Revenues
Our revenues are primarily generated from the entire life cycle of complex sensor systems under contracts primarily with the U.S. government and major domestic prime contractors, as well as with foreign governments, agencies and defense contractors. This life cycle spans the design, development, production, installation and support of the system.
Our government contracts can be divided into three major types: cost reimbursable, fixed-price, and time and materials. Cost reimbursable contracts are primarily used for system design and development activities involving considerable risks to the contractor, including risks related to cost estimates on complex systems, performance risks associated with real time signal processing, embedded software, high performance hardware, and requirements that are not fully understood by the customer or us, the development of technology that has never been used, and interfaces with other systems that are in development or are obsolete without adequate documentation. Fees under these contracts are usually fixed at the time of negotiation; however, in some cases the fee is an incentive or award fee based on cost, schedule, and performance or a combination of those factors. Although the U.S. government customer assumes the cost risk on these contracts, the contractor is not allowed to exceed the cost ceiling on the contract without the approval of the customer.
Fixed-price contracts are typically used for the production of systems. Development activities similar to activities performed under previous contacts are also usually covered by fixed-price contracts, due to the lower risk involved. In these contracts, cost risks are borne entirely by the contractor. Some fixed-price contracts include an award fee or an incentive fee as well as the negotiated profit. Most foreign customers, and some U.S. customers, use fixed-price contracts for design and development work even when the work is considered high risk.
Time and material contracts are based on hours worked, multiplied by pre-negotiated labor rates, plus other costs incurred, allocated and approved.
Many of our fixed-price contracts contain provisions under which our customers are required to make payments when we achieve certain milestones. In many instances, these milestone payments occur before we have incurred the associated costs to which the payments will be applied. For example, under certain of our production contracts, our order of materials constitutes a milestone for which we receive a significant payment, but we do not pay the materials vendors until the materials are received and placed into production. We recognize deferred revenue when we receive milestone payments for which we have not yet incurred the applicable costs. As costs are incurred and revenue recognition criteria are met, we recognize revenue.
As the time lag between our receipt of a milestone payment and our incurrence of associated costs under the contract can be several months, milestone payments under fixed-price contracts can significantly affect our cash position at any given time. The receipt of milestone payments will temporarily increase our cash on hand and our deferred revenue. As costs are incurred under the contract and contract revenue is recognized, cash and deferred revenue associated with the payment will decrease.
We expect that fluctuations in deferred revenue will occur based on the particular timing of milestone payments under our fixed-price contracts and our subsequent incurrence of costs under the contracts. Due to these fluctuations, our cash position at the end of any fiscal quarter or year may not be indicative of our cash position at the end of subsequent fiscal quarters or years.

The following table represents our revenue concentration by contract type for the three and six months ended March 29, 2009 and March 30, 2008:

                                       Three Months Ended            Six Months Ended
                                    March 29,      March 30,     March 29,      March 30,
     Contract Type                    2009           2008          2009            2008

     Fixed-price contracts               55 %           64 %          56 %             58 %
     Cost reimbursable contracts         40 %           32 %          39 %             38 %
     Time and material contracts          5 %            4 %           5 %              4 %

