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


•	2019 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 powertrain-related component products, including filtration, aftertreatment, turbochargers, fuel systems, controls systems, air handling systems, transmissions, electric power generation systems, batteries and electrified power systems. We sell our products to original equipment manufacturers (OEMs), distributors, dealers and other customers worldwide. We have long-standing relationships with many of the leading manufacturers in the markets we serve, including PACCAR Inc, Navistar International Corporation, Daimler Trucks North America and Fiat Chrysler Automobiles (Chrysler). We serve our customers through a network of approximately 600 wholly-owned and independent distributor locations and over 7,600 dealer locations in more than 190 countries and territories.

Our reportable operating segments consist of Engine, Distribution, Components, Power Systems and Electrified Power. 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, electronics, 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.

We formed the Electrified Power segment, effective January 1, 2018, which designs, manufactures, sells and supports electrified power systems ranging from fully electric to hybrid solutions along with innovative components and subsystems to serve all our markets as they adopt electrification, meeting the needs of our OEM partners and end customers.We currently offer the Cummins PowerDrive series of fully electric and hybrid powertrain systems targeting various applications in the Class 4-8 commercial vehicle markets and are developing the Cummins Battery Electric System and the Cummins Hybrid Power Plug-In System for the urban bus market, which are expected to launch in 2019 and 2020, respectively. We also design and manufacture battery modules, packs and systems for commercial, industrial and material handling applications. We use a range of cell chemistries which are suitable for pure electric, hybrid and plug-in hybrid applications. In addition to electrified powertrains for urban buses, we intend to deliver product offerings to other markets as they adopt electric solutions, including, but not limited to, pick-up and delivery applications and industrial markets. We invest in and utilize our internal research and development capabilities, along with strategic acquisitions and partnerships, to meet our objectives.

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 16 percent in 2018 compared to 2017, with all operating segments reporting higher sales. Net sales in the United States (U.S.) and Canada improved by 19 percent primarily due to increased demand in the North American on-highway markets (primarily in the heavy- and medium-duty truck markets), increased demand in all of our distribution product lines, sales from the automated transmission business acquired during the third quarter of 2017 and increased industrial demand (especially in oil and gas and construction markets). International demand growth (excludes the U.S. and Canada) in 2018 improved international net sales by 12 percent compared to 2017, with sales up in most of our markets, especially in Europe, Asia Pacific, Latin America, China and India. The increase in international sales was primarily due to increased demand in industrial markets (especially construction and mining markets in China and Europe), increased on-highway demand (especially in Brazil, Europe and India), increased demand in our distribution business (especially in Western Europe, Asia Pacific and China) and increased demand for power generation equipment (primarily in the Middle East, Asia Pacific and China).

Effective January 1, 2018, we changed our segment measure of profitability to EBITDA (defined as earnings before interest expense, income taxes, noncontrolling interests, depreciation and amortization) as a primary basis for the Chief Operating Decision Maker to evaluate the performance of each of our operating segments. EBITDA assists investors and debt holders in comparing our performance on a consistent basis without regard for depreciation and amortization, which can vary significantly depending upon many factors. Prior periods have been revised to reflect the current presentation. Segment amounts exclude certain expenses not specifically identifiable to segments. The following tables contain sales and EBITDA by operating segment for the years ended December 31, 2018 and 2017. See the section titled "OPERATING SEGMENT RESULTS" for a more detailed discussion of net sales and EBITDA by operating segment including the reconciliation of segment EBITDA to net income attributable to Cummins Inc.



	Operating Segments
	2018								2017							Percent change
				Percent of Total								Percent of Total				2018 vs. 2017
In millions	Sales			EBITDA			Sales			EBITDA			Sales		EBITDA
Engine	$	10,566		44	%	$	1,446		$	8,953		44	%	$	1,143	18	%	27	%
Distribution	7,828			33	%	563			7,058			34	%	500		11	%	13	%
Components	7,166			30	%	1,030			5,889			29	%	917		22	%	12	%
Power Systems	4,626			20	%	614			4,058			20	%	411		14	%	49	%
Electrified Power	7			—	%	(90		)	—			—	%	—		NM		NM
Intersegment eliminations	(6,422		)	(27	)%	(87		)	(5,530		)	(27	)%	55		16	%	NM
Total	$	23,771		100	%	$	3,476		$	20,428		100	%	$	3,026	16	%	15	%

"NM" - not meaningful information

Net income attributable to Cummins Inc. for 2018 was $2.1 billion, or $13.15 per diluted share, on sales of $23.8 billion, compared to 2017 net income attributable to Cummins Inc. of $1.0 billion, or $5.97 per diluted share, on sales of $20.4 billion. The increase in net income attributable to Cummins Inc. and earnings per diluted share was driven by significantly higher net sales, the 2017 Tax Cuts and Jobs Act (Tax Legislation), higher gross margin and increased equity earnings from investees, partially offset by $368 million for an Engine System Campaign, higher research, development and engineering expenses, unfavorable foreign currency impacts (primarily the British pound, Brazilian real and Angolan kwanza partially offset by the Euro) and higher interest expense. Tax Legislation resulted in the U.S. statutory rate decreasing from 35 percent to 21 percent, added incremental income tax expense in 2017 of $781 million to our tax provision (excluding the noncontrolling interest and equity investee adjustments) with a net impact of $777 million unfavorable to net income. See Note 4, "INCOME TAXES," and Note 9, "PRODUCT WARRANTY LIABILITY," to the Consolidated Financial Statements for additional information on the Tax Legislation adjustments during the one year measurement period and the Engine System Campaign, respectively. The increase in gross margin was primarily due to higher volumes, improved mix and favorable pricing, partially offset by increased warranty costs (primarily $368 million for an Engine System Campaign), higher compensation costs (driven by headcount growth to support increased sales) and unfavorable impacts from Chinese tariffs. Diluted earnings per share for 2018 benefited $0.25 per share from fewer weighted average shares outstanding, primarily due to the stock repurchase programs, including shares acquired under the accelerated share repurchase agreement.

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




	Years ended December 31,
	2018				2017
In millions, except per share amounts	Net Income		Diluted EPS		Net Income		Diluted EPS
Net income and diluted EPS attributable to Cummins Inc.	$	2,141	$	13.15	$	999	$	5.97
Net impact of Tax Legislation(1)	39		0.24		777		4.65
Net income and diluted EPS attributable to Cummins Inc. excluding Tax Legislation (2)	$	2,180	$	13.39	$	1,776	$	10.62

(1) See Note 4, "INCOME TAXES," to our Consolidated Financial Statements for additional information*.*

(2) 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 $2.4 billion of operating cash flows in 2018, compared to $2.3 billion in 2017. See the section titled "Cash Flows" in the "LIQUIDITY AND CAPITAL RESOURCES" section for a discussion of items impacting cash flows.

