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

OVERVIEW

The following discussion should be read along with the financial statements included in this Form 10-K, as well as Part II, “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations” of our Form 10-K for the year ended December 31, 2019 (“2019 Annual Report on Form 10-K”), as well as Exhibit 99.3 of our Form 8-K that we filed with the SEC on April 29, 2020, which recasts the disclosures in certain portions of the 2019 Annual Report on Form 10-K to reflect changes in the company’s reportable segments, both of which provide additional information on comparisons of years 2019 and 2018.

Acquisition of Orbital ATK

On June 6, 2018 (the “Merger Date”), the company completed its previously announced acquisition of Orbital ATK, Inc. (“Orbital ATK”) (the “Merger”). On the Merger date, Orbital ATK became a wholly-owned subsidiary of the company and its name was changed to Northrop Grumman Innovation Systems, Inc. We established Innovation Systems as a new, fourth business sector. The operating results of legacy Innovation Systems subsequent to the Merger Date have been included in the company’s consolidated results of operations and, upon our January 1, 2020 sector realignment, are reflected in the Space Systems, Defense Systems and Aeronautics Systems sectors. See Note 2 to the consolidated financial statements for further information regarding the acquisition of Orbital ATK.

In June 2018, the U.S. Federal Trade Commission (FTC) issued a Decision and Order enabling the acquisition to proceed and providing for solid rocket motors to be available on a non-discriminatory basis under certain circumstances and processes. The company has taken and continues to take robust actions to help ensure compliance with the terms of the Order. Similarly, the Compliance Officer, appointed under the Order, and the FTC have taken and continue to take various actions to oversee compliance. In October 2019, the company received a civil investigative demand from the FTC requesting certain information relating to a potential issue of the company’s compliance with the Order in connection with a then pending strategic missile competition. The company has provided information in response to the request. We believe the company has been and continues to be in full compliance with the Order, but we cannot predict the ultimate outcome of this matter.

Disposition of IT and Mission Support Services Business

On December 7, 2020, we entered into a definitive agreement to sell our IT and mission support services business for $3.4 billion in cash. The IT and mission support services business is comprised of the majority of the Information Solutions and Services (IS&S) division of Defense Systems (excluding our Vinnell Arabia business); select cyber, intelligence and missions support programs, which are part of the Cyber and Intelligence Mission Solutions (CIMS) division of Mission Systems; and the Space Technical Services business unit of Space Systems. The assets and liabilities of the IT and mission support services business were classified as held for sale in the consolidated statement of financial position as of December 31, 2020 and no impairment losses were recognized in the consolidated statement of earnings and comprehensive income for the year ended December 31, 2020. We expect to complete the sale of the IT and mission support services business in the first quarter of 2021, subject to regulatory approvals and customary closing conditions. See Note 2 to the consolidated financial statements for further information regarding the disposition.

COVID-19

Coronavirus disease 2019 (“COVID-19”) was first reported in late 2019 and has since dramatically impacted the global health and economic environment, including millions of confirmed cases, business slowdowns or shutdowns, government challenges and market volatility. In March 2020, the World Health Organization characterized COVID-19 as a global pandemic, and the President declared a national emergency concerning the COVID-19 outbreak. The company’s leadership, our crisis management and business resumption teams, and local site leadership continue closely to monitor and address the developments, including the impact on our company, our employees, our customers, our suppliers and our communities. The company has considered and continues to consider guidance from the Centers for Disease Control (CDC), other health organizations, federal, state and local governmental authorities, and our customers, among others. We have taken, and continue to take, robust actions to help protect the health, safety and well-being of our employees, to support our suppliers and local communities, and to continue to serve our customers. Our goals have been to lessen the immediate potential adverse impacts, both health and economic, and to continue to position the company for long-term success. Like the communities in which we serve, our actions have varied depending on the spread of COVID-19 and local health requirements, the needs of our employees and the needs of our business. Among other actions, we have required or enabled employees to work from home or remotely where practicable, and expanded IT and communication support to enhance their productivity; adjusted work spaces and shift schedules to facilitate social distancing for those who continue to work in our facilities; enhanced cleaning and disinfecting procedures at our facilities; required face coverings and worked

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to procure and distribute personal protective equipment (PPE); implemented health checks and visitor protocols; restricted travel; provided additional benefits to our employees, including for those most at risk; and contributed financial and manufacturing resources to supporting critical national requirements, such as for PPE. Along with the Northrop Grumman Foundation, we have provided grants for global, national and local organizations that support frontline healthcare workers, address food insecurity, advance efforts for vaccines, increase student access to technology and provide support to vulnerable populations; donated PPE items to emergency response teams and healthcare professionals, including N95 masks and Tyvek suits; and established a COVID-19 relief matching gift program for employees. More recently, we have sought to assist state and local governments as they start to distribute and deliver vaccines.

Earlier in the COVID-19 pandemic and at times of higher transmission, many state and local jurisdictions implemented mandatory stay-at-home or shelter-in-place orders. Most of those orders exempted some or all of the defense industrial base, including Northrop Grumman and many of our suppliers, as part of the essential or critical infrastructure. Our facilities have largely remained open and many of our employees who cannot work remotely are continuing to come to work and support our customers’ national security and mission-essential operations. Towards the end of the second quarter of 2020, some state and local jurisdictions started to lift mandatory stay-at-home or shelter-in-place orders and started gradually to ease restrictions. We started to implement, or prepared to implement certain return to office plans to allow some employees who had been working remotely gradually to return to the workplace. Later in 2020, as the number of cases began to rise again, and particularly in the fourth quarter of 2020, we paused or reversed many of our efforts to bring more employees back to the work place. In the fourth quarter of 2020 and the first quarter of 2021, after FDA approval, we began to explore how the company could best facilitate the provision of vaccinations to our personnel in accordance with federal guidance and state and local vaccination plans. Absenteeism rates (including because of employees in quarantine or those suffering from COVID-19) and the impacts on productivity have fluctuated significantly, especially as local cases and transmission rates have changed. Throughout, we have worked to adapt and to take robust actions to protect the health, safety and well-being of our employees and to serve our customers, considering, among other things, local circumstances, state and local requirements and guidance from the CDC. We have also taken various steps in efforts to support our suppliers, with a particular focus on critical small and midsized business partners, including passing through increased progress payments from DoD to our suppliers and accelerating payments to certain suppliers.

We have experienced and expect to continue to experience various increased costs to maintain our operations, including as a result of actions taken to protect the health, safety and well-being of our employees; because of illness, quarantines, and absenteeism; as a result of government actions; and because of disruption and stress among our suppliers and customers. We have also experienced certain lower costs, including those related to employee travel, some health benefits and personal time off. We continue to monitor this situation closely and cannot predict how it will change, including the extent of any increase in the number of COVID-19 cases and the costs and impacts to us. Our customers have generally continued to make timely payments, and we are working with them to consider the possibility of additional cost recoveries. Again, however, our customers are facing tremendous demands and budget pressures, and we cannot predict how this may change and how they will continue to allocate limited resources.