Generally, we experience revenue growth when systems move from the development stage to the production stage due to increases in sales volumes from production of multiple systems, and when we add new customers or are successful in selling new systems to existing customers. Much of our current production work has been derived from programs for which we have performed the initial development work. These programs are next generation systems replacing existing, obsolete systems that were developed by other companies. We were able to displace these companies primarily on the basis of technological capability. We continue to believe that the current state of world affairs and the U.S. government's emphasis on protecting U.S. citizens will cause funding of these programs to continue. The increase in cost reimbursable contracts as a percentage of our total revenue in the second quarter of fiscal 2009, as compared to the second quarter of fiscal 2008, is primarily due to a significant amount of work performed on several key cost reimbursable type programs including a fixed site system for a U.S. intelligence community customer and a contract to bring our surface ship lighthouse technology to the U.S. Coast Guard. On a year-to-date measure, the increased work on cost reimbursable programs in the second quarter of fiscal 2009 was offset with increases in fixed price programs in the first quarter of fiscal 2009, driven largely by increased efforts on a fixed price subcontract to Sierra Nevada for the build of the ORBCOMM Generation Two payload, which was awarded in the third quarter of fiscal 2008.
Backlog
We define backlog as the funded and unfunded amount provided in contracts less previously recognized revenue. Contract options are estimated separately and not included in backlog until they are exercised and funded.
Our funded backlog does not include the full value of our contracts because Congress often appropriates funds for a particular program or contract on a yearly or quarterly basis, even though the contract may call for performance that is expected to take a number of years.
From time to time, we will exclude from backlog portions of contract values of very long or complex contracts where we judge revenue could be jeopardized by a change in U.S. government policy. Because of possible future changes in delivery schedules and cancellations of orders, backlog at any particular date is not necessarily representative of actual revenue to be expected for any succeeding period, and actual revenue for the year may not meet or exceed the backlog represented. We may experience significant contract cancellations or reductions of amounts that were previously booked and included in backlog.

Our backlog at the dates shown was as follows (in thousands):

                                 March 29,       September 30,
                                    2009             2008

                      Funded     $  216,661     $       272,620
                      Unfunded       33,523              54,672

                      Total      $  250,184     $       327,292

Cost of Revenues
Cost of revenues consist of direct costs incurred on contracts such as labor, materials, travel, subcontracts and other direct costs and indirect costs associated with overhead expenses such as facilities, fringe benefits and other costs that are not directly related to the execution of a specific contract. We plan our spending of indirect costs on an annual basis and on cost reimbursable contracts receive government approval to bill those costs as a percentage of our direct labor, other direct costs and direct materials as we execute our contracts. The U.S. government approves the planned indirect rates as provisional billing rates near the beginning of each fiscal year. General and Administrative Expenses
Our general and administrative expenses include administrative salaries, costs related to proposal activities and other administrative costs. Research and Development
We conduct internally funded research and development into complex signal processing, system and software architectures, and other technologies that are important to continued advancement of our systems and are of interest to our current and prospective customers. The variance from year to year in internal research and development is caused by the status of our product cycles and the level of complementary U.S. government funded research and development. For the three and six months ended March 29, 2009 internally funded research and development expenditures were $2.4 million and $4.1 million, respectively, representing approximately 3% and 2% of revenues in each period, respectively. For the three and six months ended March 30, 2008 internally funded research and development expenditures were $1.8 million and $3.5 million, respectively, representing 2% of revenues in each period.
Internally funded research and development is a small portion of our overall research and development, as government funded research and development constitutes the majority of our activities in this area. Interest Income and Expense
Interest income is derived solely from interest earned on cash reserves maintained in short term investment accounts and are therefore subject to short-term interest rates that have minimal risk.
Interest expense relates to interest charged on borrowings against our line of credit and capital leases.
Critical Accounting Practices and Estimates General
Our discussion and analysis of our financial condition and results of operations are based upon our financial statements. These financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe that the estimates, assumptions, and judgments involved in the accounting practices described below have the greatest potential impact on our financial statements and, therefore, consider these to be critical accounting practices.