In October 2018, our Board of Directors authorized the acquisition of up to $2 billion of additional common stock upon completion of the 2016 repurchase plan. During 2018, we repurchased $1.1 billion, or 7.9 million shares of common stock, including 3.5 million shares repurchased under the $500 million accelerated share repurchase program. See Note 14 "SHAREHOLDERS' EQUITY," to Consolidated Financial Statements for additional information*.*

On August 22, 2018, we entered into a new five-year $2.0 billion revolving credit agreement and a 364-day $1.5 billion credit agreement that expire on August 22, 2023 and August 21, 2019, respectively. These new credit facilities replace our previous five-year $1.75 billion and 364-day $1.0 billion facilities and will be used primarily to provide backup liquidity for our commercial paper borrowings and general corporate purposes. See Note 10 "DEBT," to Consolidated Financial Statements for additional information*.*

Our debt to capital ratio (total capital defined as debt plus equity) at December 31, 2018, was 23.1 percent, compared to 19.7 percent at December 31, 2017. The increase was primarily due to an increase in outstanding commercial paper. At December 31, 2018, we had $1.5 billion in cash and marketable securities on hand and access to our $3.5 billion credit facilities, if necessary, to meet currently anticipated investment and funding needs.

In July 2018, our Board of Directors authorized an increase to our quarterly dividend of 5.6 percent from $1.08 per share to $1.14 per share.

Our global pension plans, including our unfunded and non-qualified plans, were 115 percent funded at December 31, 2018. Our U.S. qualified plan, which represents approximately 54 percent of the worldwide pension obligation, was 131 percent funded and our United Kingdom (U.K.) plan was 115 percent funded. We expect to contribute approximately $123 million to our global pension plans in 2019. In addition, we expect our 2019 net periodic pension cost to approximate $56 million. See application of critical accounting estimates within MD&A and Note 11, "PENSIONS AND OTHER POSTRETIREMENT BENEFITS," to the Consolidated Financial Statements, for additional information concerning our pension and other post retirement benefit plans.

2019 OUTLOOK

Our outlook reflects the following positive trends and challenges to our business that we expect could impact our revenue and earnings potential in 2019:

Positive Trends


•	We anticipate North American medium-duty truck and heavy-duty truck demand will remain strong.


•	We expect demand for pick-up trucks in North America will remain strong.


•	We anticipate power generation markets will remain strong, with increased demand in global data center markets.


•	We expect construction markets will remain strong in North America and Europe.


•	We expect demand in mining markets to stabilize.


•	Improving economic conditions in Brazil could positively impact demand across our business.

Challenges


•	We are experiencing cost increases as a result of trade tariffs recently imposed by the U.S. and some of its trading partners, especially China.


•	Prolonged trade disputes could negatively impact demand and trigger additional costs.


•	Market demand in truck and construction markets in China is expected to decline.


•	We anticipate demand in oil and gas markets in North America will decline.


•	Marine markets are expected to remain weak.


•	Uncertainty in the U.K. surrounding its ability to negotiate favorable terms in its withdrawal from the European Union could have material negative impacts on our European operations in the near and long-term.

In summary, we expect demand to remain strong in many of our most important markets, but also face headwinds in China and with Brexit.

RESULTS OF OPERATIONS



										Favorable/(Unfavorable)
	Years ended December 31,									2018 vs. 2017					2017 vs. 2016
In millions (except per share amounts)	2018			2017			2016			Amount			Percent		Amount			Percent
NET SALES	$	23,771		$	20,428		$	17,509		$	3,343		16	%	$	2,919		17	%
Cost of sales	18,034			15,328			13,051			(2,706		)	(18	)%	(2,277		)	(17	)%
GROSS MARGIN	5,737			5,100			4,458			637			12	%	642			14	%
OPERATING EXPENSES AND INCOME
Selling, general and administrative expenses	2,437			2,429			2,099			(8		)	—	%	(330		)	(16	)%
Research, development and engineering expenses	902			754			637			(148		)	(20	)%	(117		)	(18	)%
Equity, royalty and interest income from investees	394			357			301			37			10	%	56			19	%
Loss contingency	—			5			138			5			100	%	133			96	%
Other operating income (expense), net	(6		)	65			(5		)	(71		)	NM		70			NM
OPERATING INCOME	2,786			2,334			1,880			452			19	%	454			24	%
Interest income	35			18			23			17			94	%	(5		)	(22	)%
Interest expense	114			81			69			(33		)	(41	)%	(12		)	(17	)%
Other income, net	46			94			96			(48		)	(51	)%	(2		)	(2	)%
INCOME BEFORE INCOME TAXES	2,753			2,365			1,930			388			16	%	435			23	%
Income tax expense	566			1,371			474			805			59	%	(897		)	NM
CONSOLIDATED NET INCOME	2,187			994			1,456			1,193			NM		(462		)	(32	)%
Less: Net income (loss) attributable to noncontrolling interests	46			(5		)	62			(51		)	NM		67			NM
NET INCOME ATTRIBUTABLE TO CUMMINS INC.	$	2,141		$	999		$	1,394		$	1,142		NM		$	(395	)	(28	)%
Diluted earnings per common share attributable to Cummins Inc.	$	13.15		$	5.97		$	8.23		$	7.18		NM		$	(2.26	)	(27	)%

"NM" - not meaningful information



							Favorable/(Unfavorable) Percentage Points
Percent of sales	2018		2017		2016		2018 vs. 2017		2017 vs. 2016
Gross margin	24.1	%	25.0	%	25.5	%	(0.9	)	(0.5	)
Selling, general and administrative expenses	10.3	%	11.9	%	12.0	%	1.6		0.1
Research, development and engineering expenses	3.8	%	3.7	%	3.6	%	(0.1	)	(0.1	)

2018 vs. 2017

Net Sales

Net sales increased $3.3 billion, primarily driven by the following:


•	Engine segment sales increased 18 percent, primarily due to higher demand across all markets, especially in North American heavy-duty truck, global construction markets and medium-duty truck markets.


•	Components segment sales increased 22 percent, due to higher demand across all businesses, especially the emission solutions business, stronger market demand for trucks in North America and Western Europe, sales from the automated transmission business acquired in the third quarter of 2017 and the turbo technologies business due to higher demand in North America and Western Europe.


•	Distribution segment sales increased 11 percent, primarily due to higher demand in most geographic regions, especially in North America, and increased demand in all product lines.


•	Power Systems segment sales increased 14 percent, due to higher demand for all product lines, especially in power generation due to stronger demand in North America, Middle East and Australia, and industrial sales driven by higher demand in global mining markets and oil and gas markets in North America.

Sales to international markets (excluding the U.S. and Canada), based on location of customers, were 41 percent of total net sales in 2018, compared with 42 percent of total net sales in 2017. A more detailed discussion of sales by segment is presented in the "OPERATING SEGMENT RESULTS" section.

Cost of Sales

The types of expenses included in cost of sales are the following: raw material consumption, including direct and indirect materials; salaries, wages and benefits; depreciation on production equipment and facilities and amortization of technology intangibles; estimated costs of warranty programs and campaigns; production utilities; production-related purchasing; warehousing, including receiving and inspection; engineering support costs; repairs and maintenance; production and warehousing facility property insurance; rent for production facilities and other production overhead.

Gross Margin

Gross margin increased $637 million and decreased 0.9 points as a percentage of sales. The increase in gross margin was primarily due to higher volumes, improved mix and favorable pricing, partially offset by increased warranty costs (primarily $368 million for an Engine System Campaign), higher compensation costs (driven by headcount growth to support increased sales) and unfavorable impacts from Chinese tariffs. The decrease in gross margin percentage was primarily due to the Engine System Campaign. See Note 9, "PRODUCT WARRANTY LIABILITY," to our Consolidated Financial Statements for additional information on the Engine System Campaign.

