Northrop Grumman 2009 Annual Report Download - page 42

estimated direct labor costs. The units-of-delivery measure is a modification of the percentage-of-completion
method, which recognizes revenues as deliveries are made to the customer generally using unit sales values in
accordance with the contract terms. We estimate profit as the difference between total estimated revenue and
total estimated cost of a contract and recognize that profit over the life of the contract based on deliveries.
The use of the percentage-of-completion method depends on our ability to make reasonably dependable cost
estimates for the design, manufacture, and delivery of our products and services. Such costs are typically incurred
over a period of several years, and estimation of these costs requires the use of judgment. We record sales under
cost-type contracts as costs are incurred.
Many contracts contain positive and negative profit incentives based upon performance relative to predetermined
targets that may occur during or subsequent to delivery of the product. These incentives take the form of
potential additional fees to be earned or penalties to be incurred. Incentives and award fees that can be
reasonably assured and reasonably estimated are recorded over the performance period of the contract. Incentives
and award fees that are not reasonably assured or cannot be reasonably estimated are recorded when awarded or
at such time as a reasonable estimate can be made.
Other changes in estimates of contract sales, costs, and profits are recognized using the cumulative catch-up
method of accounting. This method recognizes in the current period the cumulative effect of the changes on
current and prior periods. Hence, the effect of the changes on future periods of contract performance is
recognized as if the revised estimate had been the original estimate. A significant change in an estimate on one or
more contracts could have a material effect on our consolidated financial position or results of operations.
Certain Service Contracts – We generally recognize revenue under contracts to provide services to non-federal
government customers when services are performed. Service contracts include operations and maintenance
contracts, and outsourcing-type arrangements, primarily in Information Systems and Technical Services. We
generally recognize revenue under such contracts on a straight-line basis over the period of contract performance,
unless evidence suggests that the revenue is earned or the obligations are fulfilled in a different pattern. Costs
incurred under these service contracts are expensed as incurred, except that direct and incremental set-up costs
are capitalized and amortized over the life of the agreement. Operating profit related to such service contracts
may fluctuate from period to period, particularly in the earlier phases of the contract.
Contracts that include more than one type of product or service are accounted for under the relevant GAAP for
revenue arrangements with multiple-elements. Accordingly, for applicable arrangements, revenue recognition
includes the proper identification of separate units of accounting and the allocation of revenue across all elements
based on relative fair values.
Cost Estimation – The cost estimation process requires significant judgment and is based upon the professional
knowledge and experience of our engineers, program managers, and financial professionals. Factors that are
considered in estimating the work to be completed and ultimate contract recovery include the availability,
productivity and cost of labor, the nature and complexity of the work to be performed, the effect of change
orders, the availability of materials, the effect of any delays in performance, the availability and timing of funding
from the customer, and the recoverability of any claims included in the estimates to complete. A significant
change in an estimate on one or more contracts could have a material effect on our consolidated financial
position or results of operations. We update our contract cost estimates at least annually and more frequently as
determined by events or circumstances. We generally review and reassess our cost and revenue estimates for each
significant contract on a quarterly basis.
We record a provision for the entire loss on the contract in the period the loss is determined when estimates of
total costs to be incurred on a contract exceed estimates of total revenue to be earned. We offset loss provisions
first against costs that are included in unbilled accounts receivable or inventoried assets, with any remaining
amount reflected in liabilities.
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