OVERVIEW

Business

Dynamics Research Corporation, headquartered in Andover, Massachusetts, is a leading provider of innovative engineering, technical, information technology and management consulting services and solutions to federal and state governments. We provide support to our customers in the primary mission areas of IT, Logistics and Readiness, Systems Integration and Technical Services, C4ISR, Homeland Security, Health and Human Services, Intelligence/Space, Cyber Security, and Public and Environmental Health.

On August 1, 2008, we completed the acquisition of Kadix which is more fully described in Note 3 of our "Notes to Consolidated Financial Statements" in Part II, Item 8 of this Form 10-K. The acquisition strengthens and expands our growth as a provider of high-end services and solutions in the homeland security and other federal civilian markets. The operating results of Kadix are included in DRC's results of operations within the Systems and Services segment for the period subsequent to the acquisition date.

We have two reportable business segments: Systems and Services, and Metrigraphics. The Systems and Services segment accounted for approximately 98% of total revenue and the Metrigraphics segment accounted for approximately 2% of total revenue in 2008.

Industry

We are cognizant of funding challenges and changing priorities of the federal government. In February 2009, the President made his initial budget submission to Congress. While a more detailed budget will be provided in April, the submission, along with the Federal Stimulus Plan, will provide clear indications of priorities and direction for the new administration. Overall, the budget provides for discretionary spending growth of 7%. Breaking the increase down by sector, the budget proposal reflects 9% growth in funding for civilian agencies and 4% growth in funding for defense. However, significant contract awards have been and will continue to be delayed and new initiatives have been slow to start.

Customers are moving away from the GSA schedule time and materials contracts toward agency sponsored ID/IQ contract vehicles and fixed price contracts and task orders. The DoD seeks to reduce spending on contracted program advisory and assistance services and often is setting this work aside for small businesses.

Concurrently, there is increasing demand from federal customers for training, business transformation, lean six sigma, human capital management, cyber security and business intelligence solutions and services. Many federal customers are seeking to streamline their procurement activities by consolidating work under large contract vehicles. Our competitive strategy is intended to align with these trends.

Outlook

Our business is conducted primarily with U.S. Government customers under both short-term and long-term contracts. We have aligned our service offerings to current economic conditions and customer needs. The U.S. Government's budgetary processes give us good visibility regarding future spending and the threat areas that they are addressing. Management believes that our current contracts, and backlog of previously awarded contracts are well aligned with the direction of our customers' future needs, and this provides us with good insight regarding future cash flows. Nonetheless, management recognizes that the current economic situation and significant changes in priorities under the new administration likely will result in significant changes in federal spending with increases in some areas and decreases in others. While we may benefit from the increases, certain programs in which we participate may be subject to reductions.

Based primarily on our current portfolio of customers, contracts and funded backlog of $149.2 million as of December 31, 2008, we expect revenue in 2009 to be in the range of approximately $280 million to $290 million.

CRITICAL ACCOUNTING POLICIES

There are business risks specific to the industries in which we operate. These risks include: estimates of costs to complete contract obligations, changes in government policies and procedures, government contracting issues and risks associated with technological development. The preparation of financial statements 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. Estimates and assumptions also affect the amount of revenue and expenses during the reported period. Actual results could differ from those estimates.

The use of alternative estimates and assumptions and changes in business strategy or market conditions may significantly impact our assets or liabilities, and potentially result in a different impact to our results of operations. We believe the following critical accounting policies affect the more significant judgments made and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

Our Systems and Services business segment provides services pursuant to time and materials, cost reimbursable and fixed-price contracts, including service-type contracts.

For time and materials contracts, revenue reflects the number of direct labor hours expended in the performance of a contract multiplied by the contract billing rate, as well as reimbursement of other billable direct costs. The risk inherent in time and materials contracts is that actual costs may differ materially from negotiated billing rates in the contract, which would directly affect operating income.