The provision for warranties issued, excluding campaigns, as a percentage of sales, was 1.9 percent in 2018 and 1.8 percent in 2017. 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 $8 million, primarily due to higher consulting expense and increased administrative expense driven by the acquisition of the automated transmission business in the third quarter of 2017. Overall, selling, general and administrative expenses, as a percentage of sales, improved to 10.3 percent in 2018 from 11.9 percent in 2017, primarily as the result of lower variable compensation expense on higher sales.

Research, Development and Engineering Expenses

Research, development and engineering expenses increased $148 million, primarily due to investments in the Electrified Power segment, increased compensation expense driven by headcount growth and expenses from the automated transmission business acquired in the third quarter of 2017, higher consulting expense and lower expense recovery. Overall, research, development and engineering expenses, as a percentage of sales, increased to 3.8 percent in 2018 from 3.7 percent in 2017. Research activities continue to focus on development of new products to meet future emission standards around the world, improvements in fuel economy performance of diesel and natural gas powered engines and development activities around fully electric and hybrid powertrain solutions.

Equity, Royalty and Interest Income From Investees

Equity, royalty and interest income from investees increased $37 million, primarily due to a $39 million unfavorable deferred tax adjustment recognized in 2017 in conjunction with the adoption of the 2017 Tax Legislation that did not repeat in 2018. The primary equity, royalty and interest income fluctuations by equity investee were higher earnings at Tata Cummins Ltd., Cummins Westport, Chongqing Cummins Engine Company, Ltd. and higher royalty and interest income, partially offset by lower earnings at Beijing Foton Cummins Engine Company, Ltd. and Dongfeng Cummins Engine Company, Ltd. See Note 3, "INVESTMENTS IN EQUITY INVESTEES, " to our Consolidated Financial Statements for additional information on the deferred tax adjustments by investee.

Other Operating Income (Expense), Net

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



	Years ended December 31,
In millions	2018			2017
Royalty income, net	$	38		$	50
Gain on sale of assets, net	2			20
Loss on write off of assets	(19		)	(4		)
Amortization of intangible assets	(20		)	(12		)
Other, net	(7		)	11
Total other operating income (expense), net	$	(6	)	$	65

Interest Income

Interest income increased $17 million, primarily due to higher interest rates on cash and marketable security balances.

Interest Expense

Interest expense increased $33 million, primarily due to higher weighted-average debt outstanding and higher interest rates.

Other Income, Net

Other income, net was as follows:



	Years ended December 31,
In millions	2018			2017
Non-service pension and other postretirement benefits credit	$	60		$	31
Rental income	8			7
Dividend income	3			5
Bank charges	(11		)	(10		)
Change in cash surrender value of corporate owned life insurance	(20		)	50
Foreign currency loss, net	(34		)	(6		)
Other, net	40			17
Total other income, net	$	46		$	94

Income Tax Expense

Our effective tax rate for 2018 was 20.6 percent compared to 58.0 percent for 2017.

The year ended December 31, 2018, contained $14 million, or $0.09 per share, of favorable net discrete tax items, primarily due to $26 million of other favorable discrete tax items, partially offset by $12 million of unfavorable discrete tax items related to the 2017 Tax Legislation.

On December 22, 2017, the U.S. enacted Tax Legislation which, among other things, changed the U.S. statutory rate to 21 percent effective January 1, 2018. The impact of the Tax Legislation resulted in an incremental tax provision charge of $781 million in 2017.

The change in the effective tax rate for the year ended, December 31, 2018 versus 2017, was primarily due to lower U.S. tax rates in 2018 associated with Tax Legislation and the significant 2017 Tax Legislation expenses in 2017.

We expect our 2019 effective tax rate to be 21.5 percent, excluding any discrete items.

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 increased $51 million, primarily due to the absence of a $43 million favorable withholding tax adjustment on Cummins India Ltd. in 2017, a $24 million unfavorable Tax Legislation withholding tax adjustment in 2018 and higher earnings in our automated transmission business during 2018. See Note 17, "NONCONTROLLING INTERESTS," to our Consolidated Financial Statements for additional information on the withholding tax adjustments.

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

Net income and diluted earnings per share attributable to Cummins Inc. increased $1.1 billion and $7.18 per share, respectively, primarily due to significantly higher net sales, Tax Legislation, higher gross margin and increased equity earnings from investees, partially offset by $368 million for an Engine System Campaign, higher research, development and engineering expenses, unfavorable foreign currency impacts (primarily the British pound, Brazilian real and Angolan kwanza partially offset by the Euro) and higher interest expense. See Note 9, "PRODUCT WARRANTY LIABILITY," to the Consolidated Financial Statements for additional information on the the Engine System Campaign.

Tax Legislation resulted in the U.S. statutory rate decreasing from 35 percent to 21 percent, added incremental income tax expense in 2017 of $781 million to our tax provision (excluding the noncontrolling interest and equity investee adjustments) with a net impact of $777 million unfavorable to net income. The 2018 charges reflect final adjustments and subsequent guidance issued by the Internal Revenue Service. The components of the 2018 and 2017 charges were as follows:



	Impact of Tax Legislation(1)
In millions	2018		2017
Income tax expense	$	12	$	781
Decrease in equity, royalty and other income from investees	3		39
Decrease (increase) in income attributable to noncontrolling interests(2)	24		(43		)
Net impact of Tax Legislation	$	39	$	777

(1) See Note 4, "INCOME TAXES," Note 3, "INVESTMENTS IN EQUITY INVESTEES" and Note 17, "NONCONTROLLING INTERESTS," to our Consolidated Financial Statements for additional information*.*

(2) Noncontrolling interest was adjusted for withholding taxes on foreign earnings which changed the income eliminated for Cummins ownership interest attributable to Cummins India, Ltd.

Diluted earnings per share for 2018 benefited $0.25 per share from fewer weighted average shares outstanding, primarily due to the stock repurchase programs, including shares acquired under the accelerated share repurchase agreement.

2017 vs. 2016

Net Sales

Net sales increased $2.9 billion, 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.

Gross Margin

Gross margin increased $642 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 $330 million, primarily due to higher compensation expense ($257 million), especially variable compensation, and higher consulting expense ($52 million). Overall, selling, general and administrative expenses, as a percentage of sales, improved to 11.9 percent in 2017 from 12.0 percent in 2016.

Research, Development and Engineering Expenses

Research, development and engineering expenses increased $117 million, primarily due to increased compensation expense ($76 million), especially variable compensation, and higher consulting expense ($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 4, "INCOME TAXES," to our Consolidated Financial Statements for additional information*.*

Loss Contingency

In 2017, we recorded a charge of $5 million in addition to the 2016 charge of $138 million for a loss contingency. See Note 9, "PRODUCT WARRANTY LIABILITY," 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 millions	2017			2016
Royalty income, net	$	50		$	28
Gain on sale of assets, net	20			2
Loss on write off of assets	(4		)	(18		)
Amortization of intangible assets	(12		)	(9		)
Other, net	11			(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 millions	2017			2016
Change in cash surrender value of corporate owned life insurance	$	50		$	18
Non-service pension and other postretirement benefits credit	31			48
Rental income	7			5
Dividend income	5			5
Gain on sale of equity investee (1)	—			17
Gain on fair value adjustment for consolidated investees (2)	—			15
Foreign currency loss, net	(6		)	(12		)
Bank charges	(10		)	(9		)
Other, net	17			9
Total other income, net	$	94		$	96

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

(2) See Note 19, "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. 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 4, "INCOME TAXES," to our Consolidated Financial Statements for additional information*.*

Noncontrolling Interests

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 for the automated transmission business.

