##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549


Form 10-K

|   |  |                                                                                             
|-- |  | --------------------------------------------------------------------------------------------
|þ  |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|  
|   |  | For the fiscal year ended December 31,
    2003                                             
|  
|or
|  
|o  |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|  
|   |  | For the transition period
    from           to                                             

Commission file number 000-02479

Dynamics Research Corporation

(Exact Name of Registrant as Specified in Its
Charter)


|                                                                                        |  |                                         
|--------------------------------------------------------------------------------------- |  | ----------------------------------------
|Massachusetts                                                                           |  | 04-2211809                              
|(State or other jurisdiction of
    incorporation or organization)                      |  | (I.R.S. Employer
    Identification No.)
|                                                                                       
|60 Frontage Road
    Andover, Massachusetts(Address of Principal Executive
    Offices) |  | 01810-5498(Zip Code)                    

Registrants telephone number, including
area code

(978) 475-9090


Securities registered pursuant to
Section 12(b) of the Act:

None


Securities registered pursuant to
Section 12(g) of the Act:


Common Stock, $0.10 par value


Indicate
by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been
subject to such filing requirements for the past
90 days.      Yes þ          No o

Indicate
by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein,
and will not be contained, to the best of registrants
knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or
any amendment to this
Form 10-K.      þ

Indicate
by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange
Act).      Yes þ          No o

The
aggregate market value of the registrants common stock,
$0.10 par value, held by nonaffiliates of the registrant as
of June 30, 2003, was $94,369,884.84 based on the reported
last sale price per share of $15.26 on that date on the Nasdaq
Stock Market. As of March 5, 2004, 8,562,496 shares of
the registrants common stock, $0.10 par value, were
outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions
of the registrants Proxy Statement involving the election
of directors, which is expected to be filed within 120 days
after the end of the registrants fiscal year, are
incorporated by reference in Part III of this Report.



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DYNAMICS RESEARCH CORPORATION

ANNUAL REPORT ON FORM 10-K FOR THE YEAR
ENDED DECEMBER 31, 2003

|                                          |      |                                                                                                        |  |  |    | 
|----------------------------------------- | ---- | ------------------------------------------------------------------------------------------------------ |  |  | -- | 
|                                          |      | Page                                                                                                  
|                                          |      |                                                                                                       
|Part I                                    |      |                                                                                                        |  | 
|                                          | Item |                                                                                                        |  |  |   
|                                          |      | 1.    Business                                                                                         |  |  | 3  | 
|                                          |      | 2.    Properties                                                                                       |  |  | 12 | 
|                                          |      | 3.    Legal
    Proceedings                                                                            |  |  | 12 | 
|                                          |      | 4.    Submission
    of Matters to a Vote of Security Holders Executive Officers of
    the Registrant |  |  | 13 | 
|Part II                                   |      |                                                                                                        |  | 
|                                          | Item |                                                                                                        |  |  |   
|                                          |      | 5.    Market
    for Registrants Common Equity and Related Stockholder
    Matters                    |  |  | 15 | 
|                                          |      | 6.    Selected
    Financial Data                                                                      |  |  | 15 | 
|                                          |      | 7.    Managements
    Discussion and Analysis of Financial Condition and Results of
    Operations    |  |  | 16 | 
|                                          |      | 7A.   Quantitative
    and Qualitative Disclosures About Market Risk                                   |  |  | 34 | 
|                                          |      | 8.    Financial
    Statements and Supplementary Data                                                  |  |  | 35 | 
|                                          |      | 9.    Changes
    In and Disagreements With Accountants on Accounting and
    Financial Disclosure     |  |  | 70 | 
|                                          |      | 9A.   Controls
    and Procedures                                                                      |  |  | 70 | 
|Part III                                  |      |                                                                                                        |  | 
|                                          | Item |                                                                                                        |  |  |   
|                                          |      | 10.   Directors
    and Executive Officers of the Registrant                                           |  |  | 72 | 
|                                          |      | 11.   Executive
    Compensation                                                                       |  |  | 72 | 
|                                          |      | 12.   Security
    Ownership of Certain Beneficial Owners and Management                               |  |  | 72 | 
|                                          |      | 13.   Certain
    Relationships and Related Transactions                                               |  |  | 73 | 
|                                          |      | 14.   Principal
    Accountant Fees and Services                                                       |  |  | 73 | 
|Part IV                                   |      |                                                                                                        |  | 
|                                          |      | 15.   Exhibits,
    Financial Statement Schedule and Reports on Form 8-K                               |  |  | 74 | 
|EX-10.21 SEVERENCE PLAN                  
|EX-10.22 2003 INCENTIVE PLAN             
|EX-10.23 THIRD AMENDMENT DATED 12-23-2003
|EX-16.1 KPMG LETTER                      
|EX-21.1 SUBSIDIARIES OF THE REGISTRANT   
|EX-23.1 CONSENT OF GRANT THORNTON LLP    
|EX-23.2 CONSENT OF KPMG LLP              
|EX-23.3 REPORT OF INDEPENDENT ACCOUNTANTS
|EX-31.1 CERTIFICATION OF CEO             
|EX-31.2 CERTIFICATION OF CFO             
|EX-32.1 CERTIFICATION OF CEO             
|EX-32.2 CERTIFICATION OF CFO             



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PART I






|        |         
|------- | --------
|Item 1. | BUSINESS

OVERVIEW

Dynamics Research Corporation (DRC or
the company) provides information technology,
engineering and other services focused on defense, public safety
and citizen services for federal, state and local governments.
Founded in 1955 and headquartered in Andover, Massachusetts, DRC
has approximately 1,700 employees, located throughout the United
States. The company operates through its parent corporation and
its wholly owned subsidiaries, HJ Ford Associates, Inc.
(HJ Ford) and Andrulis Corporation
(ANDRULIS).

DRCs core capabilities are focused on
information technology, engineering and technical subject matter
expertise, which pertain to the knowledge domains relevant to
the companys core customers. More specifically, these
capabilities include design, development, operation and
maintenance of information technology systems, engineering
services, complex logistics planning systems and services,
defense acquisition management services, simulation, modeling,
training systems and services, and custom built electronic test
equipment and services.

DRC strives to apply these processes and
technologies to enhance the performance and cost effectiveness
of a variety of mission-critical customer systems. DRC believes
that one of its distinguishing competitive features is its
ability to provide subject matter experts who work closely with
specialists in disciplines such as logistics, engineering,
information technology, modeling, simulation and training
systems to develop innovative solutions to customer challenges.

The companys business growth strategy is
focused on developing relationships with customers in the
defense, public safety and state citizen services markets whose
missions are focused on one or more of these six strategic
business areas: C4ISR (Command, control, communications,
computing, intelligence, surveillance and reconnaissance),
logistics, readiness, military space, citizen security and
citizen services. The strategy leverages seven solution sets
where DRC believes it has strong competencies and a record of
meeting its customers most difficult challenges. These
repeatable, proven, cost effective solutions are acquisition
management services; training systems and services; business
transformation; automated case management; network engineering
services; and logistics and decision support information systems.

DRC has a balanced organic and acquisition growth
strategy, supplementing organic growth with the acquisition of
businesses with additional or complementary capabilities,
providing access to new customers. Consistent with this
strategy, the company acquired two companies, HJ Ford and
ANDRULIS, in 2002.