The company’s overall 2020 revenue and operating income were not significantly impacted by COVID-19. However, our employees, suppliers and customers, the company and our global community are facing tremendous challenges and we cannot predict how this dynamic situation will evolve or the impact it will have on the company. For further information on the potential impact to the company of COVID-19, see “Risk Factors.”

Global Security and Economic Environment

The U.S. and its allies continue to face a global security environment of heightened tensions and instability, threats from state and non-state actors as well as terrorist organizations, emerging nuclear tensions, diverse regional security concerns and political instability. Global threats persist across all domains, from undersea to space to cyber. The market for defense products, services and solutions globally is driven by these complex and evolving security challenges, considered in the broader context of political and socioeconomic priorities.

The global geopolitical and economic environments also continue to be impacted by uncertainty. Geopolitical relationships are changing and global economic growth is expected to remain in the low single digits in 2021 reflecting the impact of and uncertainty surrounding geopolitical tensions globally and financial market volatility and the COVID-19 pandemic. The global economy may also be affected by Britain’s exit from the European Union, the full impact of which is not known at this time. Additionally, economic tensions and changes in international trade policies, including higher tariffs on imported goods and materials and renegotiation of free trade agreements, could impact the global market for defense products, services and solutions.

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U.S. Political and Economic Environment

The U.S. continues to face an uncertain and changing political environment and substantial fiscal and economic challenges, which affect funding for discretionary and non-discretionary budgets. The Budget Control Act of 2011 (BCA) mandated spending caps for all federal discretionary spending across a ten-year period (FY 2012 through FY 2021), including specific limits for defense and non-defense spending. In prior years, these spending caps have been revised by separate bills for specific fiscal years.

In August 2019, the Bipartisan Budget Act of 2019 was enacted, increasing spending caps under the Budget Control Act (BCA) for FY 2020 and FY 2021, the final two fiscal years covered by the BCA, and suspending the debt ceiling through July 31, 2021. In February 2020, the then President proposed a budget request for FY 2021, which addressed various capabilities highlighted in the U.S. National Security Strategy, the National Defense Strategy and the Missile Defense Review. On December 27, 2020, FY 2021 appropriations were enacted under the Consolidated Appropriations Act of 2021. In 2020, Congress also passed several emergency COVID-19 relief bills addressing certain impacts of the pandemic. It is continuing to consider other responses to the COVID-19 crisis, with broader implications for the defense industry and the overall economic environment, including the national debt. With a new President and Administration, a new Congress and pressing debt and needs, it is difficult to predict the specific course of future defense budgets. However, the threat remains very substantial and we believe that our capabilities, particularly in space, missiles, missile defense, hypersonics, counter-hypersonics, survivable aircraft and mission systems should help our customers to meet the threats and, as a result, continue to allow for long-term profitable growth in our business.

The political environment, federal budget and debt ceiling are expected to continue to be the subject of considerable debate, which could have material impacts on defense spending broadly and the company’s programs in particular.

For further information on the risks we face from the current political and economic environment, see “Risk Factors.”

Operating Performance Assessment and Reporting

We manage and assess our business based on our performance on contracts and programs (typically larger contracts or two or more closely-related contracts). We recognize sales from our portfolio of long-term contracts as control is transferred to the customer, primarily over time on a cost-to-cost basis (cost incurred relative to costs estimated at completion). As a result, sales tend to fluctuate in concert with costs incurred across our large portfolio of contracts. Due to Federal Acquisition Regulation (FAR) rules that govern our U.S. government business and related Cost Accounting Standards (CAS), most types of costs are allocable to U.S. government contracts. As such, we do not focus on individual cost groupings (such as manufacturing, engineering and design labor, subcontractor, material, overhead and general and administrative (G&A) costs), as much as we do on total contract cost, which is the key driver of our sales and operating income.

In evaluating our operating performance, we look primarily at changes in sales and operating income. Where applicable, significant fluctuations in operating performance attributable to individual contracts or programs, or changes in a specific cost element across multiple contracts, are described in our analysis. Based on this approach and the nature of our operations, the discussion of results of operations below first focuses on our four segments before distinguishing between products and services. Changes in sales are generally described in terms of volume, while changes in margin rates are generally described in terms of performance and/or contract mix. For purposes of this discussion, volume generally refers to increases or decreases in sales or cost from production/service activity levels and performance generally refers to non-volume related changes in profitability. Contract mix generally refers to changes in the ratio of contract type and/or life cycle (e.g., cost-type, fixed-price, development, production, and/or sustainment).

CONSOLIDATED OPERATING RESULTS

For purposes of the operating results discussion below, we assess our performance using certain financial measures that are not calculated in accordance with GAAP. These non-GAAP financial measures exclude Mark-to-market pension and OPB (“MTM”) expense and related tax impacts, and are described as MTM-adjusted net earnings and MTM-adjusted diluted earnings per share. These non-GAAP measures may be useful to investors and other users of our financial statements as supplemental measures in evaluating the company’s underlying financial performance by presenting the company’s operating results before the non-operational impact of pension and OPB actuarial gains and losses. These measures are also consistent with how management views the underlying performance of the business as the impact of MTM accounting is not considered in management’s assessment of the company’s operating performance or in its determination of incentive compensation awards. We reconcile these non-GAAP

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financial measures to their most directly comparable GAAP financial measures below. These non-GAAP measures may not be defined and calculated by other companies in the same manner and should not be considered in isolation or as an alternative to operating results presented in accordance with GAAP.

Selected financial highlights are presented in the table below:

			Year Ended December 31																		% Change in
$ in millions, except per share amounts			2020						2019						2018						2020						2019
Sales			$	36,799					$	33,841					$	30,095					9		%				12		%
Operating costs and expenses			32,734						29,872						26,315						10		%				14		%
Operating costs and expenses as a % of sales			89.0		%				88.3		%				87.4		%
Operating income			4,065						3,969						3,780						2		%				5		%
Operating margin rate			11.0		%				11.7		%				12.6		%
Mark-to-market pension and OPB expense			(1,034)						(1,800)						(655)						(43)		%				175		%
Federal and foreign income tax expense			539						300						513						80		%				(42)		%
Effective income tax rate			14.5		%				11.8		%				13.7		%
Net earnings			3,189						2,248						3,229						42		%				(30)		%
Diluted earnings per share			19.03						13.22						18.49						44		%				(29)		%

Sales

2020 sales increased $3.0 billion, or 9 percent, due to higher sales at all four sectors.

See “Segment Operating Results” below for further information by segment and “Product and Service Analysis” for product and service detail. See Note 16 to the consolidated financial statements for information regarding the company’s sales by customer type, contract type and geographic region for each of our segments.

Operating Income and Margin Rate

2020 operating income increased $96 million, or 2 percent, primarily due to an increase in segment operating income, partially offset by higher unallocated corporate expense and a lower net FAS (service)/CAS pension adjustment. 2020 operating margin rate declined to 11.0 percent from 11.7 percent principally due to a lower segment operating margin rate, higher unallocated corporate expense and lower net FAS (service)/CAS pension adjustment.

2020 G&A costs as a percentage of sales decreased to 9.3 percent from 9.7 percent, primarily due to higher sales volume, partially offset by higher independent research and development costs.