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

Net income and diluted earnings per share attributable to Cummins Inc. decreased $395 million and $2.26 per share, respectively, 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 4, "INCOME TAXES," to our Consolidated Financial Statements for additional information*.*

Comprehensive Income - Foreign Currency Translation Adjustment

The foreign currency translation adjustment was a net gain (loss) of $(356) million, $335 million and $(448) million for the years ended December 31, 2018, 2017 and 2016, respectively. The details were as follows:



	Years ended December 31,
	2018				2017			2016
In millions	Translation adjustment			Primary currency driver vs. U.S. dollar	Translation adjustment		Primary currency driver vs. U.S. dollar	Translation adjustment			Primary currency driver vs. U.S. dollar
Wholly-owned subsidiaries	$	(266	)	British pound, Chinese renminbi, Indian rupee, Brazilian real	$	255	British pound, Chinese renminbi, Indian rupee	$	(397	)	British pound, Chinese renminbi, partially offset by Brazilian real
Equity method investments	(60		)	Chinese renminbi, Indian rupee, British pound	60		Chinese renminbi, Russian ruble, Indian rupee	(34		)	Chinese renminbi, Indian rupee, partially offset by Mexican peso
Consolidated subsidiaries with a noncontrolling interest	(30		)	Indian rupee	20		Indian rupee	(17		)	Chinese renminbi, Indian rupee
Total	$	(356	)		$	335		$	(448	)

OPERATING SEGMENT RESULTS

Our reportable operating segments consist of the Engine, Distribution, Components, Power Systems and Electrified Power segments. This reporting structure is organized according to the products and markets each segment serves. Effective January 1, 2018, we changed our measure to EBITDA as a primary basis for the Chief Operating Decision Maker to evaluate the performance of each of our reportable operating segments. Segment amounts exclude certain expenses not specifically identifiable to segments. See Note 20, "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,									2018 vs. 2017					2017 vs. 2016
In millions	2018			2017			2016			Amount			Percent		Amount			Percent
External sales	$	8,002		$	6,661		$	5,774		$	1,341		20	%	$	887		15	%
Intersegment sales	2,564			2,292			2,030			272			12	%	262			13	%
Total sales	10,566			8,953			7,804			1,613			18	%	1,149			15	%
Research, development and engineering expenses	311			280			227			(31		)	(11	)%	(53		)	(23	)%
Equity, royalty and interest income from investees	238			219			148			19			9	%	71			48	%
Interest income	11			6			10			5			83	%	(4		)	(40	)%
Loss contingency (1)	—			5			138			5			100	%	133			96	%
Segment EBITDA	1,446			1,143			849			303			27	%	294			35	%

										Percentage Points					Percentage Points
Segment EBITDA as a percentage of total sales	13.7		%	12.8		%	10.9		%				0.9					1.9

(1) 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,						2018 vs. 2017				2017 vs. 2016
In millions	2018		2017		2016		Amount		Percent		Amount		Percent
Heavy-duty truck	$	3,652	$	2,840	$	2,443	$	812	29	%	$	397	16	%
Medium-duty truck and bus	2,855		2,513		2,272		342		14	%	241		11	%
Light-duty automotive	1,819		1,727		1,581		92		5	%	146		9	%
Total on-highway	8,326		7,080		6,296		1,246		18	%	784		12	%
Off-highway	2,240		1,873		1,508		367		20	%	365		24	%
Total sales	$	10,566	$	8,953	$	7,804	$	1,613	18	%	$	1,149	15	%

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,			2018 vs. 2017			2017 vs. 2016
	2018	2017	2016	Amount	Percent		Amount	Percent
Heavy-duty	128,500	95,900	79,000	32,600	34	%	16,900	21	%
Medium-duty	311,100	268,100	229,100	43,000	16	%	39,000	17	%
Light-duty	273,400	257,500	228,600	15,900	6	%	28,900	13	%
Total unit shipments	713,000	621,500	536,700	91,500	15	%	84,800	16	%

2018 vs. 2017

Sales

Engine segment sales increased $1.6 billion. The following were the primary drivers by market:


•	Heavy-duty truck engine sales increased $812 million, primarily due to higher demand in North American heavy-duty truck markets with increased shipments of 40 percent.


•	Off-highway sales increased $367 million, primarily due to improved demand in global construction markets with increased international unit shipments of 37 percent, mainly in China and Western Europe, and increased unit shipments of 30 percent in North America.


•	Medium-duty truck and bus sales increased $342 million, primarily due to higher demand in North American medium-duty truck markets with increased engine shipments of 14 percent.

Total on-highway-related sales for 2018 were 79 percent of total engine segment sales, compared to 79 percent in 2017.

Segment EBITDA

Engine segment EBITDA increased $303 million, primarily due to higher gross margin, decreased selling, general and administrative expenses and increased equity, royalty and interest income from investees, partially offset by increased research, development and engineering expenses and unfavorable foreign currency fluctuations primarily in the Brazilian real. The increase in gross margin was primarily due to higher volumes, improved pricing and favorable mix, partially offset by increased warranty costs (primarily $184 million for an Engine System Campaign) and higher compensation expense. See Note 9, "PRODUCT WARRANTY LIABILITY," to the Consolidated Financial Statements for additional information on the Engine System Campaign.

Gross margin as a percentage of sales declined primarily due to the increased warranty costs. The decrease in selling, general and administrative expenses was primarily due to lower variable compensation expense. An increase in research, development and engineering expenses was primarily due to lower expense recovery and higher compensation expense. The increase in equity, royalty and interest income from investees was primarily due to higher earnings at Tata Cummins, Ltd. and Cummins Westport, Inc. as the result of unfavorable Tax Legislation remeasurement adjustments of $15 million and $7 million in 2017, respectively, which did not repeat in 2018, partially offset by lower earnings at Beijing Foton Cummins Engine Co., Ltd.

2017 vs. 2016

Sales

Engine segment sales increased $1.1 billion. 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 EBITDA

Engine segment EBITDA increased $294 million, 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. The increase in gross margin 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. An increase in selling, general and administrative expenses was primarily due to higher compensation expense, especially variable compensation expense, and higher consulting expense. The increase in research, development and engineering expenses was primarily due to higher compensation expense, especially higher variable compensation expense, and higher consulting expense. 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.

Distribution Segment Results

Financial data for the Distribution segment was as follows:



										Favorable/(Unfavorable)
	Years ended December 31,									2018 vs. 2017					2017 vs. 2016
In millions	2018			2017			2016			Amount			Percent		Amount			Percent
External sales	$	7,807		$	7,029		$	6,157		$	778		11	%	$	872		14	%
Intersegment sales	21			29			24			(8		)	(28	)%	5			21	%
Total sales	7,828			7,058			6,181			770			11	%	877			14	%
Research, development and engineering expenses	20			19			13			(1		)	(5	)%	(6		)	(46	)%
Equity, royalty and interest income from investees	46			44			70			2			5	%	(26		)	(37	)%
Interest income	13			6			4			7			NM		2			50	%
Segment EBITDA (1)	563			500			508			63			13	%	(8		)	(2	)%

										Percentage Points					Percentage Points
Segment EBITDA as a percentage of total sales	7.2		%	7.1		%	8.2		%				0.1					(1.1	)


(1)	Segment EBITDA for 2016 included a gain of $15 million resulting from the acquisition of a controlling interest in a North American distributor. See Note 19, "ACQUISITIONS," to the Consolidated Financial Statements for additional information.