On October 18, 2002, DRC announced that it
was actively pursuing the divestiture of its Encoder Division.
Effective in the fourth quarter of 2002, the company began
reporting the Encoder Division as a discontinued operation on a
restated basis. On May 2, 2003, DRC completed the sale of
the Encoder Division assets to GSI Lumonics (GSI)
for $3.3 million in cash subject to adjustment. GSI also
assumed specified liabilities. The companys remaining
precision manufacturing business, the Metrigraphics Division,
develops and produces components for original equipment
manufacturers in the computer peripheral device, medical
electronics, telecommunications and other industries.
Manufacturing core capabilities are focused on the custom design
and manufacture of miniature electronics parts that are designed
to meet ultra-high precision requirements through the use of
electroforming, thin film deposition and photolithography
technologies. Financial data and other information about the
companys operating segments can be found in
Managements Discussion and Analysis of Financial Condition
and Results of Operations in Part I, Item 7 of this Annual
Report on Form 10-K, and in Note 13, Business
Segment, Geographic, Major Customer and Related Party
Information, of the companys Notes to Consolidated
Financial Statements in Part II, Item 8 of this Annual
Report on Form 10-K.

Unless otherwise indicated, all financial
information contained in this Annual Report on Form 10-K
refers to continuing operations.

DRC maintains an Internet website at
http://www.drc.com. The companys Annual Report on
Form 10-K, Quarterly Reports on Form 10-Q and Current
Reports on Form 8-K and all amendments to these reports are
available free of charge through the companys website by
clicking on the Investor Relations page and
selecting SEC Filings. These filings are also
accessible on the Securities and Exchange Commissions
website at http://www.sec.gov. The company does not
intend that the information contained on the companys
website be deemed a part of this report or to be deemed filed
with the Securities and Exchange Commission.

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MARKETS

DRCs systems and services business, which
accounted for 97.2% of revenue in 2003, is focused on providing
technical, and information technology services to government
customers. The government market is composed of three sectors:
defense, federal civilian agencies, and state and local
governments.

According to Input, Inc. (Input), a
market research firm, federal spending on technical services and
information technology is projected to be $59.1 billion for
the fiscal year ended September 30, 2004, an increase of
3.5% over fiscal 2003 levels. Information released on
February 2, 2004, by the U.S. Office of Management and
Budget as part of the Presidents annual budget request
shows that federal agencies plan to spend $59.8 billion on
information technology in fiscal 2005.

The company believes that several factors are
driving growth in the defense sector of this market. First, the
increased spending on the war on terrorism and increased efforts
to sustain military readiness, maintain homeland security and
transform the United States military forces are expected to
focus on technology-based solutions. Second, the company
believes that increased reliance on contractors to supply
mission critical services is increasing due to government
workforce ceilings.

The company believes factors driving growth in
the federal civilian agency sector include homeland security
needs, an ongoing need for systems modernization, and as in the
defense sector, government workforce ceilings. These factors
have caused, and are expected to continue to cause, federal
civilian agencies to turn to contractors on an increasing basis
to fill their needs for information technology services.

In the state and local government sector, state
and local jurisdictions are expected to spend $42.3 billion
on information technology products and services in 2004 and
$44.7 billion in 2005, according to the market research
firm Gartner, Inc. DRC has considerable experience in providing
information technology expertise in the health and human
services areas. The company believes factors driving growth in
this sector are infrastructure modernization and expansion, the
migration of information and training to the Web, and
cost-sharing incentives to facilitate data exchange with federal
agencies, which generally have large and burdensome caseloads.
These agencies must maintain extensive records, report program
data, eliminate errors, and work towards a more responsive
management. Yet the information systems of many of these
agencies are antiquated and have limited data interfacing and
reporting capabilities.

DRCs precision manufacturing business
represented 2.8% of the companys revenue in 2003,
excluding the Encoder Division, which is reported as a
discontinued operation. The precision manufacturing business
serves the commercial original equipment manufacturers
(OEM) market. This market, which continued to
decline in 2003, includes manufacturers of computer peripheral
devices, telecommunications and medical technology equipment.
The precision manufacturing business sells exclusively to
commercial customers.

MAJOR CUSTOMERS

The companys 2003 revenue, delineated by
market sector, was derived 78.3% from the defense sector, 14.4%
from federal civilian agencies, 4.5% from state and local
governments, and 2.8% from commercial OEMs.

Defense Sector

United States Air Force customers constituted the
largest component of DRCs defense revenue in 2003,
representing 49.9% of total revenue, while U.S. Navy revenue
represented 17.5%, U.S. Army revenue represented 7.0% and other
agencies represented 3.9%. Key capabilities that DRC offers
defense customers include logistics systems, business
transformation services, program management services, modeling
and simulation, training products and systems, and software
development and maintenance. In addition, DRCs test
equipment business develops, maintains and validates hardware
and software for complex weapons systems. The work DRC performs
for its major customers in this sector is described below.

Air Force Electronic Systems
Center

The mission of the Air Force Electronic Systems
Center (ESC), headquartered at Hanscom Air Force
Base, Bedford, Massachusetts, is to serve as the Center of
Excellence for command and control and information systems to
support the Air Force warfighter in war and peace. ESC provides
full spectrum architectures, weapon systems management and
technical cognizance throughout the life cycle of
communications, intelligence, surveillance, reconnaissance and
information systems.

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DRC evaluates system requirements, provides
software development and test services, integrates products into
airborne and ground weapons systems, and provides management
services supporting ESC systems program offices, including the
Combat Air Forces Command and Control, Military Satellite
Communications, Joint Surveillance Target Attack Radar, Global
Command and Control, Airborne Warning and Control Systems and
Defense Information Infrastructure offices.

DRC is the prime support contractor to the Joint
Surveillance Target Attack Radar System (Joint
STARS) Program Office, which has played a key role in
warfare and peacekeeping operations. The surveillance system is
designed to detect, classify and track ground targets in all
weather conditions on land or at sea within a 155-mile range.
DRC supports Joint STARS by providing advisory, engineering,
logistics and program management services. Under this program,
DRC also supports the Multi-Sensor Command and Control Aircraft
System (MC2A), a next-generation airborne integrated
ground surveillance system that is intended to eventually
supercede Joint STARS.

Navy Trident Missile Program

For more than forty years, the company has
provided services to the United States Navys Strategic
Systems Program Office. DRC builds specialized equipment that
tests and validates the accuracy and operability of gyroscopes
and other navigational equipment for Trident II submarines and
missiles. DRC develops and maintains performance, reliability
and logistics databases for the inertial guidance instruments
housed in missile guidance systems and submarine inertial
guidance systems. The company also provides independent analysis
and monitoring of submarine-based inertial guidance systems and
electronic modules.

Air Force Depot Operations

DRC performs logistics analyses and operations
for the United States Air Forces three domestic Air
Logistics Centers at Tinker, Robins and Hill Air Force Bases in
Midwest City, Oklahoma, Warner Robins, Georgia and Ogden, Utah,
respectively. The company provides logistics support,
information technology management and analysis, system
engineering and technical services on programs such as the B-1B,
the B-2, the B-52, the KC-135, and the E-3A aircraft repair,
maintenance and upgrade programs. DRC has installed, integrated
and is providing operational support for a customized suite of
commercial software products to improve productivity at the
United States Air Forces landing gear maintenance, repair
and overhaul operations at Hill Air Force Base. The company also
provides support to Air Force reengineering and business process
improvement initiatives at these Air Logistics Centers.

In 2003, DRC was one of three companies selected
as a prime contractor to support the Naval Air Systems Command
(NAVAIR) located at Patuxent River, Maryland, on a
new joint U.S. Navy-Air Force information technology program.
This contract supports the NAVAIR Industrial Operations
Competency, all Naval Aviation Depots, the Air Force Materiel
Command, Air Force Air Logistics Centers and the Joint DoD
Manufacturing Resource Planning (MRPII) Program
Office. DRCs role includes the delivery of acquisition
management, contract planning, program management, systems
engineering and risk management services as well as the
performance of advanced concepts and optimization studies. The
company believes this opportunity positions DRC to significantly
expand its business with the Naval Aviation Depots and Air
Forces Air Logistics Centers by providing a wide range of
enterprise and business structure expertise critical to the
implementation of Maintenance, Overhaul and Repair
(MRO) solutions tailored to each of the
services MRP II programs.

