Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

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Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

ORGANIZATION OF INFORMATION

The following Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) was prepared to provide the reader with a view and perspective of our business through the eyes of management and should be read in conjunction with our Consolidated Financial Statements and the accompanying notes to those financial statements. Our MD&A is presented in the following sections:

•Executive Summary and Financial Highlights
•2018 Outlook
•Results of Operations
•Operating Segment Results
•Liquidity and Capital Resources
•Contractual Obligations and Other Commercial Commitments
•Application of Critical Accounting Estimates
•Recently Adopted and Recently Issued Accounting Pronouncements

EXECUTIVE SUMMARY AND FINANCIAL HIGHLIGHTS

We are a global power leader that designs, manufactures, distributes and services diesel and natural gas engines and engine-related component products, including filtration, aftertreatment, turbochargers, fuel systems, controls systems, air handling systems, transmissions and electric power generation systems. We sell our products to original equipment manufacturers (OEMs), distributors and other customers worldwide. We have long-standing relationships with many of the leading manufacturers in the markets we serve, including PACCAR Inc, Daimler Trucks North America, Navistar International Corporation and Fiat Chrysler Automobiles. We serve our customers through a network of approximately 500 wholly-owned and independent distributor locations and over 7,500 dealer locations in more than 190 countries and territories.

Our reportable operating segments consist of Engine, Distribution, Components and Power Systems. This reporting structure is organized according to the products and markets each segment serves. The Engine segment produces engines (15 liters and less in size) and associated parts for sale to customers in on-highway and various off-highway markets. Our engines are used in trucks of all sizes, buses and recreational vehicles, as well as in various industrial applications, including construction, agriculture, power generation systems and other off-highway applications. The Distribution segment includes wholly-owned and partially-owned distributorships engaged in wholesaling engines, generator sets and service parts, as well as performing service and repair activities on our products and maintaining relationships with various OEMs throughout the world. The Components segment sells filtration products, aftertreatment systems, turbochargers, fuel systems and transmissions. The Power Systems segment is an integrated power provider, which designs, manufactures and sells engines (16 liters and larger) for industrial applications (including mining, oil and gas, marine and rail), standby and prime power generator sets, alternators and other power components.

Our financial performance depends, in large part, on varying conditions in the markets we serve, particularly the on-highway, construction and general industrial markets. Demand in these markets tends to fluctuate in response to overall economic conditions. Our sales may also be impacted by OEM inventory levels, production schedules and stoppages. Economic downturns in markets we serve generally result in reduced sales of our products and can result in price reductions in certain products and/or markets. As a worldwide business, our operations are also affected by currency, political, economic and regulatory matters, including adoption and enforcement of environmental and emission standards, in the countries we serve. As part of our growth strategy, we invest in businesses in certain countries that carry high levels of these risks such as China, Brazil, India, Mexico, Russia and countries in the Middle East and Africa. At the same time, our geographic diversity and broad product and service offerings have helped limit the impact from a drop in demand in any one industry or customer or the economy of any single country on our consolidated results.

Worldwide revenues improved 17 percent in 2017 compared to 2016, with all operating segments reporting higher revenue. Revenue in the U.S. and Canada improved by 15 percent primarily due to increased demand in the North American on-highway markets, increased industrial demand (especially in oil and gas, construction and mining markets) and organic growth and higher sales related to the acquisition of a North American distributor in the fourth quarter of 2016. International demand growth (excludes the U.S. and Canada) in 2017 improved revenues by 19 percent, with sales up in most of our markets,

especially in China, Russia, India and the U.K. The increase in international sales was primarily due to increased demand in the truck market in China, new emission regulations in India and increased demand in industrial markets (especially construction markets in China and mining markets in Europe).

On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act (Tax Legislation). Among other things, the Tax Legislation changed the U.S. statutory rate to 21 percent effective January 1, 2018. The impact of the Tax Legislation resulted in a net incremental charge to our Consolidated Statements of Income of $777 million. The components of the 2017 charge were as follows:

In millionsImpact of Tax Legislation**(1)**
Increase in income tax expense$781
Decrease in equity, royalty and other income from investees39
Increase in income attributable to noncontrolling interests(2)(43)
Net impact of Tax Legislation$777

(1) See Note 2, "INCOME TAXES," Note 3, "INVESTMENTS IN EQUITY INVESTEES" and Note 16,

"NONCONTROLLING INTERESTS," to our Consolidated Financial Statements for additional information*.*

(2) Noncontrolling interest was reduced for withholding taxes on foreign earnings which reduced the income eliminated for non-

Cummins ownership interest attributable to Cummins India, Ltd.

The $781 million increase in tax expense is composed of three elements - the remeasurement of deferred taxes, a one-time transitional tax on unrepatriated earnings and withholding taxes on foreign earnings.

The following table contains sales and earnings before interest expense, income tax expense and noncontrolling interests (EBIT) results by operating segment for the years ended December 31, 2017 and 2016. See the section titled "Operating Segment Results" for a more detailed discussion of net sales and EBIT by operating segment including the reconciliation of segment EBIT to net income attributable to Cummins, Inc.

Operating Segments
20172016Percent change
Percent of TotalPercent of Total2017 vs. 2016
In millionsSalesEBITSalesEBITSalesEBIT
Engine$8,95344%$959$7,80445%$686(1)15%40%
Distribution7,05834%3846,18135%39214%(2)%
Components5,88929%7544,83628%64122%18%
Power Systems4,05820%2943,51720%26315%12%
Intersegment eliminations(5,530)(27)%—(4,829)(28)%—15%—
Non-segment——55——17—NM
Total$20,428100%$2,446$17,509100%$1,99917%22%

"NM" - not meaningful information

(1) The year ended December 31, 2016, included $138 million for loss contingency charges. See the "Results of Operations" section for additional information.

Net income attributable to Cummins Inc. for 2017 was $999 million, or $5.97 per diluted share, on sales of $20.4 billion, compared to 2016 net income attributable to Cummins Inc. of $1.4 billion, or $8.23 per diluted share, on sales of $17.5 billion. The decrease in net income attributable to Cummins Inc. and earnings per diluted share was driven by a $777 million reduction for tax adjustments related to the Tax Legislation, increased selling, general and administrative expenses and higher research, development and engineering expenses, partially offset by higher net sales and gross margin, lower charges for a loss contingency and higher equity, royalty and interest income from investees. The increase in gross margin was primarily due to higher volumes, improved leverage and lower material costs, partially offset by higher warranty costs ($264 million primarily due to campaigns in the Engine, Components and Power Systems segments and changes in estimates in the Engine and Components segments) and increased variable compensation expense of $150 million. Diluted earnings per share for 2017 was negatively impacted $4.65 per share due to the Tax Legislation, partially offset by a benefit of $0.04 per share from fewer weighted-average shares outstanding, primarily due to purchases under the stock repurchase program. See Income Tax Expense section for additional information on the new Tax Legislation.

Net income and diluted earnings per share attributable to Cummins, Inc., excluding special items were as follows:

Years ended December 31,
201720162015
In millionsNet IncomeDiluted EPSNet IncomeDiluted EPSNet IncomeDiluted EPS
Net income attributable to Cummins Inc.$999$5.97$1,394$8.23$1,399$7.84
Add
Impact of Tax Legislation(1)7774.65————
Impairment of light-duty diesel assets, net of tax(2)————1330.75
Restructuring actions and other charges, net of tax(3)————610.34
Net income attributable to Cummins Inc. excluding special items(4)$1,776$10.62$1,394$8.23$1,593$8.93

(1) See Note 2, "INCOME TAXES," to our Consolidated Financial Statements for additional information*.*

(2) See Note 19, "IMPAIRMENT OF LIGHT-DUTY DIESEL ASSETS," to our Consolidated Financial Statements for additional information*.*

(3) See Note 20, "RESTRUCTURING ACTIONS AND OTHER CHARGES," to our Consolidated Financial Statements for additional information*.*

(4) These measures are not in accordance with, or an alternative for, accounting principles generally accepted in the United States of America (GAAP) and

may not be consistent with measures used by other companies. It should be considered supplemental data.

We generated $2.3 billion of operating cash flows in 2017, compared to $1.9 billion in 2016. See the section titled "Cash Flows" in the "LIQUIDITY AND CAPITAL RESOURCES" section for a discussion of items impacting cash flows.

During 2017 we repurchased $451 million, or 2.9 million shares of common stock. See Note 13, "SHAREHOLDERS' EQUITY," to the Consolidated Financial Statements for additional information.

On July 31, 2017, we formed a joint venture with Eaton Corporation PLC by purchasing a 50 percent interest in the new venture named Eaton Cummins Automated Transmission Technologies (ECJV) for $600 million in cash. In addition, each partner contributed $20 million for working capital. The joint venture will design, assemble, sell and support medium-duty and heavy-duty automated transmissions for the commercial vehicle market, including new product launches. We consolidated the results of the joint venture in our Components segment as we have a majority voting interest in the venture by virtue of a tie-breaking vote on the joint venture's board of directors. See Note 18 "ACQUISITIONS," to the Consolidated Financial Statements for additional information.

On September 5, 2017, we entered into a 364-day credit facility that allows us to borrow up to $1 billion of additional unsecured funds at any time through September 2018. Revolving credit facilities are maintained primarily to provide backup liquidity for our commercial paper borrowings, letters of credit and general corporate purposes.

Our debt to capital ratio (total capital defined as debt plus equity) at December 31, 2017, was 19.7 percent, compared to 20.6 percent at December 31, 2016. At December 31, 2017, we had $1.6 billion in cash and marketable securities on hand and access to our credit facilities, if necessary, to meet currently anticipated investment and funding needs. As of the date of filing this Annual Report on Form 10-K, our credit ratings were as follows:

Long-TermShort-Term
Credit Rating AgencySenior Debt RatingDebt RatingOutlook
Standard & Poor’s Rating ServicesA+A1Stable
Moody’s Investors Service, Inc.A2P1Stable

In July 2017, our Board of Directors authorized an increase to our quarterly dividend of 5.4 percent from $1.025 per share to $1.08 per share.