Sales for our Distribution segment by region were as follows:



							Favorable/(Unfavorable)
	Years ended December 31,						2018 vs. 2017					2017 vs. 2016
In millions	2018		2017		2016		Amount			Percent		Amount			Percent
North America	$	5,341	$	4,733	$	3,973	$	608		13	%	$	760		19	%
Asia Pacific	856		767		720		89			12	%	47			7	%
Europe	538		440		440		98			22	%	—			—	%
China	320		267		235		53			20	%	32			14	%
Africa and Middle East	241		327		366		(86		)	(26	)%	(39		)	(11	)%
India	194		190		175		4			2	%	15			9	%
Latin America	169		167		149		2			1	%	18			12	%
Russia	169		167		123		2			1	%	44			36	%
Total sales	$	7,828	$	7,058	$	6,181	$	770		11	%	$	877		14	%

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



							Favorable/(Unfavorable)
	Years ended December 31,						2018 vs. 2017				2017 vs. 2016
In millions	2018		2017		2016		Amount		Percent		Amount		Percent
Parts	$	3,234	$	3,040	$	2,627	$	194	6	%	$	413	16	%
Engines	1,634		1,369		1,100		265		19	%	269		24	%
Power generation	1,486		1,337		1,239		149		11	%	98		8	%
Service	1,474		1,312		1,215		162		12	%	97		8	%
Total sales	$	7,828	$	7,058	$	6,181	$	770	11	%	$	877	14	%

2018 vs. 2017

Sales

Distribution segment sales increased $770 million. The following were the primary drivers by region:


•	North American sales increased $608 million, representing 79 percent of the total change in Distribution segment sales, primarily due to increased demand across all product lines.


•	European sales increased $98 million, primarily due to higher demand for whole goods.


•	Asia Pacific sales increased $89 million, primarily due to higher volumes in whole goods and service.

These increases were partially offset by decreased sales of 26 percent in Africa and the Middle East.

Segment EBITDA

Distribution segment EBITDA increased $63 million, primarily due to higher gross margin and lower selling, general and administrative expenses, partially offset by the absence of a gain on sale of assets in the third quarter of 2017 and unfavorable foreign currency fluctuations (primarily in the Angolan kwanza and Australian dollar). The increase in gross margin was primarily due to higher volumes and improved pricing, partially offset by increased compensation expense and unfavorable foreign currency fluctuations (primarily in the Australian dollar and Angolan kwanza). Gross margin as a percentage of sales declined primarily due to the increase in compensation expense and unfavorable foreign currency fluctuations. The decrease in selling, general and administrative expenses was primarily due to lower variable compensation expense, partially offset by increased compensation expense.

2017 vs. 2016

Sales

Distribution segment sales increased $877 million, 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 EBITDA

Distribution segment EBITDA decreased $8 million, primarily due to higher selling, general and administrative expenses, lower equity, royalty and interest income from investees, partially offset by higher gross margin. The increase in gross margin 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 expense. 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.

Components Segment Results

Financial data for the Components segment was as follows:



										Favorable/(Unfavorable)
	Years ended December 31,									2018 vs. 2017					2017 vs. 2016
In millions	2018			2017			2016			Amount			Percent		Amount			Percent
External sales	$	5,331		$	4,363		$	3,514		$	968		22	%	$	849		24	%
Intersegment sales	1,835			1,526			1,322			309			20	%	204			15	%
Total sales	7,166			5,889			4,836			1,277			22	%	1,053			22	%
Research, development and engineering expenses	272			241			208			(31		)	(13	)%	(33		)	(16	)%
Equity, royalty and interest income from investees	54			40			41			14			35	%	(1		)	(2	)%
Interest income	5			3			4			2			67	%	(1		)	(25	)%
Segment EBITDA	1,030			917			774			113			12	%	143			18	%

										Percentage Points					Percentage Points
Segment EBITDA as a percentage of total sales	14.4		%	15.6		%	16.0		%				(1.2	)				(0.4	)

Sales for our Components segment by business were as follows:



							Favorable/(Unfavorable)
	Years ended December 31,						2018 vs. 2017				2017 vs. 2016
In millions	2018		2017		2016		Amount		Percent		Amount		Percent
Emission solutions	$	3,177	$	2,675	$	2,238	$	502	19	%	$	437	20	%
Turbo technologies	1,343		1,179		1,036		164		14	%	143		14	%
Filtration	1,265		1,153		1,010		112		10	%	143		14	%
Electronics and fuel systems	838		718		552		120		17	%	166		30	%
Automated transmissions	543		164		—		379		NM		164		NM
Total sales	$	7,166	$	5,889	$	4,836	$	1,277	22	%	$	1,053	22	%

"NM" - not meaningful information

2018 vs. 2017

Sales

Components segment sales increased $1.3 billion across all lines of business. The following were the primary drivers by business:


•	Emission solutions sales increased $502 million, primarily due to stronger market demand for trucks in North America and Western Europe.


•	Automated transmissions which was consolidated during the third quarter of 2017, delivered higher sales of $379 million in North America.


•	Turbo technologies sales increased $164 million, primarily due to higher demand in North America and Western Europe.


•	Electronics and fuel systems sales increased $120 million, primarily due to higher demand in North America.


•	Filtration sales increased $112 million, primarily due to higher demand in North America and Western Europe.

Segment EBITDA

Components segment EBITDA increased $113 million, as higher gross margin and increased equity, royalty and interest income from investees was partially offset by increased research, development and engineering expenses and higher selling, general and administrative expenses. The increase in gross margin was primarily due to higher volumes, improved mix and lower material costs, partially offset by increased warranty costs (primarily $184 million for an Engine System Campaign) and higher compensation expense driven by the acquisition of the automated transmission business in the third quarter of 2017. See Note 9, "PRODUCT WARRANTY LIABILITY," to the Consolidated Financial Statements for additional information on the Engine System Campaign. The increase in selling, general and administrative expenses was primarily due to higher administrative expenses for the automated transmission business, partially offset by lower variable compensation expense. The increase in research, development and engineering expenses was primarily due to higher compensation and administrative expenses due to the addition of the automated transmission business and increased consulting expense. The increase in equity, royalty and interest income from investees was primarily due to higher earnings at Fleetguard Filtration Systems India Pvt. as the result of unfavorable Tax Legislation adjustments in 2017.

2017 vs. 2016

Sales

Components segment sales increased $1.1 billion across all lines of business. 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 business 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 EBITDA

Components segment EBITDA increased $143 million, as higher gross margin was partially offset by increased selling, general and administrative expenses. 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 addition of the automated transmission business. Decreased equity, royalty and interest income from investees due to unfavorable impacts from Tax Legislation related to withholding taxes on foreign earnings of $12 million was mostly offset by increased earnings at Dongfeng Cummins Emission Solutions Co., Ltd. and Shanghai Fleetguard Filter Co.