Aeronautical Systems Center, Air Force
Materiel Command

The Aeronautical Systems Center, headquartered at
Wright-Patterson Air Force Base in Dayton, Ohio, is responsible
for research, development, test, evaluation and initial
acquisition of aeronautical systems and related equipment for
the Air Force. Its major active programs are the B-2 and B-1B
bombers, C-17 airlifter, Unmanned Combat Air Vehicle and F/ A-22
Raptor. There is also continuing work on the F-117A fighter,
F-15 Eagle and F-16 Fighting Falcon. Through prime contracts
held by the companys HJ Ford subsidiary, DRC provides
technical and subject matter expertise supporting a number of
the offices responsible for these programs in carrying out their
mission-essential tasks and objectives such as product support,
information service, supply management, depot maintenance,
science and technology, test and evaluation, information
management, installations and support, and combat support.

In 2002, DRC was awarded prime contracts as the
lead integrator providing F/ A-22 and Unmanned Combat Air
Vehicle Systems Program Offices acquisition logistics, systems
engineering and other program management services. The F/ A-22
Raptor, currently in low rate of initial production, is widely
regarded as the most advanced fighter in the world. The Unmanned
Combat Aerial Vehicle contract award will support ongoing
program management activities related to the migration

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of the previously unarmed Unmanned Aerial
Vehicles to an expanded role as a weapons platform. The task
orders covering this work were renewed in 2003.


Army Aviation/ Missile
Command

DRC provides programmatic consulting, engineering
and logistics management to the Army Materiel Command and Army
program executive officers for acquisition of major weapon
systems. DRC engineers analyze and review airframe, avionics,
aeromechanics and propulsion issues for Army project managers,
provide logistics and fielding support, and prepare electronic
technical manuals for rotary and fixed-wing aircraft systems.
DRC supports other United States Army activities with
acquisition logistics, systems engineering and other related
program management services for the United States Army Aviation
Center, Tank-Automotive and Armaments Command and
Communications-Electronics Command.

Army Training

In 2003, DRC was selected, as part of the
Boeing-SAIC Lead System Integrator (LSI) team, under
a new seven-year blanket purchase order, to provide training
software and documentation to support the U.S. Armys
Future Combat Systems (FCS) program. DRC is
developing training support packages for this vital
transformation program. Services to be provided include analysis
of training requirements and design, media selection and
production of training support products. The work is performed
in Orlando, Florida and Andover, Massachusetts. The company
believes that the award of this contract reflects recognition of
DRCs proven instructional system development and track
record of developing training support packages.

Air Force Air Mobility
Command

The Air Mobility Command, headquartered at Scott
Air Force Base in Belleville, Illinois, has as its primary
mission rapid, global mobility and sustainment for
Americas armed forces. The Command also plays an important
role in providing humanitarian support in the United States and
around the world. DRC provides technical and subject matter
expertise in support of this mission, providing program
planning, decision support, logistics analysis and financial
analysis services.

Air National Guard

Through its work on the Guard Information
Analysis Network (GUARDIAN), DRC is playing a key
role in the transformation of the Air National Guard and its
preparedness for homeland defense. Initially created by DRC as a
web-enabled database, GUARDIAN is intended to fulfill a critical
need for real-time information on aircraft readiness and
performance information. In late 2002, DRCs work on
GUARDIAN was extended with a $3.5 million contract award
for the first year of a proposed six-year, $37 million
effort to support Air National Guard offices in Virginia and
Maryland. DRC is now working to expand GUARDIANs
functionality so it can be used to determine and forecast
manpower resources and munitions readiness. The system is also
being converted so it is compatible with the Global Combat
Support System (GCSS) architecture for eventual
migration to the Air Force and other branches of the service.

Office of Naval Research

DRC provides engineering and information
technology services to the Office of Naval Researchs Navy
Manufacturing Technology Program, known as MANTECH. This is a
contract to continue supporting MANTECH, as well as a related
program known as Lean Pathways and the Office of the Secretary
of Defenses own MANTECH initiative. MANTECHs mission
is to drive down costs for Navy weapons systems through the
development of and transition to advanced manufacturing
technology. DRC provides support in the annual strategic
planning process, as well as project tracking and benefits
analysis. For Lean Pathways, DRC provides a transformation
process to eliminate waste and drive enterprise-wide
improvements at small and medium-sized suppliers. It supports
programs designed to improve value chain performance and weapon
systems affordability.

Missile Defense Agency

The Missile Defense Agency is chartered with
developing the future space-based missile defense capabilities.
DRC currently provides research on manufacturability and
research services to this client, under multi-year contracts.

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Air Force Materiel Support
Group

The Weapon Systems Management Information System,
a key decision-support tool for assessing the impacts of
maintenance, parts and repair status on weapons systems
availability, is the responsibility of the Materiel Support
Group (MSG). DRC provides operations, maintenance
and development support services to MSG for this system.

Naval Aviation Systems
Command

In 2000, DRC was awarded a five-year subcontract
to provide engineering and information services to the United
States Naval Aviation Systems Command Logistics Competency
(NAVAIR). DRC is a primary subcontractor to Lockheed
Martin Systems Integration-Owego in assisting NAVAIR in the
modernization of naval aviation logistics information management
systems.

Modeling, Simulation and Decision Support
Programs

DRC applies its capabilities in the area of
modeling and simulation on many engagements, including projects
for the United States Joint Forces Command, the Defense Modeling
and Simulation Office, the Naval Aviation Warfare Center and the
Chief of Naval Education and Training.

The United States Joint Forces Command Joint
Warfighting Center orchestrates military training exercises in
various world theaters. These war games entail major geographic
and functional commands, and thousands of troops, as well as the
supplies, vehicles and equipment to support them. Such exercises
require top-level coordination to maximize effectiveness and
avoid schedule and resource conflicts. DRC developed and is now
enhancing the Joint Training Information Management System
(JTIMS), a web-based application that lets
authorized personnel collaboratively plan and execute war games.
The system is designed to enable combatant commands, joint
organizations and defense agencies to align training with
assigned missions, and helps ensure missions are consistent with
organizational priorities.

DRC also has developed an analytical tool for the
Chief of Naval Education and Training designed to simulate the
training pipeline and help the Navy predict demand for various
training programs. The system has been designed to help the Navy
ascertain the costs and risks of potential changes to training
programs before they are made.

The United States Naval Aviation Warfare
Centers Training Systems Division develops instructional
programs for Navy pilots and maintenance personnel. After
identifying aviation readiness as an area of concern, the Navy
established a program to improve aviator training. DRC has
completed the first phase of this program, by analyzing course
content and recommending which material is best taught in the
classroom, through self-study programs, at simulators or in
flight for an initial set of aircraft. The next phase of this
program will involve extending the analysis to additional
aircraft. DRC engineers and training specialists are also
working to deconstruct and categorize flight mission tasks. This
information will be used to design flight simulators intended to
provide relevant, cost-effective training and accurate
performance measures.

Federal Civilian Agency Sector

The company believes that the United States
Government federal civilian agencies present an important growth
market for DRC. Growth in spending in this sector is being
driven by the threat of domestic terrorism, as well as a high
need for modernization. The creation of the Department of
Homeland Security (DHS), from the consolidation of
22 agencies, has created both opportunities as well as funding
delays. During 2003, funding on many DHS programs was delayed
due to reorganization issues. Once completed, programs will
focus on ensuring the safety and security of the US and its
citizens.

