedures were effective to ensure that information required to be disclosed
      by
      the Company in the reports that it files or submits under the Exchange Act
      is
      recorded, processed, summarized and reported within the time periods specified
      by the SEC’s rules and forms and such information is accumulated and
      communicated to management as appropriate to allow timely decisions regarding
      required disclosures.





Management’s
      Report on Internal Control over Financial Reporting





The
      Company’s management is responsible for establishing and maintaining adequate
      internal control over financial reporting.  The Company’s internal
      control over financial reporting is a process designed under the supervision
      of
      its Chief Executive Officer and Corporate Controller to provide reasonable
      assurance regarding the reliability of financial reporting and the preparation
      of the Company’s financial statements for external reporting in accordance with
      accounting principles generally accepted in the United States of
      America.  Management evaluates the effectiveness of the Company’s
      internal control over financial reporting using the criteria set forth by the
      Committee of Sponsoring Organizations of the Treadway Commission (COSO) in
      Internal Control – “Integrated Framework.”  Management, under the
      supervision and with the participation of the Company’s Chief Executive Officer
      and Corporate Controller, assessed the effectiveness of the Company’s internal
      control over financial reporting as of September 30, 2007 and concluded that
      it
      is effective.





The
      Company’s independent registered public accounting firm, Grant Thornton LLP, has
      audited the effectiveness of the Company’s internal control over financial
      reporting as of September 30, 2007, and has expressed an unqualified opinion
      in
      their report which appears in this Form 10-K.





Changes
      in Internal Controls





There
      were no changes in the Company’s internal control over financial reporting
      identified in connection with the evaluation referred to above that occurred
      during the fourth quarter of the fiscal year ended September 30, 2007 that
      have
      materially affected, or are reasonably likely to materially affect, the
      registrant’s internal control over financial reporting.





Limitations
      on the Effectiveness of Controls





The
      Company believes that a control system, no matter how well designed and
      operated, cannot provide absolute assurance that the objectives of the control
      system are met, and no evaluation of controls can provide absolute assurance
      that all controls issues and instances of fraud, if any, within a company have
      been detected.  The Company’s disclosure controls and procedures are
      designed to provide reasonable assurance of achieving their objectives, and
      the
      Company’s Chief Executive Officer and Corporate Controller have concluded that
      such controls and procedures are effective at the “reasonable assurance”
level.




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**PART
      III**





**ITEM
                10.**
            **DIRECTORS,
                EXECUTIVE OFFICERS AND CORPORATE
                GOVERNACE.**





There
      is
      hereby incorporated by reference the information under the captions "Election
      of
      Directors," “Section 16(a) Beneficial Ownership Reporting Compliance” and
“Report of the Audit Committee of the Board of Directors” in the Company’s
      definitive Proxy Statement to be filed pursuant to Regulation 14A, which Proxy
      Statement is anticipated to be filed with the Securities and Exchange Commission
      within 120 days after the end of Registrant's fiscal year ended September 30,
      2007.





**ITEM
                11.**
            **EXECUTIVE
                COMPENSATION.**





There
      is
      hereby incorporated by reference the information under the caption "Executive
      Compensation" in the Company’s definitive Proxy Statement to be filed pursuant
      to Regulation 14A, which Proxy Statement is anticipated to be filed with the
      Securities and Exchange Commission within 120 days after the end of Registrant's
      fiscal year ended September 30, 2007.





**ITEM
                12.**
            **SECURITY
                OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
                STOCKHOLDER MATTERS.**





There
      is
      hereby incorporated by reference the information under the caption "Principal
      Shareholders" in the Company’s definitive Proxy Statement to be filed pursuant
      to Regulation 14A, which Proxy Statement is anticipated to be filed with the
      Securities and Exchange Commission within 120 days after the end of Registrant's
      fiscal year ended September 30, 2007.