Our global pension plans, including our unfunded and non-qualified plans, were 116 percent funded at December 31, 2017. Our U.S. qualified plans, which represent approximately 55 percent of the worldwide pension obligation, were 131 percent funded and our U.K. plans were 118 percent funded. We expect to contribute approximately $38 million to our global pension plans in 2018. In addition, we expect our 2018 net periodic pension cost to approximate $79 million. See application of critical accounting estimates within MD&A and Note 10, "PENSION AND OTHER POSTRETIREMENT BENEFITS," to the Consolidated Financial Statements, for additional information concerning our pension and other post-retirement benefit plans.

In the first quarter of 2018, we will expand our segment reporting and add an additional segment called Electrified Power. The segment will include Brammo Inc., a low voltage battery designer acquired in 2017, and our internally developed electrification business. We will begin reporting the new segment effective with our first quarter Form 10-Q.

2018 OUTLOOK

Our outlook reflects the following positive trends and challenges to our business that we expect could impact our revenue and earnings potential in 2018:

Positive Trends

•North American heavy-duty truck demand is expected to improve.
•North American medium-duty truck demand will remain strong.
•Demand for pick up trucks in North America will remain strong.
•Industry production of medium-duty trucks in North America will remain strong.
•Market demand may continue to improve in global mining.
•Global construction markets could continue to improve.
•Economic conditions in Brazil may begin to improve, which could contribute to improved demand in our end-markets.

Challenges

•Market demand in truck markets in China is expected to decline.
•Marine markets are expected to remain weak.

In summary, we expect demand to improve or remain strong in many of our most important markets.

RESULTS OF OPERATIONS

Favorable/(Unfavorable)
Years ended December 31,2017 vs. 20162016 vs. 2015
In millions (except per share amounts)201720162015AmountPercentAmountPercent
NET SALES$20,428$17,509$19,110$2,91917%$(1,601)(8)%
Cost of sales15,33813,05714,163(2,281)(17)%1,1068%
GROSS MARGIN5,0904,4524,94763814%(495)(10)%
OPERATING EXPENSES AND INCOME
Selling, general and administrative expenses2,3902,0462,092(344)(17)%462%
Research, development and engineering expenses752636735(116)(18)%9913%
Equity, royalty and interest income from investees3573013155619%(14)(4)%
Loss contingency charges51386013396%(78)NM
Impairment of light-duty diesel assets——211——%211100%
Restructuring actions and other charges——90——%90100%
Other operating income (expense), net65(5)(17)70NM1271%
OPERATING INCOME2,3651,9282,05743723%(129)(6)%
Interest income182324(5)(22)%(1)(4)%
Interest expense816965(12)(17)%(4)(6)%
Other income, net634891531%39NM
INCOME BEFORE INCOME TAXES2,3651,9302,02543523%(95)(5)%
Income tax expense1,371474555(897)NM8115%
CONSOLIDATED NET INCOME9941,4561,470(462)(32)%(14)(1)%
Less: Net (loss) income attributable to noncontrolling interests(5)627167NM913%
NET INCOME ATTRIBUTABLE TO CUMMINS INC.$999$1,394$1,399$(395)(28)%$(5)—%
Diluted earnings per common share attributable to Cummins Inc.$5.97$8.23$7.84$(2.26)(27)%$0.395%

"NM" - not meaningful information

Favorable/(Unfavorable) Percentage Points
Percent of sales2017201620152017 vs. 20162016 vs. 2015
Gross margin24.9%25.4%25.9%(0.5)(0.5)
Selling, general and administrative expenses11.7%11.7%10.9%—(0.8)
Research, development and engineering expenses3.7%3.6%3.8%(0.1)0.2

2017 vs. 2016

Net Sales

Net sales increased $2.9 billion versus 2016, primarily driven by the following:

•Engine segment sales increased 15 percent primarily due to higher demand in most North American on-highway markets and improved demand in most global construction markets.
•Components segment sales increased 22 percent due to higher demand across all businesses, especially the emission solutions business, due to strong on-highway sales in India, North America and China.
•Distribution segment sales increased 14 percent primarily due to an increase in organic sales and higher sales related to the acquisition of a North American distributor in the fourth quarter of 2016.
•Power Systems segment sales increased 15 percent due to higher demand in all product lines, especially in industrial markets, due to higher demand in global mining and North American oil and gas markets.

Sales to international markets (excluding the U.S. and Canada), based on location of customers, were 42 percent of total net sales in 2017, compared with 42 percent of total net sales in 2016.

A more detailed discussion of sales by segment is presented in the "Operating Segment Results" section.

Gross Margin

Gross margin increased $638 million, primarily due to higher volumes, improved leverage and lower material costs, partially offset by higher warranty costs ($264 million primarily due to campaigns in the Engine, Components and Power Systems segments and changes in estimates in the Engine and Components segments) and increased variable compensation expense of $150 million. Gross margin decreased 0.5 points as a percentage of sales due to increased warranty costs and increased variable compensation expense.

The provision for warranties issued, excluding campaigns, as a percentage of sales, was 1.8 percent in 2017 and 1.7 percent in 2016. A more detailed discussion of margin by segment is presented in the "Operating Segment Results" section.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $344 million, primarily due to higher compensation expenses ($257 million), especially variable compensation, and higher consulting expenses ($52 million). Overall, selling, general and administrative expenses, as a percentage of sales, remained flat at 11.7 percent in 2017 and 2016.

Research, Development and Engineering Expenses

Research, development and engineering expenses increased $116 million, primarily due to increased compensation expense ($76 million), especially variable compensation, and higher consulting expenses ($20 million). Overall, research, development and engineering expenses, as a percentage of sales, increased to 3.7 percent in 2017 from 3.6 percent in 2016. Research activities continue to focus on development of new products to meet future emission standards around the world and improvements in fuel economy performance.

Equity, Royalty and Interest Income From Investees

Equity, royalty and interest income from investees increased $56 million, primarily due to higher earnings at Beijing Foton Cummins Engine Co. and Dongfeng Cummins Engine Company, Ltd., despite $39 million of unfavorable impacts from Tax Legislation related to withholding taxes on foreign earnings and remeasurement of deferred taxes. See Note 2, "INCOME TAXES," to our Consolidated Financial Statements for additional information*.*

Loss Contingency Charges

In 2017, we recorded a charge of $5 million in addition to the 2016 charge of $138 million for a loss contingency. See Note 12, "COMMITMENTS AND CONTINGENCIES," to the Consolidated Financial Statements for additional information.

Other Operating Income (Expense), Net

Other operating income (expense), net was as follows:

Years ended December 31,
In millions20172016
Royalty income, net$50$28
Gain on sale of assets, net202
Loss on write off of assets(4)(18)
Amortization of intangible assets(12)(9)
Other, net11(8)
Total other operating income (expense), net$65$(5)

Interest Income

Interest income decreased $5 million primarily due to lower investment balances in China and Brazil.

Interest Expense

Interest expense increased $12 million primarily due to higher weighted-average debt outstanding and hedge ineffectiveness on our interest rate swap.

Other Income, Net

Other income, net was as follows:

Years ended December 31,
In millions20172016
Change in cash surrender value of corporate owned life insurance$50$18
Rental income75
Dividend income55
Gain on sale of equity investee (1)—17
Gains on fair value adjustment for consolidated investees (2)—15
Foreign currency, net(6)(12)
Bank charges(10)(9)
Other, net179
Total other income, net$63$48

(1) See Note 3, "INVESTMENTS IN EQUITY INVESTEES," to the Consolidated Financial Statements for additional information.

(2) See Note 18, "ACQUISITIONS," to the Consolidated Financial Statements for additional information.

Income Tax Expense

Our income tax rates are generally less than the 35 percent U.S. statutory income tax rate, primarily because of lower taxes on foreign earnings and research tax credits. On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act (Tax Legislation). The Tax Legislation changed the U.S. statutory rate to 21 percent effective January 1, 2018. Our effective tax rate for 2017 was 58.0 percent compared to 24.6 percent for 2016. The impacts of the Tax Legislation resulted in additional income tax expense of $781 million to our tax provision (excluding the noncontrolling interest and equity investee adjustments). See Note 2, "INCOME TAXES," to our Consolidated Financial Statements for additional information*.*

We expect our 2018 effective tax rate to be 23 percent, excluding any discrete items (including adjustments to provisional estimates) that may arise.

Noncontrolling Interests

Noncontrolling interests eliminate the income or loss attributable to non-Cummins ownership interests in our consolidated entities. Noncontrolling interests in income of consolidated subsidiaries decreased $67 million primarily due to the $43 million impact of Tax Legislation on Cummins India Ltd. regarding withholding taxes on foreign earnings, the acquisition of the remaining interest in Wuxi Cummins Turbo Technologies Co. Ltd. in the fourth quarter of 2016 and elimination of the net loss of ECJV.

Net Income Attributable to Cummins Inc. and Diluted Earnings Per Common Share Attributable to Cummins Inc.

Net income decreased primarily due to the $777 million impact of Tax Legislation, increased selling, general and administrative expenses and higher research, development and engineering expenses, partially offset by higher net sales and gross margin, lower charges for a loss contingency and higher equity, royalty and interest income from investees. Diluted earnings per share for 2017 was negatively impacted $4.65 per share due to the Tax Legislation, partially offset by a benefit of $0.04 per share from fewer weighted-average shares outstanding, primarily due to purchases under the stock repurchase program. See Note 2, "INCOME TAXES," to our Consolidated Financial Statements for additional information*.*

2016 vs. 2015

Net Sales

Net sales decreased $1.6 billion versus 2015, primarily driven by the following:

•Engine segment sales decreased 10 percent primarily due to lower demand in North American heavy-duty and medium-duty on-highway markets and lower demand in most North American off-highway markets, partially offset by increased sales in the light-duty automotive market.
•Power Systems segment sales decreased 14 percent primarily due to lower demand in all product lines and decreased sales in most regions with the largest declines in North America, Asia, China, Latin America, the Middle East, Africa and Western Europe.
•Components segment sales decreased 6 percent primarily due to lower demand in most lines of business, principally in North American on-highway markets, partially offset by higher demand in China.
•Foreign currency fluctuations unfavorably impacted sales by approximately 2 percent primarily in the British pound, Chinese renminbi, Indian rupee, Brazilian real, South African rand, Canadian dollar and Australian dollar.