For cost reimbursable contracts, revenue is recognized as costs are incurred and includes a proportionate amount of the fee earned. Cost reimbursable contracts specify the contract fee in dollars or as a percentage of estimated costs. The primary risk on a cost reimbursable contract is that a government audit of direct and indirect costs could result in the disallowance of some costs, which would directly impact revenue and margin on the contract. Historically, such audits have not had a material impact on our revenue and operating income.

Revenue from service-type fixed-price contracts is recognized ratably over the contract period or by other appropriate output methods to measure service provided, and contract costs are expensed as incurred. Under fixed-price contracts, other than service-type contracts, revenue is recognized primarily under the percentage of completion method in accordance with American Institute of Certified Public Accountants Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. The risk on a fixed-price contract is estimates of costs to complete the contract may exceed revenues on the contract.

For all types of contracts, we recognize anticipated contract losses as soon as they become known and estimable. Out-of-pocket expenses that are reimbursable by the customer are included in contract revenue and cost of contract revenue.

Unbilled receivables are the amounts of recoverable contract revenue that have not been billed at the balance sheet date. Unbilled receivables relate principally to revenue that is billed in the month after services are performed. In certain instances, billing is deferred in compliance with the contract terms, such as milestone billing arrangements and withholdings, or delayed for other reasons. Costs related to certain U.S. Government contracts, including applicable indirect costs, are subject to audit by the government. Revenue from such contracts has been recorded at amounts we expect to realize upon final settlement.

Our Metrigraphics business segment records revenue from product sales upon transfer of both title and risk of loss to the customer, provided there is evidence of an arrangement, fees are fixed or determinable, no significant obligations remain, collection of the related receivable is reasonably assured and the customer acceptance criteria have been successfully demonstrated. Product sales are recorded net of sales taxes and net of returns upon delivery. Amounts billed to customers related to shipping and handling is classified as product sales. The cost of shipping products to the customer is recognized at the time the products are shipped and are recorded as cost of product sales.

Goodwill and Other Intangible Assets

With the acquisition of Kadix and other businesses in prior years, we acquired goodwill and other intangible assets. The identification and valuation of these intangible assets and the determination of the estimated useful lives at the time of acquisition, as well as the completion of annual impairment tests, require significant management judgments and estimates. These estimates are made based on, among other things, consultations with an accredited independent valuation consultant and reviews of projected cash flows.

We estimate fair value by employing different methodologies, including a comparison to comparable industry companies and discounted cash flows. The determination of relevant comparable industry companies impacts our assessment of fair value. Should the operating performance of our reporting unit change in comparison to these companies or should the valuation of these companies change, this could impact our assessment of the fair value of the reporting unit. Our discounted cash flow analysis factors in assumptions on revenue and expense growth rates. These estimates are based upon our historical experience and projections of future activity, factoring in customer demand, changes in technology and a cost structure necessary to achieve the related revenues. Additionally, the discounted cash flow analysis factors in expected amounts of working capital and weighted average cost of capital. Changes in judgments on any of these factors could materially impact the value of the reporting unit.

As a result of the annual impairment test performed as of December 31, 2008, we determined that the carrying amount of goodwill did not exceed its fair value and, accordingly, did not record a charge for impairment. However, we are unable to assure that goodwill will not be impaired in subsequent periods. As of December 31, 2008, we had recorded goodwill and other intangible assets of $105.0 million in the Consolidated Balance Sheets.

Income Taxes and Deferred Taxes

On January 1, 2007, we adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48"), which addresses the determination of how tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, we must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from these positions are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate resolution. We review our tax positions on a quarterly basis and more frequently as facts surrounding tax positions change. Based on these future events, we may recognize uncertain tax positions or reverse current uncertain tax positions the impact of which would effect the statement of operations and/or the balance sheet.

As part of our process of preparing consolidated financial statements, management is required to estimate the provision for income taxes, deferred tax assets and liabilities and future taxable income for purposes of assessing our ability to realize any future benefits from deferred taxes. This process involves estimating the current tax liability and assessing temporary and permanent differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in the Consolidated Balance Sheets. We had a net deferred asset of $7.7 million at December 31, 2008.