Civilian agencies must also prepare for potential
changes in their workforces. According to industry analysts,
approximately half of all federal employees engaged in program
management are estimated to be eligible for retirement over the
next four years. With its core capabilities in the design,
development, acquisition, deployment and support of high
technology systems, DRC believes it is well positioned to
attract new customers in this sector. The companys major
customer engagements in this sector are described below.

Internal Revenue Service

The Internal Revenue Service (IRS) is
DRCs largest customer in the federal civilian agency
sector. DRC is a significant contractor to the IRS, having been
awarded contracts to date with revenue which could potentially
exceed $65 million over the expected contract period of
2000 to 2005. In July 2000, DRC signed a five-year contract with
the IRS to provide technical and management services in four
task areas: telecommunications, information services,
organizational

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management and operational support. In 2001, DRC
was the recipient of a five-year information system contract
worth $20 million to $36 million to support the
IRSs Dallas-based Mid-America Development Center.
Currently, DRCs efforts focus on two major projects: the
Compliance Research Information System (CRIS), a
tool that helps IRS statisticians detect deviances that indicate
potential tax fraud; and the Integrated Collection System
(ICS), a tool for more timely, accurate and
productive tax collection. DRC is helping convert CRIS to a
web-based platform, giving hundreds of IRS statisticians access
to the latest version regardless of location or computer
configuration. DRC is also assisting with data warehousing, data
mining and expanding the system for more users. On the ICS
project, DRC is helping the IRS migrate from a legacy system to
a Windows NT environment, which will allow agents responsible
for apprehending tax evaders to access ICS, Microsoft Office and
e-mail from laptops while they are out in the field.


National Emergency Disaster Information
Center

Working under the auspices of the National Guard,
DRC built a data repository of best practices in a logical
decision tree structure that the first responder can call up on
a hand-held device. This program was in response to the National
Emergency Disaster Information Center, mandated by Congress in
2002, to provide emergency personnel, those who are often the
first to respond to an accident or disaster, with an on-the-spot
knowledge bank to help them follow best practices when making
rapid life-or-death decisions in emergencies they may not have
encountered before. This program is the first step in developing
a system for assisting the National Guard in responding most
effectively to national disasters, including those involving
weapons of mass destruction. The concept includes an information
center whose staff will also use the database and support the
first responders by anticipating what is needed next, such as
alerting nearby hospitals or summoning firefighters from a
neighboring county. The company completed its work on this
project in January 2004.

United States Customs Service Air and
Marine Interdiction Division

The United States Customs Service National
Aviation Center in Oklahoma City, Oklahoma trains pilots and
other flight personnel for aerial border surveillance. DRC has
assisted agency flight experts to plan standardized training
systems and develop courseware. Manuals and other paper
curriculum materials were converted to a computer-based system
and integrated into an overall instructional framework. DRC now
creates electronic training materials for use in classrooms, on
stand-alone computers, over the agencys local area
network, and via a secure web site for distance learning.

State and Local Government Sector

DRC designs, develops, implements, maintains and
supports software, networks and systems for state health and
human services agencies and local users of these statewide
systems. Demand for information technology services in this
sector has been weak over the past year due to state budget
deficits. As a result, during 2003, DRCs revenue in this
sector declined approximately $2 million from the 2002
level. The company remains profitable in this sector, and
believes it is in a position to expand its presence in this
market when conditions improve. A description of DRCs
major customer engagements in this sector follows.

State of Colorado

DRC has worked with and for the State of Colorado
since 1997. DRCs original Colorado effort was to develop
an integrated statewide child welfare and youth corrections
system, known as the Colorado Trails application
(Trails). The Trails application streamlines
workload management for social workers, youth corrections
officers and administrators and includes tools for determining
and managing such functions as client eligibility, court
appearances, residential facilities, finance, administration and
automatic payment generation through the states financial
processing system. DRC developed and deployed the software along
with installing a statewide network of 3,000 computers at 130
sites. DRC continues to support this application with database
and host server maintenance and support.

DRC provides network management and support for
the Colorado Department of Human Services network, now expanded
by DRC to cover 6,300 state and county workers using various
state applications and services. In 2003, DRC converted this
network to a web portal design, now providing users with secure
and customizable intranet and Internet browser-based access to
state legacy, client server and web-based applications and
services.

DRC also is performing as a key subcontracting
team member to Electronic Data Systems (EDS) for the
State of Colorado on the Colorado Benefits Management System
(CBMS) project to deploy an integrated, statewide
eligibility system that replaces six existing legacy systems.
DRCs primary responsibilities on this project include the
development and

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deployment of traditional classroom training,
online help and training tools, application implementation and
deployment management and support, and ongoing helpdesk services.


The DRC Colorado Training Team developed the DRC
Electronic Performance Support System (EPSS) for
both the Trails and CBMS applications. EPSS is an online support
toolset designed to provide just enough,
just-in-time help in use of an application. The DRC
EPSS combines traditional classroom training with electronic
support tools that facilitate continued user familiarity and
support in the use of an application. The Trails EPSS tool won
First Place and Best In Show for its online instruction and
computer-based training capability in national and international
competitions held by the Society of Technical Communications.
The DRC Colorado Training Team continues to develop EPSS for
both state and commercial customers.

New Hampshire Department of Health and
Human Services

DRC has developed and implemented the New
Hampshire statewide child welfare information system. Currently,
the company provides support, maintenance and enhancement
services related to this system.

DRCs CAPABILITIES

Systems and Services

The core capabilities of DRCs systems and
services business are focused on information technology,
engineering and technical services, applying subject matter
expertise relevant to the missions of the companys core
customers. These include the design, development, operation and
maintenance of information technology systems, acquisition and
program support, engineering services, complex logistics
planning systems and services, defense acquisition management
services, modeling, simulation, training systems and services
and custom built electronic test equipment and services. These
capabilities are described below.

Defense Acquisition Management
Services

DRCs Defense Program Management Services
capabilities include technology, planning and acquisition,
system engineering, logistics systems planning, decision
support, financial and administrative services.

Engineering Services

DRCs engineering services capabilities
include engineering analysis applied to electronic,
communication, aeronautical, naval and navigation systems,
reverse engineering of electronic components, precision
component design, maintenance and support of navigation and
guidance systems, human factors integration and business process
reengineering.

Logistics

Logistics capabilities DRC offers include
logistics analysis and support, supply chain analysis and
management, development of decision support systems, and
configuration of maintenance, repair and overhaul systems.

Information Technology

Information technology capabilities offered by
DRC include systems integration, applications development,
engineering of multi-level information system security, legacy
system data migration, development of decision support systems,
integration of commercial off-the-shelf software, network
infrastructure design and maintenance, technical management
services and consulting, and independent verification and
validation services.

Modeling and Simulation

DRCs modeling and simulation capabilities
include simulation of discrete and ongoing events,
simulation-based reengineering, logistics and supply chain
modeling, object-oriented modeling techniques and simulation
support services.

Training Systems and Services

DRCs training analysis and delivery
capabilities include training task analysis, development of
computer-based training programs and training delivery systems
and electronic performance support systems.

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Precision Manufacturing

DRCs Metrigraphics Divisions
expertise centers on photolithography, thin film deposition of
metals and dielectrics, and electroforming. The company believes
that Metrigraphics superior ability to design and
manufacture components and maintain critical tolerances is an
important driver for a wide range of high-technology
applications. The company currently applies these technologies
in four distinct applications: (1) inkjet printer cartridge
nozzle plates and hard drive test devices; (2) medical
applications for micro-flex circuits used in angioplasty and for
blood testing; (3) electrical test device for application
in flexible interposers and 3-D microstructures; and
(4) devices used in the manufacture of fiber optic system
components requiring precision alignment and 3-D microstructures.