Sales to international markets (excluding the U.S. and Canada), based on location of customers, were 42 percent of total net sales in 2016, compared with 39 percent of total net sales in 2015.

A more detailed discussion of sales by segment is presented in the "Operating Segment Results" section.

Gross Margin

Gross margin decreased $495 million and 0.5 points as a percentage of sales, primarily due to lower volumes, unfavorable mix and unfavorable foreign currency fluctuations (primarily in the Brazilian real, South African rand and Canadian dollar), partially offset by lower material and commodity costs, improved Distribution segment margins related to the acquisition of North American distributors since December 31, 2014 and lower warranty expense.

The provision for warranties issued, excluding campaigns, as a percentage of sales was 1.7 percent in 2016 and 1.8 percent in 2015. A more detailed discussion of margin by segment is presented in the "Operating Segment Results" section.

Selling, General and Administrative Expenses

Selling, general and administrative expenses decreased $46 million, primarily due to lower compensation expenses of $56 million as a result of restructuring actions taken in the fourth quarter of 2015. Compensation and related expenses include salaries, fringe benefits and variable compensation. Overall, selling, general and administrative expenses, as a percentage of sales, increased to 11.7 percent in 2016 from 10.9 percent in 2015.

Research, Development and Engineering Expenses

Research, development and engineering expenses decreased $99 million, primarily due to reduced project spending in most of our segments, decreased compensation expenses as a result of restructuring actions taken in the fourth quarter of 2015, and lower consulting expenses. Overall, research, development and engineering expenses, as a percentage of sales, decreased to 3.6 percent in 2016 from 3.8 percent in 2015. Research activities continue to focus on development of new products to meet future emission standards around the world and improvements in fuel economy performance.

Equity, Royalty and Interest Income From Investees

Equity, royalty and interest income from investees decreased $14 million, primarily due to the consolidation of partially-owned North American distributors of $12 million and lower earnings at Beijing Foton Cummins Engine Co., Ltd. of $10 million, partially offset by higher earnings at other joint ventures.

Loss Contingency Charges

In 2016, we recorded charges of $138 million in addition to the 2015 charge of $60 million for a loss contingency. See Note 12, "COMMITMENTS AND CONTINGENCIES," to the Consolidated Financial Statements for additional information.

Impairment of Light-duty Diesel Assets

In 2015, we recognized an impairment charge of $211 million on our light-duty diesel assets. See Note 19, "IMPAIRMENT OF LIGHT-DUTY DIESEL ASSETS," to the Consolidated Financial Statements for additional information.

Restructuring Actions and Other Charges

In 2015, we incurred a charge of $90 million, which included $86 million for the severance costs related to both voluntary and involuntary terminations and $4 million for asset impairments and other charges. See Note 20, "RESTRUCTURING ACTIONS AND OTHER CHARGES," to the Consolidated Financial Statements for additional information.

Other Operating Income (Expense), Net

Other operating income (expense), net was as follows:

Years ended December 31,
In millions20162015
Loss on write off of assets$(18)$(15)
Amortization of intangible assets(9)(18)
Royalty income, net2820
Other, net(6)(4)
Total other operating income (expense), net$(5)$(17)

Interest Income

Interest income was relatively flat compared to 2015.

Interest Expense

Interest expense increased $4 million versus the comparable period in 2015, primarily due to an increase in total weighted-average debt outstanding.

Other Income, Net

Other income, net was as follows:

Years ended December 31,
In millions20162015
Change in cash surrender value of corporate owned life insurance$18$(3)
Gain on sale of equity investee (1)17—
Gains on fair value adjustment for consolidated investees (2)1518
Dividend income53
Bank charges(9)(9)
Foreign currency, net(12)(18)
Other, net1418
Total other income, net$48$9

(1) See Note 3, "INVESTMENTS IN EQUITY INVESTEES," to the Consolidated Financial Statements for additional information.

(2) See Note 18, "ACQUISITIONS," to the Consolidated Financial Statements for additional information.

Income Tax Expense

Our effective tax rate for 2016 was 24.6 percent compared to 27.4 percent for 2015. The 2.8 percent decrease in our effective tax rate from 2015 to 2016 was primarily due to favorable changes in the jurisdictional mix of pre-tax income.

Noncontrolling Interests

Noncontrolling interests in income of consolidated subsidiaries decreased $9 million primarily due to lower earnings as a result of the consolidation of North American distributors since December 31, 2014 and lower earnings at Cummins India Ltd.

Net Income Attributable to Cummins Inc. and Diluted Earnings Per Common Share Attributable to Cummins Inc.

Net income was relatively flat as significantly lower gross margin and higher loss contingency charges were mostly offset by the absence of 2015 impairment and restructuring charges, in addition to lower research, development and engineering expenses, a lower effective tax rate, lower selling, general and administrative expenses and favorable changes to corporate owned life insurance. Diluted earnings per share for 2017 benefited $0.26 per share from lower shares outstanding, primarily due to purchases under the stock repurchase program.

Comprehensive Income - Foreign Currency Translation Adjustment

The foreign currency translation adjustment was a net gain (loss) of $335 million, $(448) million and $(305) million for the years ended December 31, 2017, 2016 and 2015, respectively, and was driven by the following:

Years ended December 31,
201720162015
In millionsTranslation adjustmentPrimary currency driver vs. U.S. dollarTranslation adjustmentPrimary currency driver vs. U.S. dollarTranslation adjustmentPrimary currency driver vs. U.S. dollar
Wholly-owned subsidiaries$255British pound, Chinese renminbi, Indian rupee$(397)British pound, Chinese renminbi, offset by Brazilian real$(261)British pound, Brazilian real, Chinese renminbi
Equity method investments60Chinese renminbi, Russian ruble, Indian rupee(34)Chinese renminbi, Indian rupee, offset by Mexican peso(29)Chinese renminbi, Indian rupee
Consolidated subsidiaries with a noncontrolling interest20Indian rupee(17)Chinese renminbi, Indian rupee(15)Indian rupee, Chinese renminbi
Total$335$(448)$(305)

OPERATING SEGMENT RESULTS

Our reportable operating segments consist of the Engine, Distribution, Components and Power Systems segments. This reporting structure is organized according to the products and markets each segment serves. We use segment EBIT as a primary basis for the Chief Operating Decision Maker to evaluate the performance of each of our operating segments. Segment amounts exclude certain expenses not specifically identifiable to segments. See Note 21, "OPERATING SEGMENTS," to the Consolidated Financial Statements for additional information.

Following is a discussion of results for each of our operating segments.

Engine Segment Results

Financial data for the Engine segment was as follows:

Favorable/(Unfavorable)
Years ended December 31,2017 vs. 20162016 vs. 2015
In millions201720162015AmountPercentAmountPercent
External sales (1)$6,661$5,774$6,733$88715%$(959)(14)%
Intersegment sales (1)2,2922,0301,93726213%935%
Total sales8,9537,8048,6701,14915%(866)(10)%
Depreciation and amortization184163187(21)(13)%2413%
Research, development and engineering expenses279226263(53)(23)%3714%
Equity, royalty and interest income from investees2191481467148%21%
Interest income61011(4)(40)%(1)(9)%
Loss contingency charges (2)51386013396%(78)NM
Impairment of light-duty diesel assets (2)——202——%202100%
Restructuring actions and other charges (2)——17——%17100%
Segment EBIT95968663627340%508%
Percentage PointsPercentage Points
Segment EBIT as a percentage of total sales10.7%8.8%7.3%1.91.5

"NM" - not meaningful information

(1) Due to the acquisitions of North American distributors, sales previously recognized as external sales are now included in intersegment sales.

(2) See respective sections of "Results of Operations" for additional information.

Sales for our Engine segment by market were as follows:

Favorable/(Unfavorable)
Years ended December 31,2017 vs. 20162016 vs. 2015
In millions201720162015AmountPercentAmountPercent
Heavy-duty truck$2,840$2,443$3,116$39716%$(673)(22)%
Medium-duty truck and bus2,5132,2722,50724111%(235)(9)%
Light-duty automotive1,7271,5811,4751469%1067%
Total on-highway7,0806,2967,09878412%(802)(11)%
Off-highway1,8731,5081,57236524%(64)(4)%
Total sales$8,953$7,804$8,670$1,14915%$(866)(10)%

Unit shipments by engine classification (including unit shipments to Power Systems and off-highway engine units included in their respective classification) were as follows:

Favorable/(Unfavorable)
Years ended December 31,2017 vs. 20162016 vs. 2015
201720162015AmountPercentAmountPercent
Heavy-duty95,90079,000114,40016,90021%(35,400)(31)%
Medium-duty268,100229,100247,10039,00017%(18,000)(7)%
Light-duty257,500228,600209,30028,90013%19,3009%
Total unit shipments621,500536,700570,80084,80016%(34,100)(6)%

2017 vs. 2016

Sales

Engine segment sales increased $1.1 billion versus 2016. The following were the primary drivers by market:

•Heavy-duty truck engine sales increased $397 million primarily due to higher demand in North American heavy-duty truck markets with increased shipments of 20 percent.
•Off-highway sales increased $365 million primarily due to improved demand in global industrial markets, especially in international construction markets, with increased unit shipments of 54 percent primarily in China and Western Europe.
•Medium-duty truck and bus sales increased $241 million primarily due to higher demand in North American medium-duty truck markets with increased engine shipments of 20 percent.
•Light-duty automotive sales increased $146 million primarily due to higher sales to Chrysler and higher sales of light commercial vehicles, partially offset by lower sales to Nissan.

Total on-highway-related sales for 2017 were 79 percent of total engine segment sales, compared to 81 percent in 2016.

Segment EBIT

Engine segment EBIT increased $273 million versus 2016, primarily due to improved gross margin, lower loss contingency charges and increased equity, royalty and interest income from investees, partially offset by higher selling, general and administrative expenses and higher research, development and engineering expenses. Major components of EBIT and related changes to segment EBIT and EBIT as a percentage of sales were as follows:

Year ended December 31, 2017 vs. 2016
Favorable/(Unfavorable) Change
In millionsAmountPercentPercentage point change as a percent of sales
Gross margin$19513%(0.2)
Selling, general and administrative expenses(89)(16)%—
Research, development and engineering expenses(53)(23)%(0.2)
Equity, royalty and interest income from investees7148%0.5
Loss contingency charge(1)13396%1.7

(1) See Note 12 , "COMMITMENTS AND CONTINGENCIES," to the Consolidated Financial Statements for additional information.

