Northrop Grumman 2012 Annual Report Download - page 35

NORTHROP GRUMMAN CORPORATION
-25-
Operating Performance Assessment and Reporting
We manage and assess the performance of our business based on our performance on contracts and programs (two or
more closely-related contracts), with consideration given to the Critical Accounting Policies, Estimates and
Judgments described later in this section. Revenue on our portfolio of long-term contracts is generally recognized
using the percentage of completion method, primarily the cost-to-cost method, but in some cases the units-of-
delivery method of percentage of completion accounting. As a result, sales tend to fluctuate in concert with costs
across our large portfolio of contracts. Due to Federal Acquisition Regulations (FAR) rules that govern our business,
most types of costs are allowable, and we do not focus on individual cost groupings (such as manufacturing,
engineering, and design labor costs, subcontractor costs, material costs, overhead costs, and general and
administrative costs), as much as we do on total contract costs, which is the key driver of both sales and operating
income.
Our contract management process involves the use of contract estimates-at-completion (EACs) that are generally
prepared and evaluated on a bottoms-up basis at least annually and reviewed on a quarterly basis over the contract's
period of performance. These EACs include an estimated contract operating margin based initially on the contract
award amount, adjusted to reflect estimated risks related to contract performance. These risks typically include
technical risk, schedule risk and performance risk based on our evaluation of the contract effort. Similarly, the EACs
include identified opportunities for operating margin rate improvement. Over the contract's period of performance,
our program management organizations perform evaluations of contract performance and adjust the contract revenue
and cost estimates to reflect the latest reliable information available.
Our business and program management organizations are comprised of skilled professional managers whose
objective is to satisfy the customer's expectations, deliver high quality products and services, and manage contract
risks and opportunities to achieve an appropriate operating margin rate on the contract. Our comprehensive business
and contract management process is a coordinated process involving personnel with expertise from various
disciplines including production control, contracts, cost management, mission assurance and quality, finance and
supply chain, among others. As part of this overall contract management function, these personnel monitor
compliance with our critical accounting policies related to contract accounting and compliance with U.S.
Government regulations. Contract operating income and period-to-period contract operating margin rates are
adjusted over the contract's period of performance to reflect the latest estimated revenue and cost for the contract,
including changes in the risks and opportunities affecting the contract. Such adjustments may have a favorable or
unfavorable effect on operating income depending upon the specific conditions affecting each contract.
In evaluating our operating performance, we look primarily at changes in sales and operating income, including the
effects of meaningful changes in operating income as a result of changes in contract estimates. Where applicable,
significant fluctuations in operating performance attributable to individual contracts or programs, or changes in a
specific cost element across multiple contracts are described in our analysis. Based on this approach and the nature
of our operations, the discussion of results of operations first focuses around our four segments before distinguishing
between products and services. Changes in sales are generally described in terms of volume, deliveries or other
indicators of sales activity, and contract mix. For purposes of this discussion, volume generally refers to increases or
decreases in cost or sales from production/service activity levels or delivery rates. Performance refers to changes in
contract margin rates for the period, primarily related to the changes in estimates referred to above.
CONSOLIDATED OPERATING RESULTS
Selected financial highlights, excluding the results of discontinued operations, are presented in the table below:
Year Ended December 31
$ in millions, except per share amounts 2012 2011 2010
Sales $25,218 $26,412 $28,143
Operating costs and expenses 22,088 23,136 25,316
Operating income 3,130 3,276 2,827
Operating margin rate 12.4% 12.4% 10.0%
Interest expense $ (212) $ (221) $ (269)
Federal and foreign income tax expense $ 987 $ 997 $ 462
Effective income tax rate 33.3% 32.3% 19.5%
Diluted earnings per share $ 7.81 $ 7.52 $ 6.82
Cash provided by continuing operations $ 2,640 $ 2,347 $ 2,056