BUSINESS DEVELOPMENT

The company believes it has a well-established
record of winning contract renewals and re-competitions based on
the companys line management knowledge of customer needs
and DRCs incumbent expertise. In 2001 the company
increased its level of expenditures and investment in business
development activities by approximately 50%, intended to
stimulate sustained organic growth.

The companys business development group is
charged with identifying and winning significant new business
opportunities and supporting major competitions related to
existing customers and business. The group is centrally managed,
with resources aligned to strategic business areas and
opportunities. The group also maintains a proposal development
and publication capability. The group operates with formal
processes that monitor the pipeline of opportunities, align
resources to significant opportunities and engage line and
executive management.

GOVERNMENT CONTRACTS

The federal procurement process has changed
significantly in recent years. Whereas the traditional method of
federal government procurement had been to conduct a lengthy
competitive bidding process for each award, today blanket
purchase agreements, indefinite delivery and indefinite quantity
contracts, the General Services Administration contract and
other government-wide acquisition contract vehicles, referred to
as GWACS, are the predominant forms of contracting for
information technology and technical services. These vehicles
have enabled contracting officers to accelerate the pace of
awards.

The companys government contracts fall into
one of three categories: (1) fixed-price, including
service-type contracts, (2) time and materials, and
(3) cost reimbursable. Under a fixed-price contract, the
government pays an agreed upon price for the companys
services or products, and the company bears the risk that
increased or unexpected costs may reduce its profits or cause it
to incur a loss. Conversely, to the extent the company incurs
actual costs below anticipated costs on these contracts, the
company could realize greater profits. Under a time and
materials contract, the government pays the company a fixed
hourly rate intended to cover salary costs and related indirect
expenses plus a profit margin. Under a cost reimbursable
contract, the government reimburses the company for its
allowable direct expenses and allowable and allocable indirect
costs and pays a negotiated fee.

The companys state contracts are generally
either fixed-price, including service-type contracts, or time
and materials. In certain instances, funding for these contracts
is subject to annual state legislative approval and to
termination provisions.

DRCs contracts with the United States
government and state customers generally are subject to
termination at the convenience of the United States Government
or the state. However, in the event that a United States
Government or state contract is terminated by the respective
government, the company would be reimbursed for its allowable
costs up to the time of termination and would be paid a
proportionate amount of the stipulated profit attributable to
the work actually performed. Although United States Government
or state contracts may extend for several years, they are
generally funded on an annual basis and are subject to reduction
or cancellation in the event of changes in United States
government or state requirements, appropriations failures or
budgetary concerns. If the United States Government or state
curtails expenditures for research, development and consulting
activities, such curtailment could have a material adverse
impact on the companys revenue and earnings.

BACKLOG

The companys funded backlog was
$123.9 million at December 31, 2003,
$111.1 million at December 31, 2002 and
$90.4 million at December 31, 2001. The company
expects that substantially all of its backlog at
December 31, 2003 will generate revenue during the year
ending December 31, 2004. The funded backlog generally is
subject to possible termination at the convenience of the
contracting counter party. The company has a number of
multi-year contracts with agencies of the

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United States and state governments for which
actual funding generally occurs on an annual basis. A portion of
its funded backlog is based on annual purchase contracts and
subject to annual governmental approval or appropriations
legislation, and the amount of funded backlog as of any date can
be affected by the timing of order receipts and deliveries.


COMPETITION

The companys systems and services business
competes with a large number of public and privately-held firms,
which specialize in providing government information technology
services.

The company also competes with the government
services divisions of large commercial information technology
service firms and with government information technology service
divisions of large defense weapons systems producers. The
competition varies depending on the customer, geographic market
and required capabilities. The United States Governments
in-house capabilities are also, in effect, competitors, because
various agencies are able to perform services, which might
otherwise be performed by the company. The principal competitive
factors for systems and services are past performance, technical
competence and price.

In the precision manufacturing business, the
company competes with other manufacturers of electroform vendors
and suppliers of precision management discs, scales and
reticles. The principal competitive factors affecting the
precision manufacturing business are price, product quality and
custom engineering to meet customers system requirements.

RESEARCH AND DEVELOPMENT

The company did not incur any research and
development costs during 2003. Exclusive of discontinued
operations, the company expended $0.2 million, including
overhead and indirect costs, on research and development related
to web-based capabilities during 2002. Research and development
expenditures in 2001 of $0.4 million primarily relate to
the development of MedTeams training products.

GOVERNMENT REGULATION

Compliance with federal, state and local
provisions relating to the protection of the environment has not
had and is not expected to have a material effect upon the
capital expenditures, earnings or competitive position of the
company.

As a defense contractor, the company is subject
to many levels of audit and review, including by the Defense
Contract Audit Agency, various inspectors general, the Defense
Criminal Investigative Service, the General Accounting Office,
the Department of Justice and Congressional committees. These
audits and reviews could result in the termination of contracts,
the imposition of fines or penalties, the withholding of
payments due to us or the prohibition from participating in
certain United States Government contracts for a specified
period of time. Any such action could have a material adverse
effect on our business, financial condition, results of
operations and cash flows.

Governmental awards of contracts are subject to
regulations and procedures that permit formal bidding procedures
and protests by losing bidders. Such protests may result in
significant delays in the commencement of expected contracts,
the reversal of a previous award or the reopening of the
competitive bidding process, which could have a material adverse
effect upon the companys business, financial condition,
results of operations and cash flows.

The United States Government has the right to
terminate contracts for convenience. If the Government were to
terminate contracts, the company would generally recover costs
incurred up to termination, costs required to be incurred in
connection with the termination and a portion of the fee earned
commensurate with the work performed to termination. However,
significant adverse effects on the companys indirect cost
pools may not be recoverable in connection with a termination
for convenience. Contracts with state and other governmental
entities are subject to the same or similar risks.

EMPLOYEES

At December 31, 2003, the company had 1,714
employees. The company considers its relationship with its
employees to be satisfactory.

PROPRIETARY INFORMATION

Patents, trademarks and copyrights are not
materially important to the companys business. The United
States Government has certain proprietary rights in processes
and data developed by the company in its performance of
government contracts.

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|        |           
|------- | ----------
|Item 2. | PROPERTIES

The company leases approximately 285,000 square
feet of office and manufacturing space. This space is used for
its federal and state government services and manufacturing
operations as well as its marketing and engineering offices. The
company has 113,000 square feet of manufacturing and office
space in three Wilmington, Massachusetts facilities. The
companys Metrigraphics segment utilizes a portion of this
space for its activities. The Wilmington leases expire in 2005,
with options to renew the leases to the year 2010. The remaining
leased facilities consist of offices in 27 locations across the
United States. The company owns a 135,000 square foot facility
in Andover, Massachusetts, which serves as its corporate
headquarters. The company has a mortgage, collateralized by this
facility, with an outstanding balance of $8.3 million at
December 31, 2003. The remaining facilities, as well as a
portion of the corporate headquarters building, are used by the
companys Systems and Services segment. With the exception
of approximately 50,000 square feet of leased manufacturing
space previously occupied by the divested Encoder Division, the
companys leased space is fully utilized in all material
respects. The company believes that its owned and leased
properties are adequate for its present needs.






|        |                  
|------- | -----------------
|Item 3. | LEGAL PROCEEDINGS

As a defense contractor, the company is subject
to many levels of audit and review from various government
agencies, including the Defense Contract Audit Agency, various
inspectors general, the Defense Criminal Investigative Service,
the General Accounting Office, the Department of Justice and
congressional committees. Both related to and unrelated to its
defense industry involvement, the company is, from time to time,
involved in audits, lawsuits, claims, administrative proceedings
and investigations. The company accrues for liabilities
associated with these activities when it becomes probable that
future expenditures will be made and such expenditures can be
reasonably estimated. The companys evaluation of the
likelihood of expenditures related to these matters is subject
to change in future periods, depending on then current events
and circumstances, which could have material adverse effects on
the companys financial position, results of operations and
cash flows.