For further information regarding product and service operating costs and expenses, see “Product and Service Analysis” below.

Mark-to-Market Pension and OPB Expense

The primary components of pre-tax MTM expense are presented in the table below:

			Year Ended December 31
$ in millions			2020						2019						2018
Actuarial (losses) gains on projected benefit obligation			$	(3,570)					$	(4,866)					$	2,772
Actuarial gains (losses) on plan assets			2,536						3,066						(3,426)
Other			—						—						(1)
MTM expense			$	(1,034)					$	(1,800)					$	(655)

2020 MTM expense of $1.0 billion was primarily driven by a 71 basis point decrease in the discount rate from year end 2019, partially offset by actual net plan asset returns of approximately 16.2 percent compared to our 8.0 percent asset return assumption.

Federal and Foreign Income Taxes

The 2020 effective tax rate increased to 14.5 percent from 11.8 percent in 2019. MTM expense reduced the 2020 effective tax rate by 1.3 percentage points and the 2019 effective tax rate by 3.7 percentage points. See Note 7 to the consolidated financial statements for additional information.

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Net Earnings

The table below reconciles net earnings to MTM-adjusted net earnings:

			Year Ended December 31																		% Change in
$ in millions			2020						2019						2018						2020						2019
Net earnings			$	3,189					$	2,248					$	3,229					42		%				(30)		%
MTM expense			1,034						1,800						655						(43)		%				175		%
MTM-related deferred state tax benefit(1)			(54)						(81)						(29)						(33)		%				179		%
Federal tax benefit of items above(2)			(206)						(361)						(131)						(43)		%				176		%
MTM expense, net of tax			774						1,358						495						(43)		%				174		%
MTM-adjusted net earnings			$	3,963					$	3,606					$	3,724					10		%				(3)		%

(1)MTM expense is expected to be deductible on our future state tax returns. The deferred state tax benefit was calculated using the company’s blended state tax rate of 5.25 percent in 2020 and 4.50 percent in 2019 and 2018 and included in Unallocated corporate expense within operating income.

(2)MTM expense is expected to be deductible on our future federal tax returns. The federal tax benefit in each period was calculated by subtracting the deferred state tax benefit from MTM expense and applying the 21 percent federal statutory rate.

Net earnings increased $941 million, or 42 percent, in 2020 principally due to a $584 million decrease in our MTM expense, net of tax. Excluding this impact, MTM-adjusted net earnings increased by $357 million, or 10 percent, primarily due to increases in our FAS (non-service) benefit and operating income, partially offset by higher income tax and interest expense.

Diluted Earnings Per Share

The table below reconciles diluted earnings per share to MTM-adjusted diluted earnings per share:

			Year Ended December 31																		% Change in
			2020						2019						2018						2020						2019
Diluted earnings per share			$	19.03					$	13.22					$	18.49					44		%				(29)		%
MTM expense per share			6.17						10.59						3.76						(42)		%				182		%
MTM-related deferred state tax benefit per share(1)			(0.32)						(0.48)						(0.17)						(33)		%				182		%
Federal tax benefit of items above per share(2)			(1.23)						(2.12)						(0.75)						(42)		%				183		%
MTM expense per share, net of tax			4.62						7.99						2.84						(42)		%				181		%
MTM-adjusted diluted earnings per share			$	23.65					$	21.21					$	21.33					12		%				(1)		%

(1)MTM expense is expected to be deductible on our future state tax returns. The deferred state tax benefit was calculated using the company’s blended state tax rate of 5.25 percent in 2020 and 4.50 percent in 2019 and 2018 and included in Unallocated corporate expense within operating income.

(2)MTM expense is expected to be deductible on our future federal tax returns. The federal tax benefit in each period was calculated by subtracting the deferred state tax benefit from MTM expense and applying the 21 percent federal statutory rate.

Diluted earnings per share increased $5.81, or 44 percent, principally due to a $3.37 increase associated with lower MTM expense, net of tax. Excluding this impact, MTM-adjusted diluted earnings per share increased $2.44, or 12 percent, reflecting a 10 percent increase in MTM-adjusted net earnings and a 1 percent decrease in weighted-average diluted shares outstanding.

SEGMENT OPERATING RESULTS

Basis of Presentation

Effective January 1, 2020, the company reorganized its sectors to better align the company’s broad portfolio to serve its customers’ needs. At December 31, 2020, the company was aligned in four operating sectors, which also comprise our reportable segments: Aeronautics Systems, Defense Systems, Mission Systems and Space Systems. The segment operating results below include sales and operating income for legacy Innovation Systems subsequent to the Merger date. For a more complete description of each segment’s products and services, see “Business.”

Beginning in the second quarter of 2020, the company no longer considers certain unallowable costs as part of management’s evaluation of segment operating performance. As a result, certain unallowable costs, which were previously included in segment operating results, are now reported in Unallocated corporate expense within

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operating income. This change has been applied retrospectively in the accompanying financial information. See Part II, Item 5 in the Quarterly Report on Form 10-Q for the quarter ended June 30, 2020 for further information regarding the impact of this change on the company’s prior period segment information.

We present our sectors in the following business areas, which are reported in a manner reflecting core capabilities:

Aeronautics Systems						Defense Systems						Mission Systems						Space Systems
Autonomous Systems						Battle Management & Missile Systems						Airborne Sensors & Networks						Launch & Strategic Missiles
Manned Aircraft						Mission Readiness						Cyber & Intelligence Mission Solutions						Space
												Maritime/Land Systems & Sensors
												Navigation, Targeting & Survivability

This section discusses segment sales, operating income and operating margin rates. A reconciliation of segment operating income to total operating income is provided below.

Segment Operating Income and Margin Rate

Segment operating income, as reconciled in the table below, and segment operating margin rate (segment operating income divided by sales) are non-GAAP (accounting principles generally accepted in the United States of America) measures that reflect total earnings from our four segments, including allocated pension expense we have recognized under FAR and CAS, and excluding FAS pension expense and unallocated corporate items (certain corporate-level expenses, which are not considered allowable or allocable under applicable CAS or FAR, and costs not considered part of management’s evaluation of segment operating performance). These non-GAAP measures may be useful to investors and other users of our financial statements as supplemental measures in evaluating the financial performance and operational trends of our sectors. These measures may not be defined and calculated by other companies in the same manner and should not be considered in isolation or as alternatives to operating results presented in accordance with GAAP.

			Year Ended December 31																		% Change in
$ in millions			2020						2019						2018						2020						2019
Segment operating income			$	4,188					$	3,978					$	3,514					5		%				13		%
Segment operating margin rate			11.4		%				11.8		%				11.7		%
CAS pension expense			827						832						1,017						(1)		%				(18)		%
Less: FAS (service) pension expense			(409)						(367)						(404)						11		%				(9)		%
Net FAS (service)/CAS pension adjustment			418						465						613						(10)		%				(24)		%
Intangible asset amortization and PP&E step-up depreciation			(322)						(390)						(220)						(17)		%				NM
MTM-related deferred state tax benefit(1)			54						81						29						(33)		%				179		%
Other unallocated corporate expense			(273)						(165)						(156)						65		%				6		%
Unallocated corporate expense			(541)						(474)						(347)						14		%				37		%
Total operating income			$	4,065					$	3,969					$	3,780					2		%				5		%

(1)Represents the deferred state tax benefit associated with MTM expense, which is recorded in Unallocated corporate expense consistent with other changes in deferred state taxes.