We must also assess the likelihood that our deferred tax asset will be recovered from future taxable income and, to the extent a recovery is not likely, a valuation allowance must be established. At December 31, 2008, we determined that a valuation allowance was not required.

Pension Obligations

Accounting and reporting for our pension plan requires the use of assumptions, including the discount rate and expected rate of return on assets. These assumptions are used by independent actuaries to determine the value of our pension obligations and allocate this cost to the service periods. The actuarial assumptions used to calculate pension costs are determined and reviewed annually by management after consulting with outside investment advisors and actuaries.

The assumed discount rate, which is intended to be the actual rate at which benefits could effectively be settled, is determined by a spot-rate yield curve method. The spot-rate yield curve is employed to match the plan assets cash outflows with the timing and amount of the expected benefit payments. As of December 31, 2008, the pension plan's measurement date, the weighted average discount rate used to determine the benefit obligations and net periodic benefit costs was 6.25%. A decrease of 50 basis points in the discount rate would have resulted in an increase in annual pension expense by approximately $0.4 million.

The assumed expected rate of return on plan assets, which is the average return expected on the funds invested or to be invested to provide future benefits to pension plan participants, is determined by an annual review of historical long-term asset returns and consultation with outside investment advisors. As of the pension plan's measurement date, the weighted average expected rate of return was 9.0%. A decrease of 50 basis points in the expected rate of return would have resulted in an increase in annual pension expense by approximately $0.3 million.

If assumptions differ materially from actual results in the future, our obligations under the pension plan could also differ materially, potentially requiring us to record an additional pension liability and record additional pension costs. An actuarial valuation of the pension plan is performed each year. The results of this actuarial valuation are reflected in the accounting for the pension plan upon determination. At December 31, 2008, we recorded a pension liability of $22.6 million in the Consolidated Balance Sheet that represented the underfunded benefit obligation.

Litigation, Commitments, and Contingencies

We are subject to a range of claims, lawsuits and administrative proceedings that arise in the ordinary course of business. Estimating liabilities and costs associated with these matters requires judgment and assessment based upon professional knowledge and experience of management and its internal and external legal counsel. In accordance with Statement of Financial Accounting Standards (SFAS) No. 5, Accounting for Contingencies, amounts are recorded as charges to earnings when management, after taking into consideration the facts and circumstances of each matter, including any settlement offers, has determined that it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. The ultimate resolution of any such exposure to us may vary from earlier estimates as further facts and circumstances become known.

Litigation accruals are recorded as charges to earnings when management, after taking into consideration the facts and circumstances of each matter, including any settlement offers, has determined that it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. The ultimate resolution of any exposure to the company may vary from earlier estimates as further facts and circumstances become known.

RESULTS OF OPERATIONS

Operating results and results expressed as a percentage of total revenues are as follows:

                                                                       Year Ended December 31,
                                                       2008                     2007                     2006
 (in millions)                                   $(1)          %          $(1)          %          $(1)          %
 Contract revenue                               $ 236.8        97.5 %    $ 224.7        97.9 %    $ 252.9        97.6 %
 Product sales                                      6.0         2.5          4.9         2.1          6.1         2.4
 Total revenue                                  $ 242.8       100.0 %    $ 229.6       100.0 %    $ 259.0       100.0 %

 Gross profit on contract revenue(2)            $  39.0        16.5 %    $  37.2        16.5 %    $  33.9        13.4 %
 Gross profit (loss) on product sales(2)            0.2         2.8 %       (0.1 )      (1.1 )%       1.2        19.7 %
 Total gross profit(2)                             39.2        16.1 %       37.1        16.2 %       35.1        13.6 %