The increase in gross margin versus 2016 was primarily due to higher volumes, partially offset by increased warranty costs for campaigns, changes in estimates and higher variable compensation expense. Gross margin as a percentage of sales declined primarily due to the increased warranty costs and increased variable compensation expense. The increase in selling, general and administrative expenses was primarily due to higher compensation expense, especially variable compensation expense, and higher consulting expenses. The increase in research, development and engineering expenses was primarily due to higher compensation expense, especially higher variable compensation expense, and higher consulting expenses. The increase in equity, royalty and interest income from investees was primarily due to higher earnings at Beijing Foton Cummins Engine Co. and Dongfeng Cummins Engine Company, Ltd., despite unfavorable impacts from Tax Legislation related to withholding taxes on foreign earnings and remeasurement of deferred taxes of $23 million.

2016 vs. 2015

Sales

Engine segment sales decreased $866 million versus 2015. The following were the primary drivers by market:

•Heavy-duty truck sales decreased $673 million primarily due to lower demand in the North American heavy-duty truck market with decreased engine shipments of 38 percent.
•Medium-duty truck and bus sales decreased $235 million primarily due to lower demand in most global medium-duty truck markets with decreased engine shipments of 17 percent, primarily in North America, Brazil and Mexico.
•Off-highway sales decreased $64 million primarily due to decreased engine shipments in several North American industrial markets, partially offset by increased unit shipments of 25 percent in international construction markets.

The decreases above were partially offset by an increase in light-duty automotive sales of $106 million primarily due to new sales for the Nissan pickup truck platform launched in the second half of 2015.

Total on-highway-related sales for 2016 were 81 percent of total engine segment sales, compared to 82 percent in 2015.

Segment EBIT

In 2016, we recorded additional charges of $138 million for an existing loss contingency in addition to the $60 million recorded in 2015. In 2015, we also incurred an impairment charge of $202 million for our light-duty diesel assets and incurred a restructuring charge of $17 million for actions primarily in the form of professional voluntary and involuntary employee separation programs in response to the continued deterioration in our global markets.

Engine segment EBIT increased $50 million versus 2015, primarily due to an impairment of light-duty diesel assets in 2015, lower selling, general and administrative expenses, lower research, development and engineering expenses and restructuring actions and other charges in 2015, partially offset by lower gross margin and higher loss contingency charges in 2016. Major components of EBIT and related changes to segment EBIT and EBIT as a percentage of sales were as follows:

Year ended December 31, 2016 vs. 2015
Favorable/(Unfavorable) Change
In millionsAmountPercentPercentage point change as a percent of sales
Gross margin$(210)(13)%(0.6)
Selling, general and administrative expenses7211%0.1
Research, development and engineering expenses3714%0.1
Equity, royalty and interest income from investees21%0.2
Impairment of light-duty diesel assets (1)202100%2.3
Restructuring actions and other charges (1)17100%0.2
Loss contingency charge (2)(78)NM1.1

"NM" - not meaningful information

(1) See respective sections of "Results of Operations" for additional information.

(2) See Note 12 , "COMMITMENTS AND CONTINGENCIES," to the Consolidated Financial Statements for additional information.

The decrease in gross margin versus 2015 was primarily due to lower volumes and unfavorable mix, partially offset by lower material and commodity costs and favorable product coverage. The decrease in selling, general and administrative expenses was primarily due to lower compensation expenses as the result of restructuring actions taken in the fourth quarter of 2015, and lower consulting expenses. The decrease in research, development and engineering expenses was primarily due to lower compensation expenses as a result of restructuring actions taken in the fourth quarter of 2015 and higher expense recovery from customers and external parties.

Distribution Segment Results

Financial data for the Distribution segment was as follows:

Favorable/(Unfavorable)
Years ended December 31,2017 vs. 20162016 vs. 2015
In millions201720162015AmountPercentAmountPercent
External sales$7,029$6,157$6,198$87214%$(41)(1)%
Intersegment sales292431521%(7)(23)%
Total sales7,0586,1816,22987714%(48)(1)%
Depreciation and amortization116116105——%(11)(10)%
Research, development and engineering expenses191310(6)(46)%(3)(30)%
Equity, royalty and interest income from investees447078(26)(37)%(8)(10)%
Interest income644250%——%
Restructuring actions and other charges (1)——23——%23100%
Segment EBIT (2)384392412(8)(2)%(20)(5)%
Percentage PointsPercentage Points
Segment EBIT as a percentage of total sales (3)5.4%6.3%6.6%(0.9)(0.3)
(1)See Restructuring Actions and Other Charges section of "Results of Operations" for additional information.
(2)Segment EBIT for 2016 and 2015 included gains of $15 million and $18 million, respectively, resulting from acquisitions of controlling interests in North American distributors. See Note 18, "ACQUISITIONS," to the Consolidated Financial Statements for additional information.
(3)North American distributor acquisitions are dilutive to segment EBIT as a percentage of sales.

In the first quarter of 2017, our Distribution segment reorganized its regions to align with how the segment is managed. All prior year amounts have been reclassified to conform to our new regional structure. Sales for our Distribution segment by region were as follows:

Favorable/(Unfavorable)
Years ended December 31,2017 vs. 20162016 vs. 2015
In millions201720162015AmountPercentAmountPercent
North America$4,733$3,973$3,957$76019%$16—%
Asia Pacific767720763477%(43)(6)%
Europe440440426——%143%
Africa and Middle East327366431(39)(11)%(65)(15)%
China2672352243214%115%
India190175165159%106%
Russia1671231084436%1514%
Latin America1671491551812%(6)(4)%
Total sales$7,058$6,181$6,229$87714%$(48)(1)%

Sales for our Distribution segment by product line were as follows:

Favorable/(Unfavorable)
Years ended December 31,2017 vs. 20162016 vs. 2015
In millions201720162015AmountPercentAmountPercent
Parts$3,040$2,627$2,423$41316%$2048%
Engines1,3691,1001,29426924%(194)(15)%
Power generation1,3371,2391,290988%(51)(4)%
Service1,3121,2151,222978%(7)(1)%
Total sales$7,058$6,181$6,229$87714%$(48)(1)%

2017 vs. 2016

Sales

Distribution segment sales increased $877 million versus 2016, primarily due to an increase in organic sales of $684 million (primarily in North America) and $267 million of sales related to the acquisition of a North American distributor in the fourth quarter of 2016.

Segment EBIT

Distribution segment EBIT decreased $8 million versus 2016, primarily due to higher selling, general and administrative expenses, higher research development and engineering expenses, lower equity, royalty and interest income from investees and the absence of a gain from the acquisition of controlling interests in a North American distributor in 2016, partially offset by higher gross margin. Major components of EBIT and related changes to segment EBIT and EBIT as a percentage of sales were as follows:

Year ended December 31, 2017 vs. 2016
Favorable/(Unfavorable) Change
In millionsAmountPercentPercentage point change as a percent of sales
Gross margin$11210%(0.5)
Selling, general and administrative expenses(111)(15)%—
Research, development and engineering expenses(6)(46)%(0.1)
Equity, royalty and interest income from investees(26)(37)%(0.5)
Gain on sale of assets(15)(100)%NM

"NM" - not meaningful information

The increase in gross margin versus 2016 was primarily due to higher organic volumes and the acquisition of a North American distributor in the fourth quarter of 2016, partially offset by increased variable compensation expense. Gross margin as a percentage of sales declined primarily due to the increase in variable compensation expense. The increase in selling, general and administrative expenses was primarily due to higher variable compensation expense, increased compensation expense related to the acquisition of a North American distributor and higher consulting expenses. The decrease in equity, royalty and interest income from investees was the result of the acquisition of a North American distributor in 2016 and unfavorable impacts from Tax Legislation related to withholding taxes on foreign earnings of $4 million.

2016 vs. 2015

Sales

Distribution segment sales decreased $48 million versus 2015, primarily due to a decline in organic sales of $295 million principally in North America, Asia Pacific and the Middle East and unfavorable foreign currency fluctuations (primarily in the South African rand, Canadian dollar, Chinese renminbi, Indian rupee, Australian dollar and British pound), partially offset by $344 million of segment sales related to the acquisition of North American distributors since December 31, 2014.

Segment EBIT

In 2015, we incurred a restructuring charge of $23 million for actions primarily in the form of professional voluntary and involuntary employee separation programs in response to the continued deterioration in our global markets.

Distribution segment EBIT decreased $20 million versus 2015, primarily due to higher selling, general and administrative expenses (mainly related to the acquisition of North American distributors since December 31, 2014), partially offset by higher gross margin and the absence of restructuring actions and other charges in 2015. The acquisitions resulted in $11 million and $24 million of additional amortization of intangible assets, partially offset by gains of $15 million and $18 million related to the remeasurement of our pre-existing ownership interests for North American distributor acquisitions in 2016 and 2015, respectively. Major components of EBIT and related changes to segment EBIT and EBIT as a percentage of sales were as follows:

Year ended December 31, 2016 vs. 2015
Favorable/(Unfavorable) Change
In millionsAmountPercentPercentage point change as a percent of sales
Gross margin$374%0.7
Selling, general and administrative expenses(68)(10)%(1.2)
Equity, royalty and interest income from investees(8)(10)%(0.2)
Restructuring actions and other charges (1)23NM0.4

"NM" - not meaningful information

(1) See Restructuring Actions and Other Charges section of "Results of Operations" for additional information.

The increase in gross margin versus 2015 was primarily due to the acquisitions of North American distributors since December 31, 2014 and improved pricing, partially offset by unfavorable foreign currency fluctuations (primarily in the South African rand, Canadian dollar and Australian dollar) and lower volumes. The increase in selling, general and administrative expenses was primarily due to higher compensation expenses related to the acquisitions of North American distributors and higher consulting expenses. The decrease in equity, royalty and interest income from investees was the result of the acquisitions of North American distributors.

