Lockheed Martin 2010 Annual Report Download - page 47

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Cost-plus-award-fee contracts provide for an award fee that varies within specified limits based on the customer’s assessment of
our performance against a predetermined set of criteria, such as targets based on cost, quality, technical, and schedule criteria. Cost-
plus-incentive-fee contracts provide for reimbursement of costs plus a fee which is adjusted by a formula based on the relationship of
total allowable costs to total target costs (incentive based on cost) or reimbursement of costs plus an incentive to exceed stated
performance targets (incentive based on performance). The fixed fee in a cost-plus-fixed-fee contract is negotiated at the inception of
the contract and that fixed fee does not vary with actual costs.
Fixed-price and other contracts
Under fixed-price contracts, which accounted for about 35% of our total net sales over the last three years, we agree to perform
the specified work for a pre-determined price. To the extent our actual costs vary from the estimates upon which the price was
negotiated, we will generate more or less profit, or could incur a loss. Some fixed-price contracts have a performance-based
component under which we may earn incentive payments or incur financial penalties based on our performance.
Under time-and-materials contracts, which accounted for about 5% of our total net sales over the last three years, we are paid a
fixed hourly rate for each direct labor hour expended, and we are reimbursed for allowable material costs and allowable out-of-pocket
expenses. To the extent our actual direct labor and associated costs vary in relation to the fixed hourly billing rates provided in the
contract, we will generate more or less profit, or could incur a loss.
Design, Development, and Production Contracts
We record net sales and an estimated profit on a POC basis for cost-reimbursable and fixed-price DD&P contracts. Sales are
recorded on time-and-materials contracts as the work is performed based on agreed-upon hourly rates and allowable costs.
The POC method for DD&P contracts depends on the nature of the products provided under the contract. For example, for
contracts that require us to perform a significant level of development effort in comparison to the total value of the contract and/or to
deliver minimal quantities, sales are recorded using the cost-to-cost method to measure progress toward completion. Under the cost-
to-cost method of accounting, we recognize sales and an estimated profit as costs are incurred based on the proportion that the
incurred costs bear to total estimated costs. For contracts that require us to provide a substantial number of similar items without a
significant level of development, we record sales and an estimated profit on a percentage-of-completion basis using units-of-delivery
as the basis to measure progress toward completing the contract.
When adjustments in estimated contract revenues or estimated costs at completion are required on DD&P contracts, any changes
from prior estimates are recognized in the current period for the inception-to-date effect of the changes. When estimates of total costs
to be incurred on a contract exceed total estimates of revenue to be earned, a provision for the entire loss on the contract is recorded in
the period in which the loss is determined.
Award fees and incentives, as well as penalties related to contract performance, are considered in estimating sales and profit
rates on DD&P contracts. Estimates of award fees are based on past experience and anticipated performance. We record incentives or
penalties when there is sufficient information to assess anticipated contract performance. Incentive provisions that increase or decrease
earnings based solely on a single significant event are not recognized until the event occurs. For contract change orders, claims, or
similar items, we apply judgment in estimating the amounts and assessing the potential for realization. These amounts are only
included in contract value when they can be reliably estimated and realization is considered probable. We have accounting policies in
place to address these, as well as other contractual and business arrangements to properly account for long-term contracts.
Accounting for DD&P contracts requires judgment relative to assessing risks, estimating contract revenues and costs (including
estimating award and incentive fees and penalties related to performance), and making assumptions for schedule and technical issues.
Due to the scope and nature of the work required to be performed on many of our contracts, the estimation of total revenue and cost at
completion is complicated and subject to many variables. Contract costs include material, labor, and subcontracting costs, as well as
an allocation of indirect costs. We have to make assumptions regarding labor productivity and availability, the complexity of the work
to be performed, the availability of materials, the length of time to complete the contract (to estimate increases in wages and prices for
materials), performance by our subcontractors, and the availability and timing of funding from our customer, among other variables.
Because of the significance of the judgments and estimation processes in our accounting for DD&P contracts, it is likely that
materially different amounts could be recorded if we used different assumptions or if our underlying circumstances were to change.
For example, if underlying assumptions were to change such that our estimated profit rate at completion for all DD&P contracts was
higher or lower by one percentage point, our 2010 net earnings would have increased or decreased by approximately $250 million.