As previously disclosed, on October 26,
2000, two former company employees were indicted and charged
with, among other violations, wire fraud and a conspiracy scheme
to defraud the United States Air Force out of approximately
$10 million through kickbacks and overcharging for computer
components and services. The former employees collected the
kickbacks and overcharges through separate and independent
businesses. The company received no money from their scheme.
When notified by the government of the employees
conspiracy, the company fired the two employees and voluntarily
cooperated with the governments investigation. The company
was not charged in the criminal case. Both former employees pled
guilty and were sentenced to prison. The company believes that
the government has recovered a substantial portion of the
defrauded funds from the co-conspirators. Notwithstanding the
companys efforts to settle any claims against the company
arising from the employees scheme, on October 9, 2003
the United States Attorney filed a civil complaint against the
company in the United States District Court for the District of
Massachusetts based in substantial part upon the actions and
omissions of the former employees which gave rise to the
criminal cases against them. In the civil action, the United
States Attorney is asserting on behalf of the government claims
against the company based upon the False Claims Act and the
Anti-Kickback Act, in addition to certain common law and
equitable claims. The United States Attorney seeks to recover up
to three times its actual damages and penalties under the False
Claims Act and double damages and penalties under the
Anti-Kickback Act and to recover costs and interest. The company
disputes the claims, believes it has substantive defenses, and
intends to vigorously defend itself. However, the outcome of
such litigation, if unfavorable, could have a material adverse
effect on the companys financial position, results of
operations and cash flows. The company has filed a third party
complaint, including an affirmative multiple damage claim for
unfair and deceptive practices, as part of the United States
Attorneys civil action, against Storage Engine, Inc.
(Storage Engine), formerly known as ECCS, Inc., and
its president and director. The complaint alleges that Storage
Engine directly benefited from the kickback scheme alleged by
the United States Attorney. Storage Engine, a supplier of
computer components for the Air Force, made payments to the
companys two former employees through separate and
independent businesses. Storage Engine and its president deny
the allegations.

On September 5, 2002, Genesis Tactical Group
LLC (Genesis) asserted a cross-claim against
Lockheed Martin Corporation (Lockheed) in the State
of New York Supreme Court, County of Onondaga seeking
$50.0 million in damages and against the company seeking
$35.0 million in damages. These cross-claims arise out of a
suit filed on July 30, 2002 by Lockheed against Tactical
Communications Group LLC, Genesis and the company in the State
of New York Supreme Court, County of Onondaga. The Lockheed
suit relates to a contract for services that was sold to Genesis
by the company pursuant to an asset purchase agreement in 2001.
By the terms of the asset purchase agreement, the companys
liability to Genesis is limited to $300,000, other than for
intentional misrepresentation, willful breach or fraud. Lockheed
and Genesis have settled their outstanding issues, including a
software ownership issue, and filed a stipulation of dismissal
with prejudice. The

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Genesis claim for $35.0 million against the
company was related to the software ownership issue that was
settled in favor of Genesis. Lockheeds settlement demand
to the company was $495,679 plus interest. The company believes
that $311,679 of the demanded amount is for extra work and
materials procured by Lockheed from Genesis and disputes the
balance due to other mutually agreed contract changes between
Lockheed and Genesis. The company will continue to defend
against any and all claims by Lockheed and/or Genesis. While the
company believes that the possibility of a material adverse
effect on the companys financial position, results of
operations and cash flows is remote, there can be no assurance
as to the outcome.


The company has provided documents in response to
a previously disclosed grand jury subpoena issued on
October 15, 2002 by the United States District Court for
the District of Massachusetts directing the company to produce
specified documents dating back to 1996. The subpoena relates to
an investigation, currently focused on the period from 1996 to
1999, by the Antitrust Division of the Department of Justice
into bidding and procurement activities involving the company
and several other defense contractors who have received similar
subpoenas and may also be subjects of the investigation.
Although the company is cooperating in the investigation, it
does not have a sufficient basis to predict the outcome of the
investigation. Should the company be found to have violated the
antitrust laws, the matter could have a material adverse effect
on the companys financial position, results of operations
and cash flows.






|        |                                                        
|------- | -------------------------------------------------------
|Item 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY
    HOLDERS

During the quarter ended December 31, 2003,
no matters were submitted to a vote of security holders through
the solicitation of proxies or otherwise.

Executive Officers of the Registrant

The following is a list of the names and ages of
the executive officers of the company, all positions and offices
held by each person and each persons principal occupations
or employment during the past five years. The officers were
elected by the Board of Directors and will hold office until the
next annual election of officers and their successors are
elected and qualified, or until their earlier resignation or
removal by the Board of Directors. There are no family
relationships between any executive officers and directors.

|                  |                                                         |     |    |  | 
|----------------- | ------------------------------------------------------- | --- | -- |  | 
|Name and Position |                                                         | Age
|                  |                                                         |    
|James P. Regan    |                                                         |     | 63 | 
|                  | Chairman and Chief Executive Officer                    |     |    |  | 
|William C. Hoover |                                                         |     | 54 | 
|                  | President and Chief Operating Officer                   |     |    |  | 
|Richard A. Covel  |                                                         |     | 57 | 
|                  | Vice President, General Counsel and Clerk               |     |    |  | 
|David Keleher     |                                                         |     | 54 | 
|                  | Vice President and Chief Financial Officer              |     |    |  | 
|John L. Wilkinson |                                                         |     | 64 | 
|                  | Vice President and General Manager,
    Human Resources |     |    |  | 

Mr. Regan joined the company in 1999 as
President, Chief Executive Officer and Director. He was elected
Chairman in April 2001. Prior to that, he was President and
Chief Executive Officer of CVSI, Inc. from 1997 to October 1999
and served as Senior Vice President of Litton PRC from 1992
to 1996.

Mr. Hoover joined the company in April 2003
as President and Chief Operating Officer. Prior to joining DRC,
Mr. Hoover was President and Chief Executive Officer of
Aquiline Partners, Inc. from October 2001 to April 2003. Prior
to that, he served as President of FutureNext, Senior Vice
President at Oracle Services Industries, President of
WCH Enterprises, Executive Vice President at
BDM International and President and Chief Operating Officer
of PRC, Inc.

Mr. Covel joined the company as Vice
President and General Counsel in December 2000. Prior to that,
he was General Counsel, Patent Counsel and Clerk at
Foster-Miller, Inc. from 1985 to 2000.

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Mr. Keleher joined the company as Vice
President and Chief Financial Officer in January 2000. Prior to
that, he was employed by Raytheon Company as Group Controller
for the Commercial Electronics Division in 1999 and Assistant
Corporate Controller in 1998. Prior to that, he served in
several senior management positions in corporate finance and
operations at Digital Equipment Corporation from 1981 to 1997.

Mr. Wilkinson has served in his position
since 1981.