Segment Operating Income and Margin Rate

2020 segment operating income increased $210 million, or 5 percent, and reflects higher operating income at all four sectors. Segment operating margin rate decreased to 11.4 percent from 11.8 percent principally due to a lower operating margin rate at Aeronautics Systems.

Net FAS (service)/CAS Pension Adjustment

The decrease in our 2020 net FAS (service)/CAS pension adjustment is primarily due to higher FAS (service) pension expense largely as a result of changes in actuarial assumptions as of December 31, 2019.

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Unallocated Corporate Expense

The increase in 2020 unallocated corporate expense is primarily due to the absence in 2020 of an $89 million benefit related to the favorable resolution of a cost accounting litigation matter and $60 million of higher state tax expense in the current year. State tax expense increased principally due to changes in deferred state income taxes, including a lower MTM-related deferred state tax benefit, and an increase in reserves, in part, for potential unallowable costs associated with state apportionment. These increases were partially offset by $68 million of lower intangible asset amortization and PP&E step-up depreciation.

Net Estimate-At-Completion (EAC) Adjustments - We record changes in estimated contract earnings at completion (net EAC adjustments) using the cumulative catch-up method of accounting. Net EAC adjustments can have a significant effect on reported sales and operating income and the aggregate amounts are presented in the table below:

			Year Ended December 31
$ in millions			2020						2019						2018
Favorable EAC adjustments			$	1,082					$	1,040					$	1,019
Unfavorable EAC adjustments			(616)						(560)						(442)
Net EAC adjustments			$	466					$	480					$	577

Net EAC adjustments by segment are presented in the table below:

			Year Ended December 31
$ in millions			2020						2019						2018
Aeronautics Systems(1)			$	77					$	143					$	271
Defense Systems(1)			148						99						75
Mission Systems			216						189						172
Space Systems(1)			33						63						73
Eliminations			(8)						(14)						(14)
Net EAC adjustments			$	466					$	480					$	577

(1)Amounts reflect EAC adjustments after the percent complete on legacy Innovation Systems contracts was reset to zero as of the Merger date.

For purposes of the discussion in the remainder of this Segment Operating Results section, references to operating income and operating margin rate reflect segment operating income and segment operating margin rate, respectively.

AERONAUTICS SYSTEMS

			Year Ended December 31																		% Change in
$ in millions			2020						2019						2018						2020						2019
Sales			$	12,169					$	11,116					$	10,293					9		%				8		%
Operating income			1,206						1,188						1,128						2		%				5		%
Operating margin rate			9.9		%				10.7		%				11.0		%

Sales

2020 sales increased $1.1 billion, or 9 percent, due to higher sales in both Manned Aircraft and Autonomous Systems. Higher volume on restricted programs, including a $444 million sale of equipment to a restricted customer, E-2D and Triton were partially offset by lower volume on the B-2 Defensive Management System Modernization program as it nears completion. See Note 1 to the consolidated financial statements for further detail on the sale of equipment described above.

Operating Income

2020 operating income increased $18 million, or 2 percent, due to higher sales partially offset by a lower operating margin rate. 2020 operating margin rate decreased to 9.9 percent from 10.7 percent principally due to lower net EAC adjustments as well as the sale of equipment to a restricted customer, which was dilutive to the overall sector margin rate.

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DEFENSE SYSTEMS

			Year Ended December 31																		% Change in
$ in millions			2020						2019						2018						2020						2019
Sales			$	7,543					$	7,495					$	6,612					1		%				13		%
Operating income			846						793						697						7		%				14		%
Operating margin rate			11.2		%				10.6		%				10.5		%

Sales

2020 sales increased $48 million, or 1 percent, due to higher volume in both business areas. Battle Management & Missile Systems sales increased primarily due to higher volume on the Guided Missile Launch Rocket System (GMLRS), the Advanced Anti-Radiation Guided Missile (AARGM), the Counter-Rocket, Artillery and Mortar program and other missile products, partially offset by lower volume on programs nearing completion, including an international weapons program and the close-out of our contract at the Army’s Lake City ammunition plant. Mission Readiness sales increased principally due to higher volume on restricted and international programs, partially offset by lower volume on the Hunter sustainment program as it nears completion.

Operating Income

2020 operating income increased $53 million, or 7 percent, primarily due to a higher operating margin rate. Operating margin increased to 11.2 percent from 10.6 percent principally due to improved performance at Battle Management & Missile Systems and Mission Readiness.

MISSION SYSTEMS

			Year Ended December 31																		% Change in
$ in millions			2020						2019						2018						2020						2019
Sales			$	10,080					$	9,410					$	8,949					7		%				5		%
Operating income			1,459						1,408						1,245						4		%				13		%
Operating margin rate			14.5		%				15.0		%				13.9		%

Sales

2020 sales increased $670 million, or 7 percent, due to higher volume across all four business areas. Airborne Sensors & Networks sales increased principally due to higher airborne radar volume, including the F-35, Multi-role Electronically Scanned Array (MESA) and Scalable Agile Beam Radar (SABR) programs, and higher restricted volume. Navigation, Targeting & Survivability sales increased primarily due to higher volume on self-protection, avionics and targeting programs, including LITENING, partially offset by lower volume on infrared countermeasures programs. Maritime/Land Systems & Sensors sales increased primarily due to higher volume on marine systems and restricted programs, partially offset by lower international commercial volume due, in part, to COVID-19-related impacts. Cyber & Intelligence Mission Solutions sales increased principally due to higher restricted volume, partially offset by lower volume on an intelligence program as it nears completion.

Operating Income

2020 operating income increased $51 million, or 4 percent, due to higher sales, partially offset by a lower operating margin rate. Operating margin rate decreased to 14.5 percent from 15.0 percent primarily due to lower margin rates at Maritime/Land Systems & Sensors, including COVID-19-related impacts on certain international commercial businesses.

SPACE SYSTEMS

			Year Ended December 31																		% Change in
$ in millions			2020						2019						2018						2020						2019
Sales			$	8,744					$	7,425					$	5,845					18		%				27		%
Operating income			893						794						644						12		%				23		%
Operating margin rate			10.2		%				10.7		%				11.0		%

Sales

2020 sales increased $1.3 billion, or 18 percent, due to higher sales in both Space and Launch & Strategic Missiles. Space sales were driven by higher volume on restricted programs and the Next Generation Overhead Persistent Infrared and NASA Artemis programs. Launch & Strategic Missiles sales increased due to ramp-up on the Ground

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Based Strategic Deterrent program and higher volume on launch vehicles and hypersonics programs, partially offset by lower volume on the Ground-based Midcourse Defense program.

Operating Income

2020 operating income increased $99 million, or 12 percent, due to higher sales, partially offset by a lower operating margin rate. Operating margin rate decreased to 10.2 percent from 10.7 percent principally due to lower net EAC adjustments and changes in contract mix.