Power Systems Segment Results

Financial data for the Power Systems segment was as follows:



										Favorable/(Unfavorable)
	Years ended December 31,									2018 vs. 2017					2017 vs. 2016
In millions	2018			2017			2016			Amount			Percent		Amount			Percent
External sales	$	2,625		$	2,375		$	2,064		$	250		11	%	$	311		15	%
Intersegment sales	2,001			1,683			1,453			318			19	%	230			16	%
Total sales	4,626			4,058			3,517			568			14	%	541			15	%
Research, development and engineering expenses	230			214			189			(16		)	(7	)%	(25		)	(13	)%
Equity, royalty and interest income from investees	56			54			42			2			4	%	12			29	%
Interest income	6			3			5			3			100	%	(2		)	(40	)%
Segment EBITDA	614			411			378			203			49	%	33			9	%

										Percentage Points					Percentage Points
Segment EBITDA as a percentage of total sales	13.3		%	10.1		%	10.7		%				3.2					(0.6	)

Sales for our Power Systems segment by product line were as follows:



							Favorable/(Unfavorable)
	Years ended December 31,						2018 vs. 2017				2017 vs. 2016
In millions	2018		2017		2016		Amount		Percent		Amount		Percent
Power generation	$	2,586	$	2,305	$	2,256	$	281	12	%	$	49	2	%
Industrial	1,663		1,399		941		264		19	%	458		49	%
Generator technologies	377		354		320		23		6	%	34		11	%
Total sales	$	4,626	$	4,058	$	3,517	$	568	14	%	$	541	15	%

2018 vs. 2017

Sales

Power Systems segment sales increased $568 million across all product lines. The following were the primary drivers:


•	Power generation sales increased $281 million, primarily due to higher demand in North America, Middle East and Australia.


•	Industrial sales increased $264 million, primarily due to higher demand in global mining markets, especially in China, Eastern Europe, Japan and North America, and oil and gas markets in North America.

Segment EBITDA

Power Systems segment EBITDA increased $203 million, primarily due to higher gross margin, partially offset by increased research, development and engineering expenses and higher selling, general and administrative expenses. The increase in gross margin was primarily due to increased volumes, lower warranty expense and reduced material costs, partially offset by higher compensation expense driven by volume growth. The increase in selling, general and administrative expenses was primarily due to higher consulting expense. The increase in research, development and engineering expenses was primarily due to higher compensation expense.

2017 vs. 2016

Sales

Power Systems segment sales increased $541 million across all product lines. 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 EBITDA

Power Systems segment EBITDA increased $33 million, 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 (Cummins Olyan Energy) recorded in 2016. The increase in gross margin 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 expense. The increase in research, development and engineering expenses was primarily due to higher variable compensation expense, increased project spending and higher consulting expense. 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.

Electrified Power Segment Results

We formed the Electrified Power segment during the first quarter of 2018. The primary focus of the segment is on research and development activities around fully electric and hybrid powertrain solutions. Our intellectual property is developed both in house as well as through acquisitions. As of December 31, 2018, we completed three acquisitions, which provided us with intellectual property as well as start-up sales of $7 million. On November 1, 2017, we purchased Brammo Inc., a designer and manufacturer of lithium battery packs, electric drive-trains and other electric power applications. On January 31, 2018, we purchased Johnson Matthey Battery Systems Ltd., a high voltage automotive battery systems designer and on August 15, 2018, we purchased Efficient Drivetrains, Inc., which designs and produces hybrid and fully-electric power solutions for commercial markets. See Note 19, "ACQUISITIONS," to the Consolidated Financial Statements for additional information on acquisitions. We invested $69 million in research and development activities, which along with the gross margins generated by our acquisitions and selling, general and administrative expenses resulted in a segment EBITDA loss of $90 million.

Reconciliation of Segment EBITDA 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 millions	2018			2017			2016
TOTAL SEGMENT EBITDA	$	3,563		$	2,971		$	2,509
Intersegment elimination (1)	(87		)	55			17
TOTAL EBITDA	3,476			3,026			2,526
Less:
Interest expense	114			81			69
Depreciation and amortization (2)	609			580			527
INCOME BEFORE INCOME TAXES	2,753			2,365			1,930
Less: Income tax expense	566			1,371			474
CONSOLIDATED NET INCOME	2,187			994			1,456
Less: Net income (loss) attributable to noncontrolling interests	46			(5		)	62
NET INCOME ATTRIBUTABLE TO CUMMINS INC.	$	2,141		$	999		$	1,394

(1) Includes intersegment sales, intersegment profit in inventory eliminations and unallocated corporate expenses. There were no significant unallocated corporate expenses

(2) Depreciation and amortization, as shown on a segment basis, excludes the amortization of debt discount and deferred costs included in the Consolidated Statements of Income as "Interest expense." The amortization of debt discount and deferred costs was $2 million, $3 million and $3 million for the years ended December 31, 2018, 2017 and 2016, respectively.

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 millions	December 31, 2018			December 31, 2017
Working capital (1)	$	3,434		$	3,251
Current ratio	1.54			1.57
Accounts and notes receivable, net	$	3,866		$	3,618
Days' sales in receivables	57			59
Inventories	$	3,759		$	3,166
Inventory turnover	4.9			5.0
Accounts payable (principally trade)	$	2,822		$	2,579
Days' payable outstanding	56			53
Total debt	$	2,476		$	2,006
Total debt as a percent of total capital	23.1		%	19.7		%

(1) Working capital includes cash and cash equivalents.

Cash Flows

Cash and cash equivalents were impacted as follows:



	Years ended December 31,									Change
In millions	2018			2017			2016			2018 vs. 2017			2017 vs. 2016
Net cash provided by operating activities	$	2,378		$	2,277		$	1,939		$	101		$	338
Net cash used in investing activities	(974		)	(1,052		)	(917		)	78			(135		)
Net cash used in financing activities	(1,400		)	(1,074		)	(1,413		)	(326		)	339
Effect of exchange rate changes on cash and cash equivalents	(70		)	98			(200		)	(168		)	298
Net (decrease) increase in cash and cash equivalents	$	(66	)	$	249		$	(591	)	$	(315	)	$	840

2018 vs. 2017

Net cash provided by operating activities increased $101 million, primarily due to higher earnings of $388 million, excluding the net change in the non-cash impact of 2017 Tax Legislation of $805 million, lower net pension contributions of $210 million, higher non-cash losses on corporate owned life insurance of $78 million and increased equity earnings (net of dividends) of $30 million, partially offset by higher working capital requirements of $575 million and a decrease in deferred tax expense of $43 million. During 2018, higher working capital requirements resulted in a cash outflow of $485 million compared to a cash inflow of $90 million in 2017, primarily due to higher accounts payable and inventory levels in 2018 to support business growth.

Net cash used in investing activities decreased $78 million, primarily due to the absence of the acquisition of Eaton Cummins Automated Transmission Technologies for $600 million in the third quarter of 2017, partially offset by higher capital expenditures of $203 million, lower cash flows from derivatives not designated as hedges of $178 million and higher net investments in marketable securities of $109 million.

Net cash used in financing activities increased $326 million, primarily due to higher repurchases of common stock of $689 million, partially offset by increased borrowings of commercial paper of $396 million.

The effect of exchange rate changes on cash and cash equivalents increased $168 million, primarily due to unfavorable fluctuations in the British pound of $123 million.

2017 vs. 2016

Net cash provided by operating activities increased $338 million, 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 (net of dividends) 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, primarily due to the acquisition of Eaton Cummins Automated Transmission Technologies for $600 million in 2017 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, primarily due to the British pound, which increased cash and cash equivalents $249 million.