Revenue and Cost Recognition
General
The majority of our contracts, which are with the U.S. government, are accounted for in accordance with the American Institute of Certified Public Accountants Statement of Position 81-1, Accounting for Performance of Construction-Type and Production-Type Contracts. These contracts are transacted using written contractual arrangements, most of which require us to design, develop, manufacture and/or modify complex products and systems, and perform related services according to specifications provided by the customer. We account for fixed-price contracts by using the percentage-of-completion method of accounting and for substantially all contracts, the cost-to-cost method is used to measure progress towards completion. Under this method, contract costs are charged to operations as incurred. A portion of the contract revenue, based on estimated profits and the degree of completion of the contract as measured by a comparison of the actual and estimated costs, is recognized as revenue each period. In the case of contracts with materials requirements, revenue is recognized as those materials are applied to the production process in satisfaction of the contracts' end objectives. We account for cost reimbursable contracts by charging contract costs to operations as incurred and recognizing contract revenues and profits by applying the negotiated fee rate to actual costs on an individual contract basis.
Contract revenue recognition inherently involves estimation. Examples of estimates include the contemplated level of effort to accomplish the tasks under the contract, the cost of the effort, and an ongoing assessment of our progress toward completing the contract. From time to time, as part of our management processes, facts develop that require us to revise our estimated total costs or revenue. To the extent that a revised estimate affects contract profit or revenue previously recognized, we record the cumulative effect of the revision in the period in which the facts requiring the revision become known.
Anticipated losses on contracts are also recorded in the period in which they become determinable. Unexpected increases in the cost to develop or manufacture a product, whether due to inaccurate estimates in the bidding process, unanticipated increases in material costs, inefficiencies, or other factors are borne by us on fixed-price contracts, and could have a material adverse effect on results of operations and financial condition. Unexpected cost increases in cost reimbursable contracts may be borne by us for purposes of maintaining customer relationships. If the customer agrees to fund cost increases on cost type contracts, the additional work does not have any profit and therefore dilutes margin.
Indirect rate variance
We record contract revenues and costs of operations for interim reporting purposes based on annual targeted indirect rates. At year-end, the revenues and costs are adjusted for actual indirect rates. During our interim reporting periods, variances may accumulate between the actual indirect rates and the annual targeted rates. Timing-related indirect spending variances are not applied to contract costs, research and development, and general and administrative expenses, but are included in unbilled receivables during these interim reporting periods. These rates are reviewed regularly, and we record adjustments for any material, permanent variances in the period they become determinable.
Our accounting policy for recording indirect rate variances is based on management's belief that variances accumulated during interim reporting periods will be absorbed by management actions to control costs during the remainder of the year. We consider the rate variance to be unfavorable when the actual indirect rates are greater than our annual targeted rates. During interim reporting periods, unfavorable rate variances are recorded as reductions to operating expenses and increases to unbilled receivables. Favorable rate variances are recorded as increases to operating expenses and decreases to unbilled receivables.
If we anticipate that actual contract activities will be different than planned levels, there are alternatives we can utilize to absorb the variance: we can adjust planned indirect spending during the year, modify our billing rates to our customers, or record adjustments to expense based on estimates of future contract activities.