Components Segment Results

Financial data for the Components segment was as follows:

Favorable/(Unfavorable)
Years ended December 31,2017 vs. 20162016 vs. 2015
In millions201720162015AmountPercentAmountPercent
External sales (1)$4,363$3,514$3,745$84924%$(231)(6)%
Intersegment sales (1)1,5261,3221,42720415%(105)(7)%
Total sales5,8894,8365,1721,05322%(336)(6)%
Depreciation and amortization163133109(30)(23)%(24)(22)%
Research, development and engineering expenses240208236(32)(15)%2812%
Equity, royalty and interest income from investees404135(1)(2)%617%
Interest income344(1)(25)%——%
Impairment of light-duty diesel assets (2)——9——%9100%
Restructuring actions and other charges (2)——13——%13100%
Segment EBIT75464172711318%(86)(12)%
Percentage PointsPercentage Points
Segment EBIT as a percentage of total sales12.8%13.3%14.1%(0.5)(0.8)

(1) Due to the acquisitions of North American distributors, sales previously recognized as external sales are now included in intersegment sales.

(2) See respective sections of "Results of Operations" for additional information.

In the first quarter of 2017, our Components segment reorganized its reporting structure to move the electronics business out of the emission solutions business and into the fuel systems business to enhance operational, administrative and product development efficiencies. Prior year sales were reclassified to conform with this change. We changed the name of our fuel systems business to electronics and fuel systems.

In the third quarter of 2017, we formed the Eaton Cummins Automated Transmission Technologies joint venture (ECJV), which was consolidated and included in our Components segment as the automated transmissions business. See Note 18, "ACQUISITIONS", in the Consolidated Financial Statements for additional information.

Sales for our Components segment by business were as follows:

Favorable/(Unfavorable)
Years ended December 31,2017 vs. 20162016 vs. 2015
In millions201720162015AmountPercentAmountPercent
Emission solutions$2,675$2,238$2,449$43720%$(211)(9)%
Turbo technologies1,1791,0361,14114314%(105)(9)%
Filtration1,1531,0101,01014314%——%
Electronics and fuel systems71855257216630%(20)(3)%
Automated transmissions164——164NM——%
Total sales$5,889$4,836$5,172$1,05322%$(336)(6)%

"NM" - not meaningful information

2017 vs. 2016

Sales

Components segment sales increased $1.1 billion across all lines of business versus 2016. The following were the primary drivers by business:

•Emission solutions sales increased $437 million primarily due to increased sales of products to meet new emission standards in India and stronger market demand for trucks in North America and China.
•Electronics and fuel systems sales increased $166 million primarily due to higher demand in China, Mexico and India.
•Automated transmissions contributed North American sales of $164 million following the consolidation of the ECJV during the third quarter of 2017.
•Turbo technologies sales increased $143 million primarily due to higher demand in China and North America.
•Filtration sales increased $143 million primarily due to higher demand in North America, Australia and China.

Segment EBIT

Components segment EBIT increased $113 million versus 2016, primarily due to higher gross margin, partially offset by increased selling, general and administrative expenses and research, development and engineering expenses. Major components of EBIT and related changes to segment EBIT and EBIT as a percentage of sales were as follows:

Year ended December 31, 2017 vs. 2016
Favorable/(Unfavorable) Change
In millionsAmountPercentPercentage point change as a percent of sales
Gross margin$21819%(0.5)
Selling, general and administrative expenses(99)(28)%(0.4)
Research, development and engineering expenses(32)(15)%0.2
Equity, royalty and interest income from investees(1)(2)%(0.1)

The increase in gross margin was primarily due to higher volumes, lower material costs and improved leverage, partially offset by higher warranty costs driven by campaigns and changes in estimates, unfavorable pricing and increased variable compensation expense. The increase in selling, general and administrative expenses was primarily due to higher compensation expense, especially variable compensation expense, and expenses related to the new ECJV. The increase in research, development and engineering expenses was primarily due to higher compensation expense, especially variable compensation expense, higher consulting expenses and expenses related to the new ECJV. The decrease in equity, royalty and interest income from investees was primarily due to unfavorable impacts from Tax Legislation related to withholding taxes on foreign earnings

of $12 million, partially offset by increased earnings at Dongfeng Cummins Emission Solutions Co., Ltd. and Shanghai Fleetguard Filter Co.

2016 vs. 2015

Sales

Components segment sales decreased $336 million across most lines of business versus 2015. The following were the primary drivers by business:

•Emission solutions sales decreased $211 million primarily due to lower demand in North American on-highway markets, partially offset by higher demand in China.
•Turbo technologies sales decreased $105 million primarily due to lower demand in North American on-highway markets, partially offset by higher demand in China.
•Foreign currency fluctuations unfavorably impacted sales results primarily in the Chinese renminbi, British pound and Brazilian real.
•Electronics and fuel systems sales decreased $20 million primarily due to lower demand in North American on-highway markets, partially offset by higher demand in China.

Segment EBIT

In 2015, we incurred a restructuring charge of $13 million for actions primarily in the form of professional voluntary and involuntary employee separation programs in response to the continued deterioration in our global markets. We also incurred an impairment charge of $9 million for our light-duty diesel assets.

Components segment EBIT decreased $86 million versus 2015, primarily due to lower gross margin and higher selling, general and administrative expenses, partially offset by lower research, development and engineering expenses and the absence of restructuring actions and other charges and impairment charges in 2016. Major components of EBIT and related changes to segment EBIT and EBIT as a percentage of sales were as follows:

Year ended December 31, 2016 vs. 2015
Favorable/(Unfavorable) Change
In millionsAmountPercentPercentage point change as a percent of sales
Gross margin$(111)(9)%(0.6)
Selling, general and administrative expenses(33)(10)%(1.1)
Research, development and engineering expenses2812%0.3
Equity, royalty and interest income from investees617%0.1
Impairment of light-duty diesel assets (1)9NM0.2
Restructuring actions and other charges (1)13NM0.3

"NM" - not meaningful information

(1) See respective sections of "Results of Operations" for additional information.

The decrease in gross margin was primarily due to lower volumes, unfavorable pricing, unfavorable mix and unfavorable foreign currency fluctuations (primarily in the Chinese renminbi and Brazilian real), partially offset by lower material costs. The increase in selling, general and administrative expenses was primarily due to higher consulting and compensation expenses as a result of absorbing a greater share of corporate costs under the new allocation methodology adopted during 2016, partially offset by savings from restructuring actions taken in the fourth quarter of 2015. The decrease in research, development and engineering expenses was primarily due to reduced project spending, lower consulting expenses and lower compensation expenses from restructuring actions taken in the fourth quarter of 2015.

Power Systems Segment Results

Financial data for the Power Systems segment was as follows:

Favorable/(Unfavorable)
Years ended December 31,2017 vs. 20162016 vs. 2015
In millions201720162015AmountPercentAmountPercent
External sales (1)$2,375$2,064$2,434$31115%$(370)(15)%
Intersegment sales (1)1,6831,4531,63323016%(180)(11)%
Total sales4,0583,5174,06754115%(550)(14)%
Depreciation and amortization117115110(2)(2)%(5)(5)%
Research, development and engineering expenses214189226(25)(13)%3716%
Equity, royalty and interest income from investees5442561229%(14)(25)%
Interest income355(2)(40)%——%
Restructuring actions and other charges (2)——26——%26100%
Segment EBIT2942633353112%(72)(21)%
Percentage PointsPercentage Points
Segment EBIT as a percentage of total sales7.2%7.5%8.2%(0.3)(0.7)

(1) Due to the acquisitions of North American distributors, sales previously recognized as external sales are now included in intersegment sales.

(2) See Restructuring Actions and Other Charges section of "Results of Operations" for additional information.

In the first quarter of 2017, our Power Systems segment reorganized its product lines to better reflect how the segment is managed. Prior year sales were reclassified to reflect these changes. Sales for our Power Systems segment by product line were as follows:

Favorable/(Unfavorable)
Years ended December 31,2017 vs. 20162016 vs. 2015
In millions201720162015AmountPercentAmountPercent
Power generation$2,305$2,256$2,588$492%$(332)(13)%
Industrial1,3999411,12145849%(180)(16)%
Generator technologies3543203583411%(38)(11)%
Total sales$4,058$3,517$4,067$54115%$(550)(14)%

High-horsepower unit shipments by engine classification were as follows:

Favorable/(Unfavorable)
Years ended December 31,2017 vs. 20162016 vs. 2015
201720162015AmountPercentAmountPercent
Power generation8,2007,9008,6003004%(700)(8)%
Industrial6,4004,4005,2002,00045%(800)(15)%
Total units14,60012,30013,8002,30019%(1,500)(11)%

2017 vs. 2016

Sales

Power Systems segment sales increased $541 million across all product lines versus 2016. The following were the primary drivers:

•Industrial sales increased $458 million primarily due to higher demand in global mining markets, especially in Europe, North America and China, and oil and gas markets in North America.
•Power generation sales increased $49 million primarily due to higher demand in Western Europe, North America and China, partially offset by lower demand in the Middle East, Africa and Eastern Europe.
•Generator technologies sales increased $34 million primarily due to higher demand in Europe.

Segment EBIT

Power Systems segment EBIT increased $31 million versus 2016, primarily due to higher gross margin, favorable foreign currency fluctuations and higher equity, royalty and interest income from investees, partially offset by increased selling, general and administrative expenses, higher research, development and engineering expenses and the absence of a $17 million gain on the sale of an equity investee recorded in 2016. Major components of EBIT and related changes to segment EBIT and EBIT as a percentage of sales were as follows:

Year ended December 31, 2017 vs. 2016
Favorable/(Unfavorable) Change
In millionsAmountPercentPercentage point change as a percent of sales
Gross margin$10714%(0.3)
Selling, general and administrative expenses(45)(11)%0.4
Research, development and engineering expenses(25)(13)%0.1
Equity, royalty and interest income from investees1229%0.1
Gain on sale of an equity investee(17)(100)%0.5

The increase in gross margin versus 2016 was primarily due to increased volumes, partially offset by higher warranty cost related to a campaign accrual and higher variable compensation expense. The increase in selling, general and administrative expenses was primarily due to higher variable compensation expense and higher consulting expenses. The increase in research, development and engineering expenses was primarily due to higher variable compensation expense, increased project spending and higher consulting expenses. The increase in equity, royalty and interest income from investees was primarily due to the absence of a joint venture asset impairment recorded in 2016. The decrease in the gain on sale of an equity investee was due to the absence of a $17 million gain recorded in the fourth quarter of 2016 for Cummins Olayan Energy.