Sources of Liquidity

We generate significant ongoing cash flow. Cash provided by operations is our principal source of liquidity with $2.4 billion provided in 2018. At December 31, 2018, our sources of liquidity included:



	December 31, 2018
In millions	Total		U.S.		International		Primary location of international balances
Cash and cash equivalents	$	1,303	$	244	$	1,059	U.K., China, Singapore, Belgium, Mexico, Australia, Canada
Marketable securities (1)	222		58		164		India
Total	$	1,525	$	302	$	1,223
Available credit capacity
Revolving credit facilities (2)	$	2,720
International and other uncommitted domestic credit facilities	$	237

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

(2) The five-year credit facility for $2.0 billion and the 364-day credit facility for $1.5 billion, maturing August 2023 and August 2019, respectively, are maintained primarily to provide backup liquidity for our commercial paper borrowings and general corporate purposes. At December 31, 2018, we had $780 million of commercial paper outstanding, which effectively reduced the available capacity under our revolving credit facilities to $2.7 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, which included a one-time transition tax on accumulated foreign earnings of $409 million with a cash impact of $429 million as of December 31, 2018. The payments associated with this deemed repatriation will be paid over eight years. The unrepatriated foreign earnings at December 31, 2018, will be repatriated as needed to fund cash needs. The estimated accrued withholding taxes of $184 million on foreign earnings that we plan to repatriate in the foreseeable future will be paid as cash is repatriated. See Note 4, "INCOME TAXES," to our Consolidated Financial Statements for additional information*.*

Debt Facilities and Other Sources of Liquidity

On August 22, 2018, we entered into a new five-year revolving credit agreement with a syndicate of lenders. The new credit agreement provides us with a $2.0 billion senior unsecured revolving credit facility until August 22, 2023. The credit capacity can be increased by up to $1.0 billion prior to the maturity date. See Note 10, "DEBT," to our Consolidated Financial Statements for additional information.

On August 22, 2018, we entered into a new 364-day credit agreement that allows us to borrow up to $1.5 billion of additional unsecured funds at any time through August 21, 2019. The credit capacity can be increased by up to $500 million prior to the maturity date.

Both credit agreements include a financial covenant requiring that the leverage ratio of the total debt of the company and its subsidiaries to the consolidated total capital of the company and its subsidiaries may not exceed 0.65 to 1.0. At December 31, 2018, our leverage ratio was 0.20 to 1.0. We intend to maintain credit facilities of a similar aggregate amount by renewing or replacing these facilities before expiration. These revolving credit facilities are maintained primarily to provide backup liquidity for our commercial paper borrowings and for general corporate purposes.

We can issue up to $3.5 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 programs should not exceed $3.5 billion. See Note 10, "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. Our current shelf is scheduled to expire in February 2019. We have begun the renewal process and plan to file a new automatic shelf registration statement in the first quarter of 2019.

Uses of Cash

Stock Repurchases

In October 2018, our Board of Directors authorized the acquisition of up to $2 billion of additional common stock upon completion of the 2016 repurchase plan. 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. For the year ended December 31, 2018, we made the following purchases under our stock repurchase programs:



In millions, except per share amounts	Shares Purchased	Average Cost Per Share		Total Cost of Repurchases		Cash Paid for Shares Not Received			Remaining Authorized Capacity (1)
November 2015, $1 billion repurchase program
April 1	0.3	$	166.79	$	46	$	—		$	—

December 2016, $1 billion repurchase program
April 1	0.7	$	164.48	$	117				$	883
July 1	1.5	143.69		216					667
September 30	2.8	143.58		400		100			167
December 31	1.9	139.67		267		(100		)	—
Subtotal	6.9	144.68		1,000		—			—

October 2018, $2 billion repurchase program
December 31	0.7	$	139.85	$	94				$	1,906

Total	7.9	$	145.05	$	1,140	$	—

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

On August 8, 2018, we entered into an accelerated share repurchase agreement with Goldman Sachs & Co. LLC to repurchase $500 million of our common stock under our previously announced share repurchase plans and received 3.5 million shares at an average price of $144.02 per share.

We intend to repurchase outstanding shares from time to time during 2019 to enhance shareholder value and to offset the dilutive impact of employee stock based compensation plans.

Dividends

Total dividends paid to common shareholders in 2018, 2017 and 2016 were $718 million, $701 million and $676 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 2018, our Board of Directors authorized an increase to our quarterly dividend of 5.6 percent from $1.08 per share to $1.14 per share. 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. Cash dividends per share paid to common shareholders for the last three years were as follows:



	Quarterly Dividends
	2018		2017		2016
First quarter	$	1.08	$	1.025	$	0.975
Second quarter	1.08		1.025		0.975
Third quarter	1.14		1.08		1.025
Fourth quarter	1.14		1.08		1.025
Total	$	4.44	$	4.21	$	4.00

Capital Expenditures

Capital expenditures, including spending on internal use software, were $784 million, $587 million and $594 million in 2018, 2017 and 2016, respectively. We continue to invest in new product lines and targeted capacity expansions. We plan to spend an estimated $650 million to $700 million in 2019 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 2019. In addition we plan to spend an estimated $65 million to $75 million on internal use software in 2019.

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 2018, the investment loss on our U.S. pension trust was 1.7 percent while our U.K. pension trust loss was 1.8 percent. Approximately 74 percent of our pension plan assets are held in highly liquid investments such as fixed income and equity securities. The remaining 26 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 the U.S. and U.K. plans were as follows:



	Years ended December 31,
In millions	2018		2017		2016
Defined benefit pension plans
Voluntary contribution	$	15	$	233	$	133
Mandatory contribution	22		10		1
Defined benefit pension contributions	37		243		134

Defined contribution pension plans	$	104	$	84	$	68

We anticipate making total contributions of approximately $123 million to our defined benefit pension plans in 2019. Expected contributions to our defined benefit pension plans in 2019 will meet or exceed the current funding requirements.

Current Maturities of Short and Long-Term Debt

We had $780 million of commercial paper outstanding at December 31, 2018, that matures in less than one year. The maturity schedule of our existing long-term debt does not require significant cash outflows until 2023 when our 3.65% senior notes are due. Required annual principal payments range from $9 million to $506 million over the next five years. See Note 10, "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-Term	Short-Term
Credit Rating Agency (1)	Senior Debt Rating	Debt Rating	Outlook
Standard & Poor’s Rating Services	A+	A1	Stable
Moody’s Investors Service, Inc.	A2	P1	Stable

(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. 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, 2018, are as follows:



Contractual Cash Obligations	Payments Due by Period
In millions	2019		2020-2021		2022-2023		After 2023		Total
Long-term debt and capital lease obligations (1)	$	152	$	242	$	692	$	2,331	$	3,417
Operating leases	138		190		99		81		508
Capital expenditures	165		—		—		—		165
Purchase commitments for inventory	882		—		—		—		882
Other purchase commitments	290		27		6		12		335
Transitional tax liability	—		38		149		106		293
Other postretirement benefits	24		45		43		90		202
International and other domestic letters of credit	124		21		4		2		151
Performance and excise bonds	41		66		1		2		110
Guarantees, indemnifications and other commitments	26		6		9		11		52
Total	$	1,842	$	635	$	1,003	$	2,635	$	6,115


(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 $71 million as of December 31, 2018. We are not able to reasonably estimate the period in which cash outflows relating to uncertain tax contingencies could occur. See Note 4, "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 estimating liabilities for warranty programs, accounting for income taxes and pension benefits and assessing goodwill impairments.