If our rate variance is expected to be unfavorable for the entire fiscal year, any modification of our indirect rates will likely increase revenue and operating expenses. Profit percentages on fixed-price contracts will generally decline as a result of an increase to indirect costs unless compensating savings can be achieved in the direct costs to complete the projects. Profit percentages on cost reimbursement contracts will generally decline as a percentage of total costs as a result of an increase in indirect costs even if the cost increase is funded by the customer. If our rate variance is favorable, any modification of our indirect rates will decrease revenue and operating expenses. In this event, profit percentages on fixed-price contracts will generally increase. Profit percentages on cost-reimbursable contracts will generally be unaffected as a result of any reduction to indirect costs, due to the fact that programs will typically expend all of the funds available. Any impact on operating income, however, will depend on a number of other factors, including mix of contract types, contract terms and anticipated performance on specific contracts.
At March 29, 2009, the unfavorable rate variance totaled $4.4 million, which was approximately $1.1 million more than the $3.3 million unfavorable rate variance planned for the period. Management expects the variance to be eliminated over the course of the fiscal year and therefore, no portion of the variance is considered permanent.
Award Fee Recognition
Our practice for recognizing interim fees on our cost-plus-award-fee contracts is based on management's assessment as to the likelihood that the award fee or an incremental portion of the award fee will be earned on a contract-by-contract basis. Management's assessments are based on numerous factors including: contract terms, nature of the work performed, our relationship and history with the customer, our history with similar types of projects, and our current and anticipated performance on the specific contract. No award fee is recognized until management determines that it is probable that an award fee or portion thereof will be earned. Actual fees awarded are typically within management's estimates. However, changes could arise within an award fee period causing management to either lower or raise the award fee estimate in the period in which it occurs. Goodwill
Costs in excess of the fair value of tangible and identifiable intangible assets acquired and liabilities assumed in a business combination are recorded as goodwill. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, we test for impairment at least annually using a two-step approach. Impairment of goodwill is tested at the reporting unit level by comparing the reporting unit's carrying amount, including goodwill, to the fair value of the reporting unit. The Company operates as a single reporting unit. The fair value of the reporting unit is estimated using a market capitalization approach. If the carrying amount of the unit exceeds its fair value, goodwill is considered impaired and a second step is performed to measure the amount of impairment loss, if any. We performed the test during the fourth quarter of fiscal year 2008 and found no impairment to the carrying value of goodwill. Long-Lived Assets (Excluding Goodwill)
We follow the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS No. 144") in accounting for long-lived assets such as property and equipment and intangible assets subject to amortization. SFAS No.144 requires that long-lived assets be reviewed for impairment whenever events or circumstances indicate that the carrying amount of an asset may not be fully recoverable. An impairment loss is recognized if the sum of the long-term undiscounted cash flows is less than the carrying amount of the long-lived asset being evaluated. Impairment losses are treated as permanent reductions in the carrying amount of the assets. Accounts Receivable
We are required to estimate the collectability of our accounts receivable. Judgment is required in assessing the realization of such receivables, and the related reserve requirements are based on the best facts available to us. Since most of our revenue is generated under U.S. government contracts, our current accounts receivable reserve is not significant to our overall receivables balance.

Stock-Based Compensation
We issue stock options, restricted stock units ("RSUs") and stock appreciation rights ("SARs") on an annual or selective basis to our directors and key employees. The fair value of the RSUs is computed using the closing price of the stock on the date of grant. The fair value of the stock options and the SARs is computed using a binomial option pricing model. Assumptions related to the volatility are based on an analysis of our historical volatility. The estimated fair value of each award is included in cost of revenues or general and administrative expenses over the vesting period which an employee provides services in exchange for the award.
Historical Operating Results
Three months ended March 29, 2009 compared to three months ended March 30, 2008 The following table sets forth certain items, including consolidated revenues, cost of revenues, general and administrative expenses, income tax expense and net income, and the changes in these items for the three months ended March 29, 2009 and March 30, 2008 (in thousands):

                                                     Three months quarter ended              Amount of
                                                  March 29,             March 30,            increase          % increase
                                                     2009                  2008             (decrease)         (decrease)

Contract revenues                               $     95,572          $     88,449          $   7,123                  8 %
Cost of revenues                                      77,695                73,012              4,683                  6 %
General and administrative expenses                    6,128                 4,663              1,465                 31 %
Research and development expenses                      2,366                 1,811                555                 31 %
Interest income, net                                     (11 )                  35                (46 )             -131 %
Provision for income taxes                             3,556                 3,492                 64                  2 %
Net income                                             5,816                 5,506                310                  6 %

Revenues
Revenues increased approximately $7.1 million or 8% for the three months ended March 29, 2009, as compared to the three months ended March 30, 2008 representing increases in contract activity across multiple capabilities and technologies that we provide to our customers. We realized an $8.7 million increase in revenue recognized for work completed on contracts related to tactical communications and networking capabilities for three customers, including contracts related to continued work on a subcontract to Sierra Nevada for the build of the ORBCOMM Generation Two Payload, the U.S. Army's Operational Test Tactical Engagement System, and a second production order for the Common . . .