2016 vs. 2015

Sales

Power Systems segment sales decreased $550 million across all product lines versus 2015. The following were the primary drivers:

•Power generation sales decreased $332 million, in most regions, with the largest declines in demand primarily in Asia, the Middle East, North America, Latin America, China, Western Europe, Africa and Mexico.
•Industrial sales decreased $180 million primarily due to lower demand in North America (mainly oil and gas and mining markets, partially offset by rail markets), Asia (mainly marine and mining markets), China (mainly marine and mining markets) and Africa.
•Foreign currency fluctuations unfavorably impacted sales results primarily in the British pound, Indian rupee and Chinese renminbi.
•Generator technologies sales decreased $38 million primarily due to lower demand in China and North America.

Segment EBIT

In 2015, we incurred a restructuring charge of $26 million for actions primarily in the form of professional voluntary and involuntary employee separation programs in response to the continued deterioration in our global markets.

Power Systems segment EBIT decreased $72 million versus 2015, primarily due to lower gross margin, partially offset by lower selling, general and administrative expenses, favorable foreign currency fluctuations (primarily the British pound), lower research, development and engineering expenses, the absence of restructuring actions and other charges and a gain from the divestiture of an equity investee. Major components of EBIT and related changes to segment EBIT and EBIT as a percentage of sales were as follows:

Year ended December 31, 2016 vs. 2015
Favorable/(Unfavorable) Change
In millionsAmountPercentPercentage point change as a percent of sales
Gross margin$(215)(21)%(2.3)
Selling, general and administrative expenses7516%0.3
Research, development and engineering expenses3716%0.2
Equity, royalty and interest income from investees(14)(25)%(0.2)
Restructuring actions and other charges (1)26100%0.6
Gain on sale of an equity investee17100%0.5

(1) See Restructuring Actions and Other Charges section of "Results of Operations" for additional information.

The decrease in gross margin versus 2015 was primarily due to lower volumes and increased project costs. The decrease in selling, general and administrative expenses was primarily due to lower compensation expenses as the result of restructuring actions taken in the fourth quarter of 2015 and lower consulting expenses. The decrease in research, development and engineering expenses was primarily due to reduced project spending, lower consulting expenses and lower compensation expenses as the result of restructuring actions taken in the fourth quarter of 2015. The decrease in equity, royalty and interest income from investees was primarily due to the impact of an $8 million asset impairment incurred by one of our joint ventures. In 2016, we sold our remaining 49 percent interest in Cummins Olayan Energy for $61 million and recognized a gain of $17 million.

Reconciliation of Segment EBIT to Net Income Attributable to Cummins Inc.

The table below reconciles the segment information to the corresponding amounts in the Consolidated Statements of Income.

Years ended December 31,
In millions201720162015
TOTAL SEGMENT EBIT$2,391$1,982$2,110
Non-segment EBIT (1)5517(20)
TOTAL EBIT2,4461,9992,090
Less: Interest expense816965
INCOME BEFORE INCOME TAXES2,3651,9302,025
Less: Income tax expense1,371474555
CONSOLIDATED NET INCOME9941,4561,470
Less: Net (loss) income attributable to noncontrolling interest(5)6271
NET INCOME ATTRIBUTABLE TO CUMMINS INC.$999$1,394$1,399

(1) Includes intersegment sales, intersegment profit in inventory eliminations and unallocated corporate expenses. The year ended December 31, 2015, included an $11 million corporate restructuring charge. There were no significant unallocated corporate expenses for the years ended December 31, 2017 and 2016.

LIQUIDITY AND CAPITAL RESOURCES

Key Working Capital and Balance Sheet Data

We fund our working capital with cash from operations and short-term borrowings, including commercial paper, when necessary. Various assets and liabilities, including short-term debt, can fluctuate significantly from month to month depending on short-term liquidity needs. As a result, working capital is a prime focus of management attention. Working capital and balance sheet measures are provided in the following table:

Dollars in millionsDecember 31, 2017December 31, 2016
Working capital (1)$3,251$3,382
Current ratio1.571.78
Accounts and notes receivable, net$3,618$3,025
Days’ sales in receivables5961
Inventories$3,166$2,675
Inventory turnover5.04.7
Accounts payable (principally trade)$2,579$1,854
Days' payable outstanding5351
Total debt$2,006$1,856
Total debt as a percent of total capital19.7%20.6%

(1) Working capital includes cash and cash equivalents.

Cash Flows

Cash and cash equivalents were impacted as follows:

Years ended December 31,Change
In millions2017201620152017 vs. 20162016 vs. 2015
Net cash provided by operating activities$2,277$1,939$2,065$338$(126)
Net cash used in investing activities(1,052)(917)(918)(135)1
Net cash used in financing activities(1,074)(1,413)(1,650)339237
Effect of exchange rate changes on cash and cash equivalents98(200)(87)298(113)
Net increase (decrease) in cash and cash equivalents$249$(591)$(590)$840$(1)

2017 vs. 2016

Net cash provided by operating activities increased $338 million versus 2016, primarily due to improved earnings of $358 million, excluding the non-cash impact of Tax Legislation of $820 million and lower working capital levels of $352 million, partially offset by higher pension contributions of $109 million, a decrease in deferred tax expense of $104 million, lower loss contingency charges of $117 million and higher equity earnings of $77 million. The lower working capital requirements in 2017 resulted in a cash inflow of $90 million compared to a cash outflow of $262 million in 2016.

Net cash used in investing activities increased $135 million versus 2016, primarily due to higher acquisitions of businesses, net of cash acquired of $568 million and the absence of $60 million in proceeds from the sale of of equity investees in 2016, partially offset by lower net investments in marketable securities of $244 million, higher cash flows from derivatives not designated as hedges of $178 million and higher proceeds from the disposal of property, plant and equipment of $96 million.

Net cash used in financing activities decreased $339 million versus 2016, primarily due to lower repurchases of common stock of $327 million.

The effect of exchange rate changes on cash and cash equivalents increased $298 million versus 2016, primarily due to the British pound, which increased cash and cash equivalents $249 million.

2016 vs. 2015

Net cash provided by operating activities decreased $126 million versus 2015, primarily due to the absence of the 2015 impairment of light-duty diesel assets of $211 million and a $123 million year over year impact related to restructuring, partially offset by an increase in deferred income taxes of $158 million and higher loss contingency charges of $62 million resulting in lower cash net income in 2016.

Net cash used in investing activities decreased $1 million versus 2015, primarily due to lower capital expenditures of $213 million and proceeds from the sale of equity investees of $60 million, partially offset by higher net investments in marketable securities of $160 million and changes in cash flows from derivatives not designated as hedges of $110 million.

Net cash used in financing activities decreased $237 million versus 2015, primarily due to higher net borrowings of commercial paper of $212 million, lower common stock repurchases of $122 million and higher proceeds from borrowings of $67 million, partially offset by higher acquisitions of noncontrolling interests of $88 million and higher payments on borrowings and capital lease obligations of $87 million.

The effect of exchange rate changes on cash and cash equivalents decreased $113 million versus 2015, primarily due to the British pound, which decreased cash and cash equivalents $112 million.

Sources of Liquidity

We generate significant ongoing cash flow. Cash provided by operations is our principal source of liquidity with $2.3 billion provided in 2017.

At December 31, 2017, our sources of liquidity included:

December 31, 2017
In millionsTotalU.S.InternationalPrimary location of international balances
Cash and cash equivalents$1,369$360$1,009U.K., Singapore, China, Belgium, Australia, Canada
Marketable securities (1)19849149India
Total$1,567$409$1,158
Available credit capacity
Revolving credit facility (2)$2,452
International and other uncommitted domestic credit facilities$240

(1) The majority of marketable securities could be liquidated into cash within a few days.

(2) The five-year credit facility for $1.75 billion and the 364-day credit facility for $1.0 billion, maturing November 2020 and September 2018, respectively, are maintained primarily to provide backup liquidity for our commercial paper borrowings and general corporate purposes. At December 31, 2017, we had $298 million of commercial paper outstanding, which effectively reduced the $1.75 billion available capacity under our five-year revolving credit facility to $1.45 billion.

Cash, Cash Equivalents and Marketable Securities

A significant portion of our cash flows is generated outside the U.S. We manage our worldwide cash requirements considering available funds among the many subsidiaries through which we conduct our business and the cost effectiveness with which those funds can be accessed. As a result, we do not anticipate any local liquidity restrictions to preclude us from funding our operating needs with local resources.

The Tax Legislation made significant changes to U.S. tax law, including a one-time transition tax on accumulated foreign earnings of $298 million with a cash impact of $338 million. The payments associated with this deemed repatriation will be paid over eight years. The unrepatriated foreign earnings at December 31, 2017, will be repatriated as needed to fund cash needs. The estimated accrued withholding taxes of $331 million on foreign earnings that we plan to repatriate in the foreseeable future will be paid as cash is repatriated. See Note 2, "INCOME TAXES," to our Consolidated Financial Statements for additional information*.*

Debt Facilities and Other Sources of Liquidity

On November 13, 2015, we entered into an amended and restated five-year revolving credit agreement with a syndicate of lenders, which provides us with a $1.75 billion senior unsecured revolving credit facility and expires on November 13, 2020. On September 5, 2017, we entered into a 364-day credit facility that allows us to borrow up to $1 billion of additional unsecured funds at any time through September 2018. We have access to both credit facilities which total $2.75 billion of borrowing capacity. We intend to maintain credit facilities of a similar aggregate amount by renewing or replacing these facilities before expiration. Revolving credit facilities are maintained primarily to provide backup liquidity for our commercial paper borrowings, letters of credit and general corporate purposes.