 Selling, general and administrative               22.3         9.2 %       21.8         9.5 %       24.1         9.3 %
 Provision for litigation                          14.8         6.1 %        0.2         0.1 %          -         0.0 %
 Amortization of intangible assets                  2.6         1.1 %        2.6         1.1 %        2.8         1.1 %
 Operating Income (loss)                           (0.6 )      (0.2 )%      12.5         5.4 %        8.2         3.2 %
 Interest expense, net                             (1.4 )      (0.6 )%      (1.5 )      (0.7 )%      (2.0 )      (0.8 )%
 Other income, net                                  0.0         0.0 %        0.8         0.4 %        0.6         0.2 %
 Provision (benefit) for income taxes(3)           (0.7 )      35.9 %        4.7        39.7 %        2.7        40.6 %
 Cumulative benefit of accounting change, net
of tax                                                -         0.0 %          -         0.0 %        0.1         0.0 %
 Net income (loss)                              $  (1.3 )      (0.5 )%   $   7.1         3.1 %    $   4.1         1.6 %

(1) Totals may not add due to rounding.
(2) These amounts represent a percentage of contract revenues, product sales and total revenues, respectively.
(3) The percentage for provision (benefit) for income taxes relate to a percentage of income before provision for income taxes.

Revenue

We reported total revenue of $242.8 million, $229.6 million and $259.0 million in 2008, 2007 and 2006, respectively. Total revenue increased by $13.2 million, or 5.8% in 2008 compared to 2007 due to the acquisition of Kadix, partially offset by decreased revenues in the national defense and intelligence sector. The decrease in revenue in 2007 compared to 2006 resulted from a decline in contract revenue.

Contract Revenues

Contract revenues in our Systems and Services segment were earned from the
following sectors:

                                                                   Year Ended December 31,
                                                    2008                    2007                    2006
(in millions)                                 $ (1)       % (1)       $ (1)       % (1)       $ (1)       % (1)
National defense and intelligence agencies   $ 156.8        66.3 %   $ 179.1        79.7 %   $ 206.0        81.4 %
Federal civilian agencies                       32.9        13.9        27.5        12.2        27.9        11.0
Homeland security                               19.3         8.1         3.9         1.7         2.7         1.1
State and local government agencies             25.8        10.9        13.6         6.1        15.3         6.0
Other                                            2.0         0.8         0.7         0.3         1.1         0.4
Total contract revenue                       $ 236.8       100.0 %   $ 224.7       100.0 %   $ 252.9       100.0 %

(1) Totals may not add due to rounding.

The decrease in revenues from national defense and intelligence agencies in 2008 compared to 2007 was due to decreased revenues derived from the U.S. Air Force ASC small business set-aside Consolidated Acquisition of Professional Services ("CAPS") contract, the transition from the U.S. Air Force ESC full and open Information Technology Services Program ("ITSP") II contract to the small business set-aside Professional Acquisition Support Services ("PASS") contract and lower revenue related to the U.S. Navy Trident Missile program. The decrease in revenues from national defense and intelligence agencies in 2007 compared to 2006 was

due to the transition into the new CAPS contract in August 2006 and the loss of the Air National Guard contract in May 2006, partially offset by increased revenues from the Naval Air System Command AIRSpeed subcontract awarded in March 2006.

In January 2008, we purchased from THE CENTECH GROUP, Inc., a prime CAPS contract, on which minimal work was being performed. While awaiting the government's decision on approval of the contract novation, through the CENTECH contract we have won numerous task order re-competitions. We have received notification that CENTECH's request to novate their CAPS contract to DRC has been denied. CENTECH and we are currently considering avenues for reconsideration of this decision and continuing to perform as a subcontractor on the CENTECH CAPS contract.

The ESC PASS contract was re-competed in 2007 as a small business set-aside and certain engineering work previously performed by us under ITSP II was directed to a new contract for which the Company did not receive an award.

The increase in revenues from Homeland Security in 2008 compared to 2007 was primarily due to added revenues related to the Kadix acquisition and new task orders won in 2008.

The increase in revenues from other federal civilian agencies in 2008 compared to 2007 was due to added revenues related to the Kadix acquisition and new task orders won in 2008. The increase in revenues from federal civilian agencies in 2007 compared to 2006 was primarily due to added revenues from the FDIC contract awarded in November 2007.