PRODUCT AND SERVICE ANALYSIS

The following table presents product and service sales and operating costs and expenses by segment:

						Year Ended December 31
$ in millions						2020												2019												2018
Segment Information:						Sales						Operating Costs and Expenses						Sales						Operating Costs and Expenses						Sales						Operating Costs and Expenses
Aeronautics Systems
Product						$	10,437					$	9,435					$	9,387					$	8,428					$	8,665					$	7,731
Service						1,610						1,417						1,626						1,407						1,555						1,369
Intersegment eliminations						122						111						103						93						73						65
Total Aeronautics Systems						12,169						10,963						11,116						9,928						10,293						9,165
Defense Systems
Product						3,024						2,740						2,784						2,572						1,703						1,521
Service						3,791						3,305						4,020						3,513						4,159						3,718
Intersegment eliminations						728						652						691						617						750						676
Total Defense Systems						7,543						6,697						7,495						6,702						6,612						5,915
Mission Systems
Product						6,744						5,757						6,022						5,073						5,790						4,992
Service						2,557						2,201						2,660						2,314						2,441						2,109
Intersegment eliminations						779						663						728						615						718						603
Total Mission Systems						10,080						8,621						9,410						8,002						8,949						7,704
Space Systems
Product						6,810						6,084						5,659						5,021						4,311						3,798
Service						1,826						1,672						1,683						1,535						1,471						1,343
Intersegment eliminations						108						95						83						75						63						60
Total Space Systems						8,744						7,851						7,425						6,631						5,845						5,201
Segment Totals
Total Product						$	27,015					$	24,016					$	23,852					$	21,094					$	20,469					$	18,042
Total Service						9,784						8,595						9,989						8,769						9,626						8,539
Total Segment(1)						$	36,799					$	32,611					$	33,841					$	29,863					$	30,095					$	26,581

(1)A reconciliation of segment operating income to total operating income is included in “Segment Operating Results.”

Product Sales and Costs

2020 product sales increased $3.2 billion, or 13 percent, due to higher product sales at all four sectors, including restricted programs and E-2D at Aeronautics Systems; restricted programs, Next Gen OPIR and GBSD at Space Systems; restricted, F-35 and airborne radar programs at Mission Systems; and AARGM, GMLRS and other missile products at Defense Systems.

2020 product costs increased $2.9 billion, or 14 percent, consistent with the higher product sales described above and reflects lower product margins at Mission Systems and Aeronautics Systems.

Service Sales and Costs

2020 service sales decreased $205 million, or 2 percent, primarily due to lower service sales at Defense Systems principally due to lower volume on the Hunter sustainment program and a shift toward more product content in the lifecycle of certain programs.

2020 service costs decreased $174 million, or 2 percent, consistent with the lower service sales described above.

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BACKLOG

Backlog represents the future sales we expect to recognize on firm orders received by the company and is equivalent to the company’s remaining performance obligations at the end of each period. It comprises both funded backlog (firm orders for which funding is authorized and appropriated) and unfunded backlog. Unexercised contract options and indefinite delivery indefinite quantity (IDIQ) contracts are not included in backlog until the time the option or IDIQ task order is exercised or awarded. Backlog is converted into sales as costs are incurred or deliveries are made.

Backlog consisted of the following at December 31, 2020 and 2019:

						2020																		2019
$ in millions						Funded						Unfunded						Total Backlog						Total Backlog						% Change in 2020
Aeronautics Systems						$	10,587					$	13,415					$	24,002					$	26,021					(8)		%
Defense Systems						6,942						1,189						8,131						8,481						(4)		%
Mission Systems						9,444						4,361						13,805						14,226						(3)		%
Space Systems						5,569						29,462						35,031						16,112						117		%
Total backlog						$	32,542					$	48,427					$	80,969					$	64,840					25		%

2020 net awards totaled $52.9 billion. Significant 2020 new awards include $17.4 billion for restricted programs ($9.0 billion at Space Systems, $6.0 billion at Aeronautics Systems and $2.2 billion at Mission Systems), $13.3 billion for the Ground Based Strategic Deterrent EMD program, $1.9 billion for Next Gen OPIR, $1.7 billion for F-35, $0.9 billion for Triton, $0.9 billion for E-2D and $0.8 billion for Global Hawk.

LIQUIDITY AND CAPITAL RESOURCES

We endeavor to ensure the most efficient conversion of operating income into cash for deployment in our business and to maximize shareholder value through cash deployment activities. In addition to our cash position, we use various financial measures to assist in capital deployment decision-making, including cash provided by operating activities and adjusted free cash flow, a non-GAAP measure described in more detail below.

As of December 31, 2020, we had cash and cash equivalents of $4.9 billion; approximately $276 million was held outside of the U.S. by foreign subsidiaries. In March 2020, we issued $2.25 billion of unsecured senior notes for general corporate purposes, including debt repayment and working capital, to help preserve financial flexibility in light of uncertainty resulting from the COVID-19 pandemic. In April 2020, we entered into a one-year $500 million uncommitted credit facility to provide an additional source of potential financing. On October 15, 2020, the company repaid $1.0 billion of unsecured senior notes upon maturity.

The Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) established a program with provisions to allow U.S. companies to defer the employer’s portion of social security taxes between March 27, 2020 and December 31, 2020 and pay such taxes in two installments in 2021 and 2022. Under Section 3610, the CARES Act also authorized the government to reimburse qualifying contractors for certain costs of providing paid leave to employees as a result of COVID-19. The company has begun to seek, and anticipates continuing to seek, recovery for certain COVID-19-related costs under Section 3610 of the CARES Act and through our contract provisions. In addition, the U.S. Department of Defense (DoD) has taken steps to increase the rate for certain progress payments from 80 percent to 90 percent for costs incurred and work performed on relevant contracts. While it is unclear how much we will be able to recover, in particular under Section 3610, we believe these actions should continue to mitigate some potential COVID-19-related negative impacts to our operating cash flows in 2021.

Cash and cash equivalents and cash generated from operating activities, supplemented by borrowings under credit facilities, commercial paper and/or in the capital markets, if needed, are expected to be sufficient to fund our operations for at least the next 12 months. Capital expenditure commitments were $1.3 billion at December 31, 2020, and are expected to be paid with cash on hand.

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Operating Cash Flow

The table below summarizes key components of cash flow provided by operating activities:

						Year Ended December 31
$ in millions						2020						2019						2018
Net earnings						$	3,189					$	2,248					$	3,229
Non-cash items(1)						2,601						2,683						1,775
Changes in assets and liabilities:
Trade working capital						227						128						(65)
Retiree benefits, excluding MTM expense						(1,678)						(703)						(1,083)
Other, net						(34)						(59)						(29)
Net cash provided by operating activities						$	4,305					$	4,297					$	3,827

(1)Includes depreciation and amortization, MTM expense, stock based compensation expense and deferred income taxes.

2020 cash provided by operating activities was comparable to the prior period and reflects higher net earnings and improved trade working capital as well as a $750 million discretionary pre-tax pension contribution ($593 million after-tax) as compared to a $120 million discretionary pre-tax pension contribution ($95 million after-tax) in the prior year period.

