General Dynamics 2013 Annual Report Download - page 22

(Dollars in millions, except per-share amounts or unless otherwise noted)
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
For an overview of our business groups, including a discussion of products
and services provided, see the Business discussion contained in Item 1.
BUSINESS ENVIRONMENT
More than 60 percent of our revenues are from the U.S. government.
Accordingly, our financial performance is impacted by U.S. government
spending levels, particularly defense spending. Over the past several
years, U.S. defense spending has been reduced, due in part to the
country’s fiscal shortfall. To address this shortfall, the Budget Control
Act of 2011 (BCA) mandated a $487 billion, or 8 percent, reduction to
previously-planned defense funding over 10 years. The BCA also
included a mechanism, referred to as the sequester, that can impose
additional defense cuts of up to $500 billion, or 9 percent, over nine
years starting in fiscal year (FY) 2013.
The Bipartisan Budget Act of 2013 (BBA) prescribed defense top-
line funding for FY 2014 and 2015 at levels generally consistent with
FY 2013, reducing budget uncertainties and providing near-term
stability. The BBA also included sequester reductions of approximately
$30 billion in FY 2014 and $43 billion in FY 2015, less than the
amounts imposed by the BCA.
In adherence to the BBA, Congress appropriated $497 billion in FY
2014 for the Department of Defense (DoD), including approximately
$156 billion for procurement and research and development (R&D)
budgets, also known as investment accounts, relatively consistent with
FY 2013. These investment accounts are the source of the majority of
our U.S. government revenues.
The long-term outlook for our U.S. defense business is buoyed by the
relevance of our programs to the U.S. military’s funding priorities, the
diversity of our programs and customers, our insight into customer
requirements stemming from our incumbency on core programs, our
ability to evolve our products to address a fast-changing threat
environment and our proven track record of successful contract execution.
We continue to pursue opportunities outside the U.S. presented by
demand for military equipment and information technologies from our
international operations and through exports from our North American
businesses. While the revenue potential can be significant, our work for
these customers is subject to changing budget priorities and overall
spending pressures, as well as timing of contract awards.
In our Aerospace group, business-jet market conditions were strong
in 2013. The group benefited from improved order interest across the
group’s range of customers and lower customer contract defaults. We
expect our continued investment in new aircraft products to support
Aerospace’s long-term growth. Similarly, we believe aircraft-service
revenues provide the group diversified exposure to aftermarket sales
fueled by the global installed business-jet fleet.
RESULTS OF OPERATIONS
INTRODUCTION
An understanding of our accounting practices is important to evaluate
our operating results. We recognize the majority of our revenues using
the percentage-of-completion method of accounting. The following
paragraphs explain how this method is applied in recognizing revenues
and operating costs in our Aerospace and defense groups.
In the Aerospace group, contracts for new aircraft have two major
phases: the manufacture of the “green” aircraft and the aircraft’s
outfitting, which includes exterior painting and installation of customer-
selected interiors. We record revenues on these contracts at the
completion of these two phases: when green aircraft are delivered to and
accepted by the customer, and when the customer accepts final delivery
of the outfitted aircraft. Revenues in the Aerospace group’s other original
equipment manufacturers (OEMs) completions and services businesses
are recognized as work progresses or upon delivery of services. Changes
in revenues result from the number and mix of new aircraft deliveries
(green and outfitted), progress on aircraft completions and the level of
aircraft service activity during the period.
The majority of the Aerospace group’s operating costs relates to new
aircraft production for firm orders and consists of labor, material and
overhead costs. The costs are accumulated in production lots and
recognized as operating costs at green aircraft delivery based on the
estimated average unit cost in a production lot. While changes in the
estimated average unit cost for a production lot impact the level of
operating costs, the amount of operating costs reported in a given period
is based largely on the number and type of aircraft delivered. Operating
costs in the Aerospace group’s completions and services businesses are
generally recognized as incurred.
For new aircraft, operating earnings and margins are a function of the
prices of our aircraft, our operational efficiency in manufacturing and
outfitting the aircraft, and the mix of aircraft deliveries between the
higher-margin large-cabin and lower-margin mid-cabin aircraft.
Additional factors affecting the group’s earnings and margins include the
volume, mix and profitability of completions and services work
performed, the market for pre-owned aircraft, and the level of general
and administrative (G&A) and net R&D costs incurred by the group.
In the defense groups, revenue on long-term government contracts is
recognized as work progresses, either as products are produced or
services are rendered. As a result, changes in revenues are discussed
18 General Dynamics Annual Report 2013