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##### Table of Contents






PART II






|        |                                                                          
|------- | -------------------------------------------------------------------------
|Item 5. | MARKET FOR REGISTRANTS COMMON EQUITY AND
    RELATED STOCKHOLDER MATTERS

The companys common stock is traded on the
Nasdaq National Market under the symbol DRCO. The
following table sets forth, for the periods indicated, the high
and low sale prices per share of the companys common
stock, as reported by the Nasdaq National Market. These market
quotations reflect inter-dealer prices, without retail mark-up,
mark-down or commission and may not necessarily represent actual
transactions.

|                                    |                |      |   |       |  |  |   |       | 
|----------------------------------- | -------------- | ---- | - | ----- |  |  | - | ----- | 
|                                    |                | High |   | Low  
|                                    |                |      |   |      
|Fiscal year ended December 31, 2003 |                |      |   |       |  |  |   |      
|                                    | First quarter  |      | $ | 14.90 |  |  | $ | 9.70  | 
|                                    | Second quarter |      | $ | 16.16 |  |  | $ | 9.33  | 
|                                    | Third quarter  |      | $ | 19.21 |  |  | $ | 15.20 | 
|                                    | Fourth quarter |      | $ | 19.50 |  |  | $ | 15.22 | 
|                                   
|Fiscal year ended December 31, 2002 |                |      |   |       |  |  |   |      
|                                    | First quarter  |      | $ | 25.26 |  |  | $ | 15.81 | 
|                                    | Second quarter |      | $ | 25.30 |  |  | $ | 19.30 | 
|                                    | Third quarter  |      | $ | 24.48 |  |  | $ | 13.89 | 
|                                    | Fourth quarter |      | $ | 15.85 |  |  | $ | 9.13  | 

Number of Holders

As of March 9, 2004, there were
691 holders of record of the companys common stock.

Dividend Policy

In September 1984, the companys Board of
Directors voted not to declare cash dividends to preserve cash
for the future growth and development of the company. The
company did not declare any cash dividends between 1984 and 2003
and does not intend to in the near future. In addition, the
companys financing arrangements restrict the
companys ability to pay dividends, as described in
Liquidity and Capital Resources in Part II, Item 7 of
this Annual Report on Form 10-K and in Note 7,
Financing Arrangements, of the companys Notes
to Consolidated Financial Statements in Part II,
Item 8 of this Annual Report on Form 10-K.






|        |                        
|------- | -----------------------
|Item 6. | SELECTED FINANCIAL DATA

The selected condensed consolidated financial
data set forth below is derived from the audited consolidated
financial statements of the company for the years ended
December 31, 2003, 2002, 2001 and 2000, and as of
December 31, 2003, 2002 and 2001, and the unaudited
restated consolidated financial statements of the company for
the year ended December 31, 1999 and as of
December 31, 2000 and 1999. On December 20, 2002 and
May 31, 2002, the company acquired Andrulis Corporation and
HJ Ford Associates, Inc., respectively. The results of
these acquired entities are included in the companys
historical results for the periods subsequent to their
respective acquisitions. On October 18, 2002, the company
announced that it was actively pursuing the divestiture of its
Encoder Division (previously reported as a segment). For all
periods, presented, the results of the Encoder Division have
been accounted for within discontinued operations as a result of
the decision to exit the business in 2002. This information
should be read in conjunction with Managements
Discussion and Analysis of Financial Condition and Results of
Operations included as Part II, Item 7 of this
Annual Report

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on Form 10-K, and the consolidated financial
statements and note thereto of the company included in
Part II Item 8 of this Annual Report on
Form 10-K. The historical results provided below are not
necessarily indicative of future results.


|                                                                      |                                                    |                                           |         |       |       |      |         |       |       |             |         |       |       |   |         |      |       |   |         |       |        |  
|--------------------------------------------------------------------- | -------------------------------------------------- | ----------------------------------------- | ------- | ----- | ----- | ---- | ------- | ----- | ----- | ----------- | ------- | ----- | ----- | - | ------- | ---- | ----- | - | ------- | ----- | ------ | -
|                                                                      |                                                    |                                          
|                                                                      |                                                    | Year ended December 31,                  
|                                                                      |                                                    |                                          
|                                                                      |                                                    | 2003                                      |         | 2002  |       | 2001 |         | 2000  |       | 1999       
|                                                                      |                                                    |                                           |         |       |       |      |         |       |       |            
|(in thousands, except share and per share data)                       |                                                    |                                           |         |       |       |      |         |       |       | (unaudited)
|Revenue                                                               |                                                    | $                                         | 244,808 |       |       | $    | 192,610 |       |       | $           | 190,264 |       |       | $ | 182,527 |      |       | $ | 178,407 |      
|Operating income (loss)                                               |                                                    | $                                         | 15,389  |       |       | $    | 12,647  |       |       | $           | 13,010  |       |       | $ | 6,584   |      |       | $ | (10,593 | )    
|Income (loss) from continuing operations                              |                                                    | $                                         | 8,655   |       |       | $    | 7,357   |       |       | $           | 7,102   |       |       | $ | 2,808   |      |       | $ | (8,376  | )    
|Income (loss) from discontinued operations                            |                                                    |                                           | (1,635  | )     |       |      | (1,124  | )     |       |             | (619    | )     |       |   | 1,545   |      |       |   | (512    | )    
|Gain (loss) on disposal of discontinued operations                    |                                                    |                                           | (348    | )     |       |      |        |       |       |             | 62      |       |       |   | 206     |      |       |   | 1,362   |      
|                                                                      |                                                    |                                           |         |       |       |      |         |       |       |             |         |       |       |   |         |      |       |   |         |      
|                                                                      |                                                    | Net income (loss)                         |         | $     | 6,672 |      |         | $     | 6,233 |             |         | $     | 6,545 |   |         | $    | 4,559 |   |         | $     | (7,526 | )
|                                                                      |                                                    |                                           |         |       |       |      |         |       |       |             |         |       |       |   |         |      |       |   |         |      
|Earnings (loss) per share  basic                                     |                                                    |                                           |         |       |       |      |         |       |       |             |         |       |       |   |         |      |       |   |         |      
|                                                                      | Income (loss) from continuing operations           |                                           | $       | 1.05  |       |      | $       | 0.92  |       |             | $       | 0.92  |       |   | $       | 0.37 |       |   | $       | (1.14 | )     
|                                                                      | Income (loss) from discontinued operations         |                                           |         | (0.20 | )     |      |         | (0.14 | )     |             |         | (0.08 | )     |   |         | 0.20 |       |   |         | (0.07 | )     
|                                                                      | Gain (loss) on disposal of discontinued operations |                                           |         | (0.04 | )     |      |         |      |       |             |         | 0.01  |       |   |         | 0.03 |       |   |         | 0.19  |       
|                                                                      |                                                    |                                           |         |       |       |      |         |       |       |             |         |       |       |   |         |      |       |   |         |      
|                                                                      |                                                    | Net earnings (loss) per
    share  basic |         | $     | 0.81  |      |         | $     | 0.78  |             |         | $     | 0.85  |   |         | $    | 0.60  |   |         | $     | (1.02  | )
|                                                                      |                                                    |                                           |         |       |       |      |         |       |       |             |         |       |       |   |         |      |       |   |         |      
|Earnings (loss) per share  diluted                                   |                                                    |                                           |         |       |       |      |         |       |       |             |         |       |       |   |         |      |       |   |         |      
|                                                                      | Income (loss) from continuing operations           |                                           | $       | 0.98  |       |      | $       | 0.83  |       |             | $       | 0.88  |       |   | $       | 0.36 |       |   | $       | (1.14 | )     
|                                                                      | Income (loss) from discontinued operations         |                                           |         | (0.18 | )     |      |         | (0.13 | )     |             |         | (0.08 | )     |   |         | 0.20 |       |   |         | (0.07 | )     
|                                                                      | Gain (loss) on disposal of discontinued operations |                                           |         | (0.04 | )     |      |         |      |       |             |         | 0.01  |       |   |         | 0.03 |       |   |         | 0.19  |       
|                                                                      |                                                    |                                           |         |       |       |      |         |       |       |             |         |       |       |   |         |      |       |   |         |      
|                                                                      |                                                    | Net earnings (loss) per share  diluted   |         | $     | 0.76  |      |         | $     | 0.70  |             |         | $     | 0.81  |   |         | $    | 0.59  |   |         | $     | (1.02  | )
|                                                                      |                                                    |                                           |         |       |       |      |         |       |       |             |         |       |       |   |         |      |       |   |         |      
|Net cash provided by operating
    activities  continuing operations |                                                    | $                                         | 13,186  |       |       | $    | 9,915   |       |       | $           | 23,554  |       |       | $ | 3,765   |      |       | $ | 12,706  |      
|Research and development expense                                      |                                                    | $                                         |        |       |       | $    | 175     |       |       | $           | 367     |       |       | $ |        |      |       | $ | 1,273   |      
|Capital expenditures                                                  |                                                    | $                                         | 8,163   |       |       | $    | 3,347   |       |       | $           | 3,595   |       |       | $ | 2,917   |      |       | $ | 2,440   |      
|Depreciation                                                          |                                                    | $                                         | 3,007   |       |       | $    | 3,192   |       |       | $           | 2,989   |       |       | $ | 3,155   |      |       | $ | 5,442   |      