Adjusted Free Cash Flow

Adjusted free cash flow, as reconciled in the table below, is a non-GAAP measure defined as net cash provided by operating activities, less capital expenditures, plus proceeds from sale of equipment to a customer (not otherwise included in net cash provided by operating activities) and the after-tax impact of discretionary pension contributions. Adjusted free cash flow includes proceeds from the sale of equipment to a customer as such proceeds were generated in a customer sales transaction. It also includes the after-tax impact of discretionary pension contributions for consistency and comparability of financial performance. This measure may not be defined and calculated by other companies in the same manner. We use adjusted free cash flow as a key factor in our planning for, and consideration of, acquisitions, the payment of dividends and share repurchases. This non-GAAP measure may be useful to investors and other users of our financial statements as a supplemental measure of our cash performance, but should not be considered in isolation, as a measure of residual cash flow available for discretionary purposes, or as an alternative to operating cash flows presented in accordance with GAAP.

The table below reconciles net cash provided by operating activities to adjusted free cash flow:

						Year Ended December 31																		% Change in
$ in millions						2020						2019						2018						2020						2019
Net cash provided by operating activities						$	4,305					$	4,297					$	3,827					—		%				12		%
Capital expenditures						(1,420)						(1,264)						(1,249)						12		%				1		%
Proceeds from sale of equipment to a customer						205						—						—						NM						NM
After-tax discretionary pension contributions						593						95						186						524		%				(49)		%
Adjusted free cash flow						$	3,683					$	3,128					$	2,764					18		%				13		%

2020 adjusted free cash flow increased $555 million, principally driven by higher net earnings and improved trade working capital as well as $205 million in proceeds from the sale of equipment to a customer, partially offset by higher capital expenditures.

Investing Cash Flow

2020 net cash used in investing activities was comparable to the prior period and reflects higher capital expenditures, as well as $205 million in proceeds from the sale of equipment to a customer.

Financing Cash Flow

2020 net cash used in financing activities decreased to $432 million from $2.4 billion principally due to $2.2 billion of net proceeds from the issuance of long-term debt in the first quarter of 2020.

Share Repurchases – See Note 3 to the consolidated financial statements for further information on our share repurchase programs.

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Commercial Paper, Credit Facilities and Unsecured Senior Notes – See Note 10 to the consolidated financial statements for further information on our commercial paper, credit facilities and unsecured senior notes.

Financial Arrangements – See Note 12 to the consolidated financial statements for further information on our use of standby letters of credit and guarantees.

Other Sources of Capital – We believe we can obtain additional capital, if necessary for long-term liquidity, from such sources as the public or private capital markets, the sale of assets, sale and leaseback of operating assets, and leasing rather than purchasing new assets. We have an effective shelf registration statement on file with the SEC, which allows us to access capital in a timely manner.

Contractual Obligations

At December 31, 2020, we had contractual commitments to repay debt with interest, make payments under operating leases, settle obligations related to agreements to purchase goods and services and make payments on various other liabilities. Payments due under these obligations and commitments, and the estimated timing of those payments, are as follows:

$ in millions						Total						2021						2022- 2023						2024- 2025						2026 and beyond
Long-term debt						$	15,091					$	742					$	2,558					$	1,506					$	10,285
Interest payments on long-term debt						8,473						596						1,126						996						5,755
Operating leases						2,022						298						495						327						902
Purchase obligations(1)						17,761						8,279						4,065						2,941						2,476
Other long-term liabilities(2)						1,619						370						579						157						513
Total contractual obligations						$	44,966					$	10,285					$	8,823					$	5,927					$	19,931

(1)A “purchase obligation” is defined as an agreement to purchase goods or services that is enforceable and legally binding on us and that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. These amounts are primarily comprised of open purchase order commitments to suppliers and subcontractors pertaining to funded contracts.

(2)Other long-term liabilities, including their current portions, primarily consist of total accrued environmental reserves, deferred compensation, and other miscellaneous liabilities. It excludes obligations for uncertain tax positions of $1.5 billion as we are not able to reasonably estimate the timing of future cash flows related to such positions.

The table above excludes estimated minimum funding requirements for the company’s pension and OPB plans, as set forth by the Employee Retirement Income Security Act, as amended. For further information about future minimum contributions for these plans, see Note 13 to the consolidated financial statements. Further details regarding long-term debt and operating leases can be found in Notes 10 and 15, respectively, to the consolidated financial statements.

CRITICAL ACCOUNTING POLICIES, ESTIMATES AND JUDGMENTS

Our consolidated financial statements are based on GAAP, which requires us to make estimates and assumptions about future events that affect the amounts reported in our consolidated financial statements. We employ judgment in making our estimates in consideration of historical experience, currently available information and various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from our estimates and assumptions, and any such differences could be material to our consolidated financial statements. We believe the following accounting policies are critical to the understanding of our consolidated financial statements and require the use of significant management judgment in their application. For a summary of our significant accounting policies, see Note 1 to the consolidated financial statements.

Revenue Recognition

Due to the long-term nature of our contracts, we generally recognize revenue over time using the cost-to-cost method, which requires us to make reasonably dependable estimates regarding the revenue and cost associated with the design, manufacture and delivery of our products and services.

Contract sales may include estimates of variable consideration, including cost or performance incentives (such as award and incentive fees), contract claims and requests for equitable adjustment (REAs). Variable consideration is included in total estimated sales to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. We estimate variable consideration as the most likely amount to which we expect to be entitled.

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Our cost estimation process is based on the professional knowledge of our engineering, program management and financial professionals, and draws on their significant experience and judgment. We prepare EACs for our contracts and calculate an estimated contract profit based on total estimated contract sales and cost. Since our contracts typically span a period of several years, estimation of revenue, cost, and progress toward completion requires the use of judgment. Factors considered in these estimates include our historical performance, the availability, productivity and cost of labor, the nature and complexity of work to be performed, the effect of change orders, availability and cost of materials, components and subcontracts, the effect of any delays in performance and the level of indirect cost allocations.

We generally review and reassess our sales, cost and profit estimates for each significant contract at least annually or more frequently as determined by the occurrence of events, changes in circumstances and evaluations of contract performance to reflect the latest reliable information available. The company performs on a broad portfolio of long-term contracts, including the development of complex and customized military platforms and systems, as well as advanced electronic equipment and software, that often include technology at the forefront of science. Cost estimates on fixed-price development contracts are inherently more uncertain as to future events than production contracts, and, as a result, there is typically more variability in those estimates, as well as financial risk associated with unanticipated cost growth. Changes in estimates occur for a variety of reasons, including changes in contract scope, the resolution of risk at lower or higher cost than anticipated, unanticipated performance and other risks affecting contract costs, performance issues with subcontractors or suppliers, changes in indirect cost allocations, such as overhead and G&A costs, and changes in estimated award and incentive fees. Identified risks typically include technical, schedule and/or performance risk based on our evaluation of the contract effort. Similarly, the changes in estimates may include changes in, or resolution of, identified opportunities for operating margin improvement.

For the impacts of changes in estimates on our consolidated statements of earnings and comprehensive income, see “Segment Operating Results” and Note 1 to the consolidated financial statements.