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 9, "PRODUCT WARRANTY LIABILITY," to our Consolidated Financial Statements contains a summary of the activity in our warranty liability account for 2018, 2017 and 2016 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 basis. 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, 2018, we recorded net deferred tax assets of $147 million. The assets included $340 million for the value of net operating loss and credit carryforwards. A valuation allowance of $327 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). The SEC issued guidance permitting final calculations to be completed within a one year measurement period ending December 22, 2018. 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. As additional tax reform guidance was released during 2018, any provisional amounts were reported in income from continuing operations in the period in which tax reform guidance was issued. We have completed our accounting for the tax effects of the enactment of the Tax Legislation and included in our reporting the nature and amount of any measurement period adjustments recognized during 2018 and the effect of measurement period adjustments on the effective tax rate.

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 4, "INCOME TAXES," to our Consolidated Financial Statements.

Pension Benefits

We sponsor a number of pension plans globally, with the majority of assets in the U.S. and the U.K. 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 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, 2018, based upon our target asset allocations, it is anticipated that our U.S. investment policy will generate an average annual return over the 30-year projection period equal to or in excess of 6.25 percent approximately 37 percent of the time, including the additional positive returns expected from active investment management.

The one-year return for our U.S. plans was (1.7) percent for 2018. Our U.S. plan assets have averaged annualized returns of 10.22 percent over the prior ten years, and resulted in approximately $313 million of actuarial gains in accumulated other comprehensive income in the same period. Based on the historical returns and forward-looking return expectations and as plan assets continue to be de-risked, consistent with our investment policy, we believe an investment return assumption of 6.25 percent per year in 2019 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, 2018, 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 percent approximately 50 percent of the time. The one-year return for our U.K. plans was (1.8) percent for 2018. We have generated average annualized returns of 9.97 percent over ten years, resulting in approximately $352 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. 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 2019 for U.K. pension assets is reasonable. Our pension plan asset allocations at December 31, 2018 and 2017 and target allocation for 2019 are as follows:



	U.S. Plans						U.K. Plans
	Target Allocation		Percentage of Plan Assets at December 31,				Target Allocation			Percentage of Plan Assets at December 31,
Investment description	2019		2018		2017		2019		2018			2017
Liability matching	68.0	%	68.0	%	68.3	%	56.5	%		56.5	%		56.1	%
Risk seeking	32.0	%	32.0	%	31.7	%	43.5	%		43.5	%		43.9	%
Total	100.0	%	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 2016-2018 and our expected rate of return for 2019.



	Long-term Expected Return Assumptions
	2019		2018		2017		2016
U.S. plans	6.25	%	6.50	%	7.25	%	7.50	%
U.K. plans	4.00	%	4.00	%	4.50	%	4.70	%

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 $889 million ($699 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, 2018, we had net pension actuarial losses of $635 million and $230 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 $74 million after-tax in 2018. The loss is primarily due to lower asset returns in the U.S. and U.K., partially offset by higher discount rates in the U.S. and U.K.

The table below sets forth the net periodic pension cost for the years ended December 31 and our expected cost for 2019.



In millions	2019		2018		2017		2016
Net periodic pension cost	$	56	$	86	$	82	$	42

We expect 2019 net periodic pension cost to decrease compared to 2018, primarily due to higher discount rates in the U.S. and U.K., partially offset by a lower expected rate of return in the U.S. The increase in net periodic pension cost in 2018 compared to 2017 was primarily due to lower expected asset returns in the U.S. and U.K. as we de-risked plan trust assets, partially offset by reduced loss amortizations in the U.S. and U.K. The increase in net periodic pension cost in 2017 compared to 2016 was due to on-boarding 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 weighted-average discount rates used to develop our net periodic pension cost are set forth in the table below.



	Discount Rates
	2019		2018		2017		2016
U.S. plans	4.36	%	3.66	%	4.12	%	4.47	%
U.K. plans	2.80	%	2.55	%	2.70	%	3.95	%

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, 2018, 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 2019 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 millions	Impact on Pension Cost Increase/(Decrease)
Discount rate used to value liabilities
0.25 percent increase	$	(15	)
0.25 percent decrease	16
Expected rate of return on assets
1 percent increase	(48		)
1 percent decrease	48

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 11, "PENSIONS 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.

Goodwill Impairment

We are required to make certain subjective and complex judgments in assessing whether a goodwill impairment event has occurred, including assumptions and estimates used to determine the fair value of our reporting units. We test for goodwill impairment at the reporting unit level and our reporting units are the operating segments or the components of operating segments that constitute businesses for which discrete financial information is available and is regularly reviewed by management.

Under GAAP for goodwill, we have the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value as a basis for determining whether it is necessary to perform an annual quantitative goodwill impairment test. We have elected this option on certain reporting units. The following events and circumstances are considered when evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount:


•	Macroeconomic conditions, such as a deterioration in general economic conditions, fluctuations in foreign exchange rates and/or other developments in equity and credit markets;


•	Industry and market considerations, such as a deterioration in the environment in which an entity operates, material loss in market share and significant declines in product pricing;


•	Cost factors, such as an increase in raw materials, labor or other costs;


•	Overall financial performance, such as negative or declining cash flows or a decline in actual or forecasted revenue;


•	Other relevant entity-specific events, such as material changes in management or key personnel and


•	Events affecting a reporting unit, such as a change in the composition or carrying amount of its net assets including acquisitions and dispositions.

The examples noted above are not all-inclusive, and we will consider other relevant events and circumstances that affect the fair value of a reporting unit in determining whether to perform the quantitative goodwill impairment test.

Our goodwill recoverability assessment is based on our annual strategic planning process. This process includes an extensive review of expectations for the long-term growth of our businesses and forecasted future cash flows. Our valuation method is an “income approach” using a discounted cash flow model in which cash flows anticipated over several periods, plus a terminal value at the end of that time horizon, are discounted to their present value using an appropriate rate of return. Our estimates are based upon our historical experience, our current knowledge from our commercial relationships and available external information about future trends.

Our valuation method requires us to make projections of revenue, operating expenses, working capital investment and fixed asset additions for the reporting units over a multi-year period. Additionally, management must estimate a weighted-average cost of capital, which reflects a market rate, for each reporting unit for use as a discount rate. The discounted cash flows are compared to the carrying value of the reporting unit and, if less than the carrying value, the difference is recorded as a goodwill impairment loss. In addition, we also perform a sensitivity analysis to determine how much our forecasts can fluctuate before the fair value of a reporting unit would be lower than its carrying amount. We perform the required procedures as of the end of our fiscal third quarter. We determined that the automated transmission business is our only reporting unit with material goodwill where the estimated fair value does not substantially exceed the carrying value. The estimated fair value of the reporting unit exceeds its carrying amount by approximately 21 percent. Total goodwill in this reporting unit is $544 million and the total carrying amount at the time of the evaluation was $1.2 billion. This reporting unit is made up of only one business, our joint venture with Eaton (Eaton Cummins Automated Transmission Technologies) which was acquired and recorded at fair value in the third quarter of 2017. As a result, we did not expect that the estimated fair value would exceed the carrying value by a significant amount. We valued this reporting unit primarily using an income approach based on its expected future cash flows. The critical assumptions that factored into the valuation are the projected future revenues and EBITDA margins of the

business as well as the discount rate used to present value these future cash flows. A 100 basis point increase in the discount rate would result in a 15 percent decline in the fair value of the reporting unit.

RECENTLY ADOPTED AND RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

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

Previous: Item 6. Selected Financial Data · Next: Item 7A. Quantitative and Qualitative Disclosures About Market Risk