We can issue up to $1.75 billion of unsecured short-term promissory notes ("commercial paper") pursuant to our board authorized commercial paper programs. The programs facilitate the private placement of unsecured short-term debt through third party brokers. We intend to use the net proceeds from the commercial paper borrowings for general corporate purposes.

The total combined borrowing capacity under the revolving credit facility and commercial paper program should not exceed $2.75 billion. See Note 9, "DEBT," to our Consolidated Financial Statements for additional information.

As a well-known seasoned issuer, we filed an automatic shelf registration for an undetermined amount of debt and equity securities with the Securities and Exchange Commission (SEC) on February 16, 2016. Under this shelf registration we may offer, from time to time, debt securities, common stock, preferred and preference stock, depositary shares, warrants, stock purchase contracts and stock purchase units.

Uses of Cash

Stock Repurchases

In December 2016, our Board of Directors authorized the acquisition of up to $1 billion of additional common stock upon completion of the 2015 repurchase plan. In 2017, we made the following purchases under the 2015 repurchase program:

In millions (except per share amounts) For each quarter endedShares PurchasedAverage Cost Per ShareTotal Cost of RepurchasesRemaining Authorized Capacity (1)
April 20.3$151.32$51$445
July 20.5153.9569376
October 11.7155.05271105
December 310.4166.006046
Total2.9$155.81$451

(1) The remaining authorized capacity under the 2015 plan was calculated based on the cost to purchase the shares but excludes commission expenses in accordance with the authorized plan.

We intend to repurchase outstanding shares from time to time during 2018 to enhance shareholder value and to offset the dilutive impact of employee stock based compensation plans.

Dividends

Total dividends paid to common shareholders in 2017, 2016 and 2015 were $701 million, $676 million and $622 million, respectively. Declaration and payment of dividends in the future depends upon our income and liquidity position, among other factors, and is subject to declaration by our Board of Directors, who meet quarterly to consider our dividend payment. We expect to fund dividend payments with cash from operations.

In July 2017, our Board of Directors authorized an increase to our quarterly dividend of 5.4 percent from $1.025 per share to $1.08 per share. In July 2016, our Board of Directors authorized an increase to our quarterly dividend of 5.1 percent from $0.975 per share to $1.025 per share. In July 2015, our Board of Directors authorized an increase to our quarterly dividend of 25 percent from $0.78 per share to $0.975 per share. Cash dividends per share paid to common shareholders for the last three years were as follows:

Quarterly Dividends
201720162015
First quarter$1.025$0.975$0.78
Second quarter1.0250.9750.78
Third quarter1.081.0250.975
Fourth quarter1.081.0250.975
Total$4.21$4.00$3.51

Acquisitions

On July 31, 2017, we formed a joint venture with Eaton Corporation PLC by purchasing a 50 percent interest in the new venture named Eaton Cummins Automated Transmission Technologies (ECJV) for $600 million in cash. In addition, each partner contributed $20 million for working capital. See Note 18 "ACQUISITIONS," to the Consolidated Financial Statements for additional information.

On November 1, 2017, we acquired Brammo Inc., an engineerer and manufacturer of lithium ion batteries primarily related to the utility vehicle markets, for $68 million. See Note 18 "ACQUISITIONS," to the Consolidated Financial Statements for additional information.

Capital Expenditures

Capital expenditures, including spending on internal use software, were $587 million in 2017, compared to $594 million in 2016. We continue to invest in new product lines and targeted capacity expansions. We plan to spend between $730 million and $760 million in 2018 on capital expenditures as we continue with product launches and facility improvements. Approximately 50 percent of our capital expenditures are expected to be invested outside of the U.S. in 2018.

Pensions

The funded status of our pension plans is dependent upon a variety of variables and assumptions including return on invested assets, market interest rates and levels of voluntary contributions to the plans. In 2017, the investment return on our U.S. pension trust was 12.9 percent while our U.K. pension trust return was 4.4 percent. Approximately 77 percent of our pension plan assets are held in highly liquid investments such as fixed income and equity securities. The remaining 23 percent of our plan assets are held in less liquid, but market valued investments, including real estate, private equity, venture capital, opportunistic credit and insurance contracts.

We sponsor funded and unfunded domestic and foreign defined benefit pension plans. Contributions to these plans were as follows:

Years ended December 31,
In millions201720162015
Defined benefit pension plans
Voluntary contribution$233$133$82
Mandatory contribution101108
Defined benefit pension contributions243134190
Defined contribution pension plans$84$68$74

We anticipate making total contributions of approximately $38 million to our defined benefit pension plans in 2018. Expected contributions to our defined benefit pension plans in 2018 will meet or exceed the current funding requirements.

Current Maturities of Short and Long-Term Debt

We had $298 million of commercial paper outstanding at December 31, 2017, that matures in less than one year. The maturity schedule of our existing long-term debt does not require significant cash outflows in the intermediate term. Required annual principal payments range from $6 million to $63 million over the next five years. See Note 9 "DEBT"to the Consolidated Financial Statements for additional information.

Credit Ratings

Our ratings and outlook from each of the credit rating agencies as of the date of filing are shown in the table below.

Long-TermShort-Term
Credit Rating Agency (1)Senior Debt RatingDebt RatingOutlook
Standard & Poor’s Rating ServicesA+A1Stable
Moody’s Investors Service, Inc.A2P1Stable

(1) Credit ratings are not recommendations to buy, are subject to change and each rating should be evaluated independently of any other rating. In addition, we undertake no obligation to update disclosures concerning our credit ratings, whether as a result of new information, future events or otherwise.

Management's Assessment of Liquidity

Our financial condition and liquidity remain strong. Our solid balance sheet and credit ratings enable us to have ready access to credit and the capital markets. We assess our liquidity in terms of our ability to generate adequate cash to fund our operating, investing and financing activities. We believe our operating cash flow and liquidity provides us with the financial flexibility needed to fund working capital, common stock repurchases, acquisitions, capital expenditures, dividend payments, projected pension obligations and debt service obligations. While we expect more efficient access to overseas earnings as a result of Tax Legislation, we continue to generate cash from operations in the U.S. and maintain access to our revolving credit facility as noted above.

CONTRACTUAL OBLIGATIONS AND OTHER COMMERCIAL COMMITMENTS

A summary of our contractual obligations and other commercial commitments, at December 31, 2017, are as follows:

Contractual Cash ObligationsPayments Due by Period
In millions20182019-20202021-2022After 2022Total
Loans payable$57$—$—$—$57
Long-term debt and capital lease obligations (1)1692541802,8173,420
Operating leases14018810470502
Capital expenditures28030——310
Purchase commitments for inventory789———789
Other purchase commitments26217716302
Transitional tax liability575477150338
Other postretirement benefits295551108243
International and other domestic letters of credit9057—2149
Performance and excise bonds2614611102
Guarantees, indemnifications and other commitments31371051
Total$1,930$672$487$3,174$6,263
(1)Includes principal payments and expected interest payments based on the terms of the obligations.

The contractual obligations reported above exclude our unrecognized tax benefits of $41 million as of December 31, 2017. We are not able to reasonably estimate the period in which cash outflows relating to uncertain tax contingencies could occur. See Note 2, "INCOME TAXES," to the Consolidated Financial Statements for additional information.

APPLICATION OF CRITICAL ACCOUNTING ESTIMATES

A summary of our significant accounting policies is included in Note 1, "SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES," of our Consolidated Financial Statements which discusses accounting policies that we have selected from acceptable alternatives.

Our Consolidated Financial Statements are prepared in accordance with generally accepted accounting principles in the U.S. (GAAP) which often requires management to make judgments, estimates and assumptions regarding uncertainties that affect the reported amounts presented and disclosed in the financial statements. Management reviews these estimates and assumptions based on historical experience, changes in business conditions and other relevant factors they believe to be reasonable under the circumstances. In any given reporting period, our actual results may differ from the estimates and assumptions used in preparing our Consolidated Financial Statements.

Critical accounting estimates are defined as follows: the estimate requires management to make assumptions about matters that were highly uncertain at the time the estimate was made; different estimates reasonably could have been used; or if changes in the estimate are reasonably likely to occur from period to period and the change would have a material impact on our financial condition or results of operations. Our senior management has discussed the development and selection of our accounting policies, related accounting estimates and the disclosures set forth below with the Audit Committee of our Board of Directors. We believe our critical accounting estimates include those addressing the estimation of liabilities for warranty programs, accounting for income taxes and pension benefits.

Warranty Programs

We estimate and record a liability for base warranty programs at the time our products are sold. Our estimates are based on historical experience and reflect management's best estimates of expected costs at the time products are sold and subsequent adjustment to those expected costs when actual costs differ. As a result of the uncertainty surrounding the nature and frequency of product recall programs, the liability for such programs is recorded when we commit to a recall action or when a recall becomes probable and estimable, which generally occurs when it is announced. Our warranty liability is generally affected by component failure rates, repair costs and the point of failure within the product life cycle. Future events and circumstances related to these factors could materially change our estimates and require adjustments to our liability. New product launches require a greater use of judgment in developing estimates until historical experience becomes available. Product specific experience is typically available four or five quarters after product launch, with a clear experience trend evident eight quarters after launch. We generally record warranty expense for new products upon shipment using a preceding product's warranty history and a multiplicative factor based upon preceding similar product experience and new product assessment until sufficient new product data is available for warranty estimation. We then use a blend of actual new product experience and preceding product historical experience for several subsequent quarters, and new product specific experience thereafter. Note 8, "PRODUCT WARRANTY LIABILITY," to our Consolidated Financial Statements contains a summary of the activity in our warranty liability account for 2017, 2016 and 2015 including adjustments to pre-existing warranties.

Accounting for Income Taxes

We determine our income tax expense using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax effects of temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Future tax benefits of net operating loss and credit carryforwards are also recognized as deferred tax assets. We evaluate the recoverability of our deferred tax assets each quarter by assessing the likelihood of future profitability and available tax planning strategies that could be implemented to realize our net deferred tax assets. At December 31, 2017, we recorded net deferred tax liabilities of $85 million. The assets included $359 million for the value of net operating loss and credit carryforwards. A valuation allowance of $347 million was recorded to reduce the tax assets to the net value management believed was more likely than not to be realized. In the event our operating performance deteriorates, future assessments could conclude that a larger valuation allowance will be needed to further reduce the deferred tax assets.