**Equity
      Compensation Plan Information**





The
      following table provides information as of September 30, 2007 with respect
      to
      the shares of the Company’s Common Stock that may be issued under the Company’s
      existing equity compensation plans.





A
            
            
            B
            
            
            CPlan
                Category
            
            Number
                of Securities to be Issued upon Exercise of Outstanding
                Options
            
            
            Weighted
                Average Exercise Price of Outstanding Options
            
            
            Number
                of Securities Remaining Available for Future Issuance Under Equity
                Compensation Plans (Excluding Securities Reflected in Column
                A)Equity
                Compensation Plans Approved by ShareholdersRestated
                Employees’ Stock Incentive Plan
            
            
            303,226
            
            
            $
            10.39
            
            
            
            290,901
            (1)1996
                Employee Stock Purchase Plan
            
            
            (2)
            
            
            
            (2)
            
            
            
            403,713Equity
                Compensation Plans Not Approved by Shareholders (3)
            
            
            -
            
            
            
            -
            
            
            
            -Total
            
            
            303,226
            
            
            $
            10.39
            
            
            
            694,614





(1)
            The
                number of securities remaining may be used for issuance of either
                options
                or restricted stock.


(2)
            We
                are unable to ascertain with specificity the number of securities
                to be
                issued under the 1996 Employee Stock Purchase Plan or the weighted
                average
                purchase price of the shares that may be purchased under the
                plan.  Under the plan, eligible employees may make contributions
                to the plan of not more than five percent of the participant’s
                compensation during each pay period in the offering period.  The
                offering periods commence quarterly beginning October 1, January
                1, April
                1, and July 1 of each year.  Purchases are made on the last
                business day of each offering period at a purchase price per share
                equal
                to 85% of the fair market value of the Common Stock on the purchase
                date.  There are 500,000 shares of Common Stock reserved under
                the plan.


(3)
            There
                are no Equity Compensation Plans that have not been approved by
                Shareholders.


57
 Table
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**ITEM
                13.**
            **CERTAIN
                RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
                INDEPENDENCE.**





None





**ITEM
                14.**
            **PRINCIPAL
                ACCOUNTANT FEES AND
                SERVICES.**





There
      is
      hereby incorporated by reference the information under the caption “Audit
      Committee Report and Other Related Matters” in the Company’s definitive Proxy
      Statement to be filed pursuant to Regulation 14A, which Proxy Statement is
      anticipated to be filed with the Securities and Exchange Commission within
      120
      days after the end of Registrant's fiscal year ended September 30,
      2007.








**PART
      IV**





**ITEM
                15.**
            **EXHIBITS
                AND FINANCIAL STATEMENT
                SCHEDULES.**


PAGE


**(a)**
            **The
                following documents are filed as part of this
                report:**





**1.      Financial
      Statements:**





Reference
                is made to Part II, Item 8, for a listing of required financial statements
                filed with this report
            29





**2.      Financial
      Statement Schedules:**





Financial
                statement schedules are omitted because they are not applicable or
                the
                required information is included in the accompanying consolidated
                financial statements or notes
                thereto.





**3.      Exhibits:**





(3)           Articles
      of Incorporation and Bylaws





(3.1)
            Restated
                Articles of Incorporation (filed as Exhibit 3.1 to the Registration
                Statement on Form S-1 (Registration No. 33-63194) filed with the
                Securities and Exchange Commission on May 24, 1993 and incorporated
                herein
                by reference)


(3.2)
            Registrant’s
                Amended and Restated Bylaws dated November 14, 2007 (filed as Exhibit
                3.1(ii) to the Form 8-K filed with the Securities and Exchange Commission
                on November 20, 2007 and incorporated herein by
                reference)





(4)           Instruments
      defining the rights of security holders, including indentures





(4.1)
            Registrant’s
                Second Amended and Restated Rights Agreement, dated as of November
                13,
                2007, between the Registrant and American Stock Transfer & Trust
                Company (filed as Exhibit 10.1 to the Form 8-K filed with the Securities
                and Exchange Commission on November 19, 2007 and incorporated herein
                by
                reference)