Retirement Benefits

Overview – The determination of projected benefit obligations, the fair value of plan assets, and pension and OPB expense for our retirement benefit plans requires the use of estimates and actuarial assumptions. We perform an annual review of our actuarial assumptions in consultation with our actuaries. As we determine changes in the assumptions are warranted, or as a result of plan amendments, future pension and OPB expense and our projected benefit obligation could increase or decrease. The principal estimates and assumptions that have a significant effect on our consolidated financial position and annual results of operations are the discount rate, cash balance crediting rate, expected long-term rate of return on plan assets, estimated fair market value of plan assets, and the mortality rate of those covered by our pension and OPB plans. The effects of actual results differing from our assumptions and the effects of changing assumptions (i.e. actuarial gains or losses) are recognized immediately through earnings upon annual remeasurement in the fourth quarter, or on an interim basis as triggering events warrant remeasurement.

Discount Rate – The discount rate represents the interest rate used to determine the present value of future cash flows currently expected to be required to settle our pension and OPB obligations. The discount rate is generally based on the yield of high-quality corporate fixed-income investments. At the end of each year, we determine the discount rate using a theoretical bond portfolio model of bonds rated AA or better to match the notional cash outflows related to projected benefit payments for each of our significant benefit plans. Taking into consideration the factors noted above, our weighted-average composite pension discount rate was 2.68 percent at December 31, 2020, and 3.39 percent at December 31, 2019.

The effects of a hypothetical change in the discount rate may be nonlinear and asymmetrical for future years as the discount rate changes. Holding all other assumptions constant, an increase or decrease of 25 basis points in the December 31, 2020 discount rate assumption would have the following estimated effects on 2020 pension and OPB obligations, which would be reflected in the 2020 MTM expense (benefit), and 2021 expected pension and OPB expense:

$ in millions			25 Basis Point Decrease in Rate						25 Basis Point Increase in Rate
2021 pension and OPB (benefit) expense			$	(45)					$	42
2020 pension and OPB obligation and MTM expense (benefit)			1,471						(1,385)

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Cash Balance Crediting Rate – A portion of the company’s pension obligation and resulting pension expense is based on a cash balance formula, where participants’ hypothetical account balances are accumulated over time with pay-based credits and interest. Interest is credited monthly using the current 30-Year Treasury bond rate. The interest crediting rate is part of the cash balance formula and independent of actual pension investment earnings. The cash balance crediting rate used for FAS purposes tends to move in concert with the discount rate but has an offsetting effect on pension benefit obligations and the related MTM expense (benefit). The minimum cash balance crediting rate allowed under the plan is 2.25 percent. The cash balance crediting rate assumption has been set to the minimum threshold of 2.25 percent as of December 31, 2020, and will remain at 2.25 percent through 2026. Holding all other assumptions constant, an increase or decrease of 25 basis points in the December 31, 2020 cash balance crediting rate assumption would have the following estimated effects on the 2020 pension benefit obligation, which would be reflected in the 2020 MTM expense (benefit), and 2021 expected pension expense:

$ in millions			25 Basis Point Decrease in Rate						25 Basis Point Increase in Rate
2021 pension (benefit) expense			$	—					$	11
2020 pension obligation and MTM expense (benefit)			—						169

Expected Long-Term Rate of Return on Plan Assets – The expected long-term rate of return on plan assets (EROA) assumption reflects the average rate of net earnings we expect on current and future benefit plan investments. EROA is a long-term assumption, which we review annually and adjust to reflect changes in our long-term view of expected market returns and/or significant changes in our plan asset investment policy. Due to the inherent uncertainty of this assumption, we consider multiple data points at the measurement date including the plan’s target asset allocation, historical asset returns and third party projection models of expected long-term returns for each of the plans’ strategic asset classes. In addition to the data points themselves, we consider trends in the data points, including changes from the prior measurement date. The EROA assumptions we use for pension benefits are consistent with those used for OPB plans; however, we reduce the EROA for OPB plans to allow for the impact of tax on investment earnings, as certain Voluntary Employee Beneficiary Association trusts are taxable.

During 2020, the Investment Committee of the company’s benefit plans reviewed and approved the plans’ major asset class allocations. The current asset allocation is approximately 40% public equities, 35% fixed-income, 20% alternatives and 5% cash. At this time, the Investment Committee is not contemplating any significant changes to that mix. For further information on plan asset investments, see Note 13 to the consolidated financial statements.

While historical market returns are not necessarily predictive of future market returns, given our long history of plan performance supported by the stability in our investment mix, investment managers, and active asset management, we believe our actual historical performance is a reasonable metric to consider when developing our EROA. Our average annual rate of return from 1976 to 2020 was approximately 11.2 percent and our 20-year and 30-year rolling average rates of return were approximately 8.0 percent and 10.2 percent, respectively, each determined on an arithmetic basis and net of expenses. Our 2020 actual net plan asset returns were approximately 16.2 percent.

Consistent with our past practice, we obtained long-term capital market forecasting models from several third parties and, using our target asset allocation, developed an expected rate of return on plan assets from each model. We considered not only the specific returns projected by those third party models, but also changes in the models year-to-year when developing our EROA.

For determining 2020 FAS expense, we assumed an expected long-term rate of return on pension plan assets of 8.0 percent and an expected long-term rate of return on OPB plan assets of 7.66 percent. For 2021 FAS expense, we have assumed an expected long-term rate of return on pension plan assets of 7.5 percent and 7.22 percent on OPB plans. We decreased the EROA assumption following an assessment of the historical and anticipated long-term returns of various asset classes, including consideration of recent Federal Reserve policy changes that are expected to extend the duration of the current low interest rate environment. Holding all other assumptions constant, an increase or decrease of 25 basis points in our December 31, 2020 EROA assumption would have the following estimated effects on 2021 expected pension and OPB expense:

$ in millions			25 Basis Point Decrease						25 Basis Point Increase
2021 pension and OPB expense (benefit)			$	88					$	(88)

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In addition, holding all other assumptions constant, an increase or decrease of 100 basis points in actual versus expected return on plan assets would have the following estimated effects on our 2021 MTM expense (benefit):

$ in millions			100 Basis Point Decrease						100 Basis Point Increase
2021 MTM expense (benefit)			$	351					$	(351)

Estimated Fair Market Value of Plan Assets – For certain plan assets where the fair market value is not readily determinable, such as real estate, private equity, hedge funds and opportunistic investments, we develop estimates of fair value using the best information available. Estimated fair values on these plan assets are based on redemption values and net asset values, as well as valuation methodologies that include third party appraisals, comparable transactions, discounted cash flow valuation models and public market data.

Mortality Rate – Mortality assumptions are used to estimate life expectancies of plan participants. In October 2014, the Society of Actuaries Retirement Plans Experience Committee (RPEC) issued updated mortality tables and a mortality improvement scale, which reflected longer life expectancies than previously projected. In October 2019, the RPEC issued an updated mortality base table (the Private Retirement Plans Mortality table for 2012 (Pri-2012)), which we adopted after reviewing our own historical mortality experience. In October 2020, the RPEC released a new projection scale (MP-2020) that included a reshaping of the long-term mortality improvement assumption. The MP-2020 projection scale includes long-term mortality improvement assumptions greater than 1.0% at earlier ages, but trends down more rapidly than the prior projection scales. After considering the information released by the RPEC in October 2020, we adopted the full MP-2020 projection scale while continuing to use the Pri-2012 White Collar table. Accordingly, we updated the mortality assumptions used in calculating our pension and OPB obligations recognized at December 31, 2020, and the amounts estimated for our 2021 pension and OPB expense.