On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act (Tax Legislation). We have not completed our accounting for the tax effects of enactment of the Tax Legislation. We made provisional estimates of the effects on our existing deferred tax balances, the one-time transition tax, and the withholding tax accrued on those earnings not permanently reinvested at December 31, 2017. The final transition impacts of the Tax Legislation may differ from our estimates, possibly materially, due to, among other things, changes in interpretations for the Tax Legislation, any legislative action to address questions that arise because of the Tax Legislation, any changes in accounting standards for income taxes or related interpretations in response to the Tax Legislation, or any updates or changes to estimates the company has utilized to calculate the transition impacts. Final calculations will be completed within the one year measurement period ending December 22, 2018, as required under the rules issued by the SEC. Any change of provisional amounts will be reported in income from continuing operations in the period in which the initial estimates are revised. In addition, we operate within multiple taxing jurisdictions and are subject to tax audits in these jurisdictions. These audits can involve complex issues, which may require an extended period of time to resolve. We accrue for the estimated additional tax and interest that may result from tax authorities disputing uncertain tax positions. We have taken and we believe we have made adequate provisions for income taxes for all years that are subject to audit based upon the latest information available. A more complete description of our income taxes and the future benefits of our net operating loss and credit carryforwards is disclosed in Note 2, "INCOME TAXES," to our Consolidated Financial Statements.

Pension Benefits

We sponsor a number of pension plans primarily in the U.S. and the U.K. and to a lesser degree in various other countries. In the U.S. and the U.K., we have several major defined benefit plans that are separately funded. We account for our pension programs in accordance with employers' accounting for defined benefit pension and other postretirement plans under GAAP. GAAP requires that amounts recognized in financial statements be determined using an actuarial basis. As a result, our pension benefit programs are based on a number of statistical and judgmental assumptions that attempt to anticipate future events and are used in calculating the expense and liability related to our plans each year at December 31. These assumptions include discount rates used to value liabilities, assumed rates of return on plan assets, future compensation increases, employee turnover rates, actuarial assumptions relating to retirement age, mortality rates and participant withdrawals. The actuarial assumptions we use may differ significantly from actual results due to changing economic conditions, participant life span and withdrawal rates. These differences may result in a material impact to the amount of net periodic pension cost to be recorded in our Consolidated Financial Statements in the future.

The expected long-term return on plan assets is used in calculating the net periodic pension cost. We considered several factors in developing our expected rate of return on plan assets. The long-term rate of return considers historical returns and expected returns on current and projected asset allocations. Projected returns are based primarily on broad, publicly traded passive fixed income and equity indices and forward-looking estimates of the value added by active investment management. At December 31, 2017, based upon our target asset allocations, it is anticipated that our U.S. investment policy will generate an average annual return over the 10-year projection period equal to or in excess of 6.5 percent approximately 32 percent of the time while returns of 7.0 percent or greater are anticipated 21 percent of the time, including the additional positive returns expected from active investment management.

Our plan assets have averaged annualized returns of 10.5 percent over the prior eight years, and resulted in approximately $418 million of actuarial gains in accumulated other comprehensive income in the same period. Based on the historical returns and forward-looking return expectations, we believe an investment return assumption of 6.5 percent per year in 2018 for U.S. pension assets is reasonable.

The methodology used to determine the rate of return on pension plan assets in the U.K. was based on establishing an equity-risk premium over current long-term bond yields adjusted based on target asset allocations. At December 31, 2017, based upon our target asset allocations, it is anticipated that our U.K. investment policy will generate an average annual return over the 20-year projection period equal to or in excess of 4.1 percent approximately 50 percent of the time while returns of 4.8 percent or greater are anticipated 25 percent of the time. We expect modest additional positive returns from active investment management. The one-year return for our U.K. plans was 4.4 percent for 2017, and similar to our U.S. plans, the strong returns since 2010 have resulted in approximately $383 million of actuarial gains in accumulated other comprehensive income. Our strategy with respect to our investments in pension plan assets is to be invested with a long-term outlook. Therefore, the risk and return balance of our asset portfolio should reflect a long-term horizon. Based on the historical returns and forward-looking return expectations as the plan assets continue to be de-risked, we believe an investment return assumption of 4.0 percent in 2018 for U.K. pension assets is reasonable. Our pension plan asset allocations at December 31, 2017 and 2016 and target allocation for 2018 are as follows:

U.S. PlansU.K. Plans
Target AllocationPercentage of Plan Assets at December 31,Target AllocationPercentage of Plan Assets at December 31,
Investment description201820172016201820172016
Liability matching68.0%68.3%57.8%56.5%56.1%54.6%
Risk seeking32.0%31.7%42.2%43.5%43.9%45.4%
Total100.0%100.0%100.0%100.0%100.0%100.0%

The differences between the actual return on plan assets and expected long-term return on plan assets are recognized in the asset value used to calculate net periodic cost over five years. The table below sets forth the expected return assumptions used to develop our pension cost for the period 2015-2017 and our expected rate of return for 2018.

Long-term Expected Return Assumptions
2018201720162015
U.S. plans6.50%7.25%7.50%7.50%
U.K. plans4.00%4.50%4.70%5.80%

A lower expected rate of return will increase our net periodic pension cost and reduce profitability.

GAAP for pensions offers various acceptable alternatives to account for the differences that eventually arise between the estimates used in the actuarial valuations and the actual results. It is acceptable to delay or immediately recognize these differences. Under the delayed recognition alternative, changes in pension obligations (including those resulting from plan amendments) and changes in the value of assets set aside to meet those obligations are not recognized in net periodic pension cost as they occur but are recognized initially in accumulated other comprehensive loss and subsequently amortized as components of net periodic pension cost systematically and gradually over future periods. In addition to this approach, GAAP also allows immediate recognition of actuarial gains or losses. Immediate recognition introduces volatility in financial results. We have chosen to delay recognition and amortize actuarial differences over future periods. If we adopted the immediate recognition approach, we would record a loss of $864 million ($680 million after-tax) from cumulative actuarial net losses for our U.S. and U.K. pension plans.

The difference between the expected return and the actual return on plan assets is deferred from recognition in our results of operations and under certain circumstances such as when the difference exceeds 10 percent of the market value of plan assets or the projected benefit obligation, amortized over future years of service. This is also true of changes to actuarial assumptions. Under GAAP, the actuarial gains and losses are recognized and recorded in accumulated other comprehensive loss. At December 31, 2017, we had net pension actuarial losses of $649 million and $207 million for the U.S. and U.K. pension plans, respectively. As these amounts exceed 10 percent of their respective plan assets, the excess is amortized over the average remaining service lives of participating employees. Net actuarial losses decreased our shareholders' equity by $28 million after-tax in 2017. The loss is due to lower discount rates in the U.S. and U.K. and unfavorable foreign currency, partially offset by strong asset performance in the U.S. and the U.K.

The table below sets forth the net periodic pension cost for the years ended December 31 and our expected cost for 2018.

In millions2018201720162015
Net periodic pension cost$79$82$42$63

We expect 2018 net periodic pension cost to decrease compared to 2017, primarily due to reduced loss amortization in the U.S. and U.K., which resulted from strong asset performance, partially offset by lower expected asset returns in the U.S. and U.K. as we de-risk plan trust assets. The increase in net periodic pension cost in 2017 compared to 2016 was primarily due to onboarding North American distributors to Cummins pension benefits, a lower expected rate of return in the U.S. and U.K. and lower discount rates in the U.S. and U.K. The decrease in net periodic pension cost in 2016 compared to 2015 was due to reduced loss amortizations in the U.S. and U.K. and higher discount rates in the U.S. and U.K., partially offset by lower expected asset returns in the U.K. as we de-risked plan trust assets. Another key assumption used in the development of the net periodic pension cost is the discount rate. The weighted-average discount rates used to develop our net periodic pension cost are set forth in the table below.

Discount Rates
2018201720162015
U.S. plans3.66%4.12%4.47%4.07%
U.K. plans2.55%2.70%3.95%3.80%

Changes in the discount rate assumptions will impact the interest cost component of the net periodic pension cost calculation.

The discount rate enables us to state expected future cash payments for benefits as a present value on the measurement date. The guidelines for setting this rate are discussed in GAAP which suggests the use of a high-quality corporate bond rate. We used bond information provided by Moody's Investor Services, Inc. and Standard & Poor's Rating Services. All bonds used to develop our hypothetical portfolio in the U.S. and U.K. were deemed high-quality, non-callable bonds (Aa or better) at December 31, 2017, by at least one of the bond rating agencies.

Our model called for projected payments until near extinction for the U.S. and the U.K. For both countries, our model matches the present value of the plan's projected benefit payments to the market value of the theoretical settlement bond portfolio. A single equivalent discount rate is determined to align the present value of the required cash flow with the value of the bond portfolio. The resulting discount rate is reflective of both the current interest rate environment and the plan's distinct liability characteristics.

The table below sets forth the estimated impact on our 2018 net periodic pension cost relative to a change in the discount rate and a change in the expected rate of return on plan assets.

In millionsImpact on Pension Cost Increase/(Decrease)
Discount rate used to value liabilities
0.25 percent increase$(16)
0.25 percent decrease17
Expected rate of return on assets
1 percent increase(48)
1 percent decrease48

The above sensitivities reflect the impact of changing one assumption at a time. A higher discount rate decreases the plan obligations and decreases our net periodic pension cost. A lower discount rate increases the plan obligations and increases our net periodic pension cost. It should be noted that economic factors and conditions often affect multiple assumptions simultaneously and the effects of changes in key assumptions are not necessarily linear. Note 10, "PENSION AND OTHER POSTRETIREMENT BENEFITS," to our Consolidated Financial Statements provides a summary of our pension benefit plan activity, the funded status of our plans and the amounts recognized in our Consolidated Financial Statements.

RECENTLY ADOPTED AND RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

See Note 1, "SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES", to the Consolidated Financial Statements for additional information.

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