(10)           Material
      contracts





(10.1)
            Construction
                and Lease Agreement dated October 17, 1989 between the Port of Walla
                Walla
                and Registrant (filed as Exhibit 10.1 to the Registration Statement
                on
                Form S-1 (Registration No. 33-63194) filed with the Securities and
                Exchange Commission on May 24, 1993 and incorporated herein by
                reference)


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(10.2)*
            Registrant's
                1989 Employees' Stock Option Plan, as amended (filed as Exhibit 10.5
                to
                the Registration Statement on Form S-1 (Registration No. 33-63194)
                filed
                with the Securities and Exchange Commission on May 24, 1993 and
                incorporated herein by reference)


(10.3)*
            Registrant's
                Restated 1989 Employees' Stock Option Plan, as amended (filed as
                Exhibit
                10.1 to the Form 10-Q filed with the Securities and Exchange Commission
                on
                May 12, 1995 and incorporated herein by
                reference)


(10.4)*
            Registrant's
                1996 Employees' Stock Option Plan (filed as Exhibit 10.1 to the Form
                10-Q
                filed with the Securities and Exchange Commission on May 2, 1996
                and
                incorporated herein by reference)


(10.5)*
            Registrant's
                1996 Employee Stock Purchase Plan (filed as Exhibit 10.2 to the Form
                10-Q
                filed with the Securities and Exchange Commission on May 2, 1996
                and
                incorporated herein by reference)


(10.6)*
            Registrant’s
                Restated Employees’ Stock Option Plan (1996 Plan as amended through July
                12, 2000) (filed as Exhibit 10.13 to the Form 10-K filed with the
                Securities and Exchange Commission on December 19, 2002 and incorporated
                herein by reference)


(10.7)
            Credit
                Agreement dated August 8, 2002 between Suplusco Holding B.V., Key
                Technology B.V. and ABN AMRO Bank N.V. (filed as Exhibit 10.22 to
                the Form
                10-Q filed with the Securities and Exchange Commission on February
                14,
                2003 and incorporated herein by
                reference)


(10.8)
            Addendum
                No. 1 to Construction and Lease Agreement executed December 31, 2002
                between the Port of Walla Walla and Registrant (filed as Exhibit
                10.24 to
                the Form 10-Q filed with the Securities and Exchange Commission on
                February 14, 2003 and incorporated herein by
                reference)


(10.9)*
            Registrant’s
                2003 Restated Employees’ Stock Incentive Plan, (1996 Plan as amended and
                restated as of December 15, 2003) (filed as Exhibit 10.1 to Form
                10-Q
                filed with the Securities and Exchange Commission on May 14, 2004
                and
                incorporated herein by reference)


(10.10)
            Addendum
                No. 2 to Construction and Lease Agreement executed June 8, 2005 between
                the Port of Walla Walla and Registrant (filed as Exhibit 10.1 to
                the Form
                8-K filed with the Securities and Exchange Commission on June 13,
                2005 and
                incorporated herein by reference)


(10.11)*
            Form
                of Restricted Stock Bonus Agreement (Continued Employment Vesting)
                (filed
                as Exhibit 10.1 to the Form 8-K filed with the Securities and Exchange
                Commission on September 12, 2005 and incorporated herein by
                reference)


(10.12)*
            Form
                of Restricted Stock Bonus Agreement (Performance Vesting) (filed
                as
                Exhibit 10.2 to the Form 8-K filed with the Securities and Exchange
                Commission on September 12, 2005 and incorporated herein by
                reference)


(10.13)*
            2003
                Restated Employee’s Stock Incentive Plan (as approved by the shareholders
                of the Company on February 8, 2006) (filed as Exhibit 10.1 to the
                Form 8-K
                filed with the Securities and Exchange Commission on February 14,
                2006 and
                incorporated herein by reference)