The increase in revenues from state and local government agencies in 2008 compared to 2007 was primarily due to additional change orders under the State of Ohio contract during 2007 and 2008. With the completion of the implementation phase of the Ohio project in October 2008, revenues derived from the project are anticipated at a reduced level in 2009. In the second quarter of 2008 we began a new child welfare system development project with the State of Tennessee which generated $7.0 million of revenue in 2008. The decrease in revenues from state and local government agencies in 2007 compared to 2006 was primarily due to lower revenues from our contract with the State of Ohio, under which a significant portion of the work has been completed, partially offset by higher revenues from our State of Colorado contract awarded in April 2006.

Revenues by contract type as a percentage of Systems and Services segment revenues were as follows:

                                                          Year Ended December 31,
                                                       2008           2007       2006
     Time and materials                                    49 %           57 %      62 %
     Cost reimbursable                                     18             22        19
     Fixed price, including service type contracts         33             21        19
                                                          100 %          100 %     100 %

     Prime contract                                        63 %           56 %      67 %
     Sub-contract                                          37             44        33
                                                          100 %          100 %     100 %

Prime contract revenues increased in 2008 compared with 2007 as a result of an increasing portion of contracts awarded under DRC's agency-wide multiple award schedule ID/IQ contracts. Prime contract revenues decreased in 2007 compared with 2006 as a result of the transition to the CAPS contract which has been classified as subcontract revenue.

Product Sales

Product sales for the Metrigraphics segment were $6.0 million, $4.9 million and $6.1 million for 2008, 2007 and 2006, respectively. The increase in revenue from product sales for the Metrigraphics segment in 2008 compared to 2007 primarily was due to higher sales to a new medical device customer. The decrease in revenue from product sales for the Metrigraphics segment in 2007 compared to 2006 primarily was due to a decrease in medical device sales.

Funded Backlog

Our funded backlog was $149.2 million at December 31, 2008, $116.5 million at December 31, 2007 and $92.9 million at December 31, 2006. For 2008, our book-to-bill ratio was 1.1 to 1.0. We expect that substantially all of our backlog at December 31, 2008 will generate revenue during the year ending December 31, 2009.

Gross Profit

Total gross profit was $39.2 million, $37.1 million and $35.1 million resulting in a gross margin of 16.1% in 2008, 16.2% in 2007 and 13.6% in 2006.

Our gross profit on contract revenue was $39.0 million, $37.2 million and $33.9 million resulting in a gross margin of 16.5% in both 2008 and 2007 and 13.4% in 2006. The increase in gross profit in 2008 compared to 2007 was attributable to higher revenues primarily related to the Kadix acquisition and lower indirect costs, partially offset by costs associated with workforce reductions. The increase in gross profit in 2007 compared to 2006 was primarily attributable to the reduction in low margin subcontractor revenues resulting from the transition to the new CAPS contract in August 2006 as noted above. We recorded severance costs of $1.7 million, $0.6 million and $1.1 million in cost of contract revenue in 2008, 2007 and 2006, respectively.

Our gross profit (loss) on product sales was $0.2 million, $(0.1) million and $1.2 million resulting in a gross margin of 2.8%, (1.1)% and 19.7% for 2008, 2007 and 2006, respectively. The increase in gross profit in 2008 compared to 2007 was due to higher sales to medical device customers. The decline in gross profit in 2007 compared to 2006 was primarily attributable to a lower level of sales.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $22.3 million in 2008, $21.8 million in 2007, and $24.1 million in 2006. Selling, general and administrative expenses as a percent of total revenue was 9.2%, 9.5% and 9.3% for 2008, 2007 and 2006, respectively. The increase in selling, general and administrative expenses in 2008 compared to 2007 was primarily due to the addition of Kadix's selling, general and administrative expenses partially offset by continuing cost reduction efforts and lower deferred compensation and stock compensation costs. The decrease in selling, general and administrative expenses in 2007 compared to 2006 was a result of cost savings initiatives undertaken in the first half of 2006, which also included higher severance costs.

Provision for Litigation

During 2008 and 2007 we recorded a provision for litigation of $14.8 million and $0.2 million, respectively. We anticipate paying the $15.0 million litigation . . .