For further information regarding our pension and OPB plans, see “Risk Factors” and Notes 1 and 13 to the consolidated financial statements.

Litigation, Commitments and Contingencies

We are subject to a range of claims, disputes, enforcement actions, investigations, lawsuits, overhead cost claims, environmental matters, income tax matters and administrative proceedings that arise in the ordinary course of business. Estimating liabilities and costs associated with these matters requires judgment based upon the professional knowledge and experience of management. We determine whether to record a reserve and, if so, what amount based on consideration of the facts and circumstances of each matter as then known to us. Determinations regarding whether to record a reserve and, if so, of what amount, reflect management’s assessment regarding what is likely to occur; they do not necessarily reflect what management believes should occur. The ultimate resolution of any such exposure to us may vary materially from earlier estimates as further facts and circumstances develop or become known to us.

Environmental Matters – We are subject to environmental laws and regulations in the jurisdictions in which we do or have done business. Factors that could result in changes to the assessment of probability, range of reasonably estimated costs and environmental accruals include: modification of planned remedial actions; changes in the estimated time required to conduct remedial actions; discovery of more or less extensive (or different) contamination than anticipated; information regarding the potential causes and effects of contamination; results of efforts to involve other responsible parties; financial capabilities of other responsible parties; changes in laws and regulations, their interpretation or application; contractual obligations affecting remediation or responsibilities; and improvements in remediation technology. As we expect to be able to recover a portion of environmental remediation liabilities through overhead charges on government contracts, such amounts are deferred in prepaid expenses and other current assets (current portion) and other non-current assets until charged to contracts. We use judgment to evaluate the recoverability of our environmental remediation costs, assessing, among other things, U.S. government regulations, our U.S. government contract mix and past practices. Portions of the company’s environmental liabilities we do not expect to be recoverable have been expensed.

Income Tax Matters – The evaluation of tax positions taken in a filed tax return, or planned to be taken in a future tax return or claim, requires the use of judgment. We establish reserves for uncertain tax positions when, despite the belief that our tax positions are supportable, there remains uncertainty in a tax position taken in our filed tax returns or planned to be taken in a future tax return or claim. The company follows a recognition and measurement approach, considering the facts, circumstances, and information available at the reporting date. Judgment is exercised by the company in determining the level of evidence necessary and appropriate to support its assessment using all available information. The technical merits of a given tax position are derived from sources of authority in

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the tax law and their applicability to the facts and circumstances of the position. In measuring the tax position, the company considers the amounts and probabilities of the outcomes that could be realized upon settlement. When it is more likely than not that a tax position will be sustained, we record the largest amount of tax benefit with a greater than 50 percent likelihood of being realized upon ultimate settlement with a taxing authority. To the extent we prevail in matters for which reserves have been established or are required to pay amounts in excess of reserves, there could be a significant impact on our consolidated financial position and annual results of operations. During 2020, we increased our gross unrecognized tax benefits by approximately $346 million, primarily related to state apportionment, our methods of accounting associated with the timing of revenue recognition and related costs, and the 2017 Tax Act.

For further information on litigation, commitments and contingencies, see “Risk Factors” and Note 1, Note 7, Note 11 and Note 12 to the consolidated financial statements.

Goodwill and Other Purchased Intangible Assets

Overview – We allocate the purchase price of acquired businesses to the underlying tangible and intangible assets acquired and liabilities assumed based upon their respective fair values, with the excess recorded as goodwill. Such fair value assessments require judgments and estimates that can be affected by contract performance and other factors over time, which may cause final amounts to differ materially from original estimates. Adjustments to the fair value of purchased assets and liabilities after the initial measurement period are recognized in net earnings.

We recognize purchased intangible assets in connection with our business acquisitions at fair value on the acquisition date. The most significant purchased intangible assets recognized from our acquisitions are generally customer-related intangible assets, including customer contracts and commercial customer relationships. We determine the fair value of those customer-related intangible assets based on estimates and judgments, including the amount and timing of expected future cash flows, long-term growth rates and discount rates. In some cases, we use discounted cash flow analyses, which are based on estimates of future sales, earnings and cash flows after considering such factors as general market conditions, customer budgets, existing firm and future orders, changes in working capital, long term business plans and recent operating performance.

Impairment Testing – We test for impairment of goodwill annually at each of our reporting units, which comprise our operating segments. The results of our annual goodwill impairment tests as of December 31, 2020 and 2019, respectively, indicated that the estimated fair value of each reporting unit exceeded its respective carrying value. There were no impairment charges recorded in the years ended December 31, 2020, 2019 and 2018.

In addition to performing an annual goodwill impairment test, we may perform an interim impairment test if events occur or circumstances change that suggest goodwill in any of our reporting units may be impaired. Such indicators may include, but are not limited to, the loss of significant business, significant reductions in federal government appropriations or other significant adverse changes in industry or market conditions. During 2020, we considered COVID-19-related impacts on our business and determined there were no impairment indicators requiring us to perform an interim goodwill impairment test.

When testing goodwill for impairment, we compare the fair values of each of our reporting units to their respective carrying values. To determine the fair value of our reporting units, we primarily use the income approach based on the cash flows we expect the reporting units to generate in the future, consistent with our operating plans. This income valuation method requires management to project sales, operating expenses, working capital, capital spending and cash flows for the reporting units over a multi-year period, as well as to determine the weighted-average cost of capital (WACC) used as a discount rate and terminal value assumptions. The WACC takes into account the relative weights of each component of our consolidated capital structure (equity and debt) and represents the expected cost of new capital adjusted as appropriate to consider lower risk profiles associated with longer-term contracts and barriers to market entry. The terminal value assumptions are applied to the final year of the discounted cash flow model. We use industry multiples (including relevant control premiums) of operating earnings to corroborate the fair values of our reporting units determined under the market valuation method of the income approach.

We test for impairment of our purchased intangible assets when events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Our assessment is based on our projection of the undiscounted future operating cash flows of the related asset group. If such projections indicate that future undiscounted cash flows are not sufficient to recover the carrying amount, we recognize a non-cash impairment charge to reduce the carrying amount to fair value. There were no impairment charges recorded in the years ended December 31, 2020, 2019 and 2018.

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NORTHROP GRUMMAN CORPORATION

Impairment assessment inherently involves management judgments as to assumptions about expected future cash flows and the impact of market conditions on those assumptions. Due to the many variables inherent in the estimation of a business’ fair value and the relative size of our recorded goodwill and other purchased intangible assets, differences in assumptions may have a material effect on the results of our impairment analysis.

OTHER MATTERS

Off-Balance Sheet Arrangements

As of December 31, 2020, we had no significant off-balance sheet arrangements.

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NORTHROP GRUMMAN CORPORATION