(10.14)*
            Form
                of Restricted Stock  Agreement (filed as Exhibit 10.2 to the
                Form 8-K filed with the Securities and Exchange Commission on February
                14,
                2006 and incorporated herein by
                reference)


(10.15)*
            Restated
                1996 Employee Stock Purchase Plan (including Amendment No. 1) (filed
                as
                Exhibit 10.1 to the Form 10-Q filed with the Securities and Exchange
                Commission on May 12, 2006 and incorporated herein by
                reference)


(10.16)
            Credit
                Agreement, dated July 27, 2006, between Registrant and Wells Fargo
                HSBC
                Trade Bank, N.A. (filed as Exhibit 10.1 to the Form 8-K filed with
                the
                Securities and Exchange Commission on August 2, 2006 and incorporated
                herein by reference)


(10.17)
            Revolving
                Credit Loans Note, dated July 27, 2006, between Registrant and Wells
                Fargo
                HSBC Trade Bank, N.A. (filed as Exhibit 10.2 to the Form
                8-K


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 Table
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filed
                with the Securities and Exchange Commission on August 2, 2006 and
                incorporated herein by reference)


(14)
            Registrant’s
                Code of Business Conduct and Ethics, dated August 12, 2004 (filed
                as
                Exhibit 99.1 to the Form 8-K filed with the Securities and Exchange
                Commission on August 18, 2004 and incorporated herein by
                reference)


(21)
            List
                of Subsidiaries


(23.1)
            Consent
                of Independent Registered Public Accounting
                Firm


(31.1)
            Certification
                pursuant to Section 302 of the Sarbanes-Oxley Act of
                2002


(31.2)
            Certification
                pursuant to Section 302 of the Sarbanes-Oxley Act of
                2002


(32.1)
            Certification
                pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section
                906 of
                the Sarbanes-Oxley Act of 2002


(32.2)
            Certification
                pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section
                906 of
                the Sarbanes-Oxley Act of 2002





*      Management
      contract or compensatory plan or arrangement.


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***SIGNATURES***





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the Registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized.





KEY
      TECHNOLOGY, INC.





By:
            /s/  David
                M. CampDavid
                M. CampPresident
                and Chief Executive Officer





By:
            /s/  James
                R. BrausenJames
                R. BrausenCorporate
                Controller
              (Principal
                Financial Officer and Principal Accounting
                Officer)





December
      14, 2007








Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed by the following persons on behalf of the Registrant and in the
      capacities and on the dates indicated.








/s/  Charles
                H. Stonecipher
            
            December
                14, 2007Charles
                H. Stonecipher, Chairman/s/  John
                E. Pelo
            
            December
                14, 2007John
                E. Pelo, Director/s/  Richard
                Lawrence
            
            December
                14, 2007Richard
                Lawrence, Director/s/  Michael
                L. Shannon
            
            December
                14, 2007Michael
                L. Shannon, Director/s/  Donald
                A. Washburn
            
            December
                14, 2007Donald
                A. Washburn, Director/s/  David
                M. Camp
            
            December
                14, 2007David
                M. Camp, Director, President and Chief Executive Officer


61
 Table
          of Contents




KEY
      TECHNOLOGY, INC.




**FORM
      10-K**


**EXHIBIT
      INDEX**





EXHIBIT


NUMBER





21
            List
                of Subsidiaries23.1
            Consent
                of Independent Registered Public Accounting Firm31.1
            Certification
                pursuant to Section 302 of the Sarbanes-Oxley Act of
                200231.2
            Certification
                pursuant to Section 302 of the Sarbanes-Oxley Act of
                200232.1
            Certification
                pursuant to 18 U.S. C. Section 1350 as adopted pursuant to Section
                906 of
                the Sarbanes-Oxley Act of 200232.2
            Certification
                pursuant to 18 U.S. C. Section 1350 as adopted pursuant to Section
                906 of
                the Sarbanes-Oxley Act of 2002




62