|                                                                                     |  |                    |           |      |  |      |           |             |  |             |           |   |  |   |           |   |  |   |           |   
|------------------------------------------------------------------------------------ |  | ------------------ | --------- | ---- |  | ---- | --------- | ----------- |  | ----------- | --------- | - |  | - | --------- | - |  | - | --------- | --
|                                                                                     |  |                   
|                                                                                     |  | As of December 31,
|                                                                                     |  |                   
|                                                                                     |  | 2003               |           | 2002 |  | 2001 |           | 2000        |  | 1999       
|                                                                                     |  |                    |           |      |  |      |           |             |  |            
|                                                                                     |  |                    |           |      |  |      |           | (unaudited) |  | (unaudited)
|Total assets                                                                         |  | $                  | 121,070   |      |  | $    | 111,676   |             |  | $           | 80,821    |   |  | $ | 78,175    |   |  | $ | 74,464    |   
|Current portion of long-term debt, notes payable
    and revolving credit facilities |  | $                  | 9,000     |      |  | $    | 15,144    |             |  | $           | 500       |   |  | $ | 6,284     |   |  | $ | 19,700    |   
|Long-term debt (less current portion)                                                |  | $                  | 7,750     |      |  | $    | 8,250     |             |  | $           | 8,750     |   |  | $ | 9,250     |   |  | $ |          |   
|Stockholders equity                                                                 |  | $                  | 48,651    |      |  | $    | 39,809    |             |  | $           | 37,138    |   |  | $ | 29,289    |   |  | $ | 23,805    |   
|Return on invested capital                                                           |  |                    | 14.0      | %    |  |      | 14.4      | %           |  |             | 17.7      | % |  |   | 8.6       | % |  |   | (12.9     | )%
|Stockholders equity per share                                                       |  | $                  | 5.76      |      |  | $    | 4.88      |             |  | $           | 4.68      |   |  | $ | 3.85      |   |  | $ | 3.23      |   
|Return on stockholders equity                                                       |  |                    | 20.3      | %    |  |      | 18.6      | %           |  |             | 23.5      | % |  |   | 14.7      | % |  |   | (24.4     | )%
|Backlog (unaudited)                                                                  |  | $                  | 123,895   |      |  | $    | 111,070   |             |  | $           | 90,382    |   |  | $ | 88,000    |   |  | $ | 81,717    |   
|Number of shares outstanding                                                         |  |                    | 8,443,082 |      |  |      | 8,164,180 |             |  |             | 7,940,610 |   |  |   | 7,601,519 |   |  |   | 7,363,324 |   






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | MANAGEMENTS DISCUSSION AND ANALYSIS OF
    FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

Certain statements in this Annual Report on
Form 10-K constitute forward-looking statements
which involve known risks, uncertainties and other factors which
may cause the actual results, performance or achievements of
Dynamics Research Corporation (DRC or the
company) to be materially different from any future
results, performance or achievements

16



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expressed or implied by such forward-looking
statements. Such factors include the Factors That May
Affect Future Results set forth in this Managements
Discussion and Analysis of Financial Condition and Results of
Operations. Precautionary statements made herein should be read
as being applicable to all related forward-looking statements
whenever they appear in this report.


OVERVIEW

DRC, founded in 1955 and headquartered in
Andover, Massachusetts, provides information technology,
engineering and other services focused on defense, public safety
and citizen services for federal, state and local governments.
DRCs core capabilities are focused on information
technology, engineering and technical subject matter expertise
that pertain to the knowledge domains relevant to the
companys core customers.

The company has two reportable business segments:
Systems and Services, and Metrigraphics. The Systems and
Services segment provides technical and information technology
services to government customers. These services include
logistics information systems; business transformation; design,
development, operation and maintenance of information technology
systems; engineering services; defense acquisition management
services; modeling and simulation; decision support; training
systems and services; automated case management; and
custom-built electronic test equipment and services. Revenues
for this segment are reported in the caption Contract
revenue in the companys Consolidated Statements of
Operations. The Metrigraphics segment develops and builds
components for original equipment manufacturers
(OEM) in the computer peripheral device, medical
electronics, telecommunications and other industries, with the
focus on the custom design and manufacture of miniature
electronic parts that meet high precision requirements through
the use of electroforming, thin film deposition and
photolithography technologies. Revenues for this segment are
reported in the caption Product sales in the
companys Consolidated Statements of Operations.

The companys business growth strategy is
focused on developing relationships with customers in defense,
public safety and state citizen services markets whose missions
are focused on one or more of these six strategic business
areas: C4ISR (Command, control, communications, computing,
intelligence, surveillance and reconnaissance), logistics,
readiness, military space, citizen security and citizen
services. The strategy leverages seven solution sets where DRC
believes it has strong competencies and a record of meeting its
customers most difficult challenges. These repeatable,
proven, cost effective solutions are acquisitions management
services; training systems and services; business
transformation; automated case management; network engineering
services; and logistics and decision support information systems.

DRC has a balanced organic and acquisition growth
strategy aimed at gaining market segment leadership and
penetrating new market segments, with specific focus on
sustained organic growth. This strategy is intended to achieve
four key objectives: to increase shareholder value; to grow
sales in selected markets; to achieve operational excellence;
and to become an employer of choice.

ACQUISITIONS

On December 20, 2002, the company completed
the acquisition of all of the outstanding shares of capital
stock of Andrulis Corporation (ANDRULIS), and on
May 31, 2002, the company completed the acquisition of all
of the outstanding voting common stock of HJ Ford
Associates, Inc. (HJ Ford). The results of
these acquired entities are included in the companys
Consolidated Statements of Operations, Consolidated Statements
of Changes in Stockholders Equity and Comprehensive Income
(Loss) and Consolidated Statements of Cash Flows for the periods
subsequent to their respective acquisitions.

As part of the HJ Ford purchase, the company
acquired a 40% interest in a small disadvantaged business, as
defined by the United States government. This business is
accounted for using the equity method. The ownership interest is
reported as a component of Other noncurrent assets
in the companys Consolidated Balance Sheets.

DISCONTINUED OPERATIONS

On October 18, 2002, the company announced
that it was actively pursuing the divestiture of the Encoder
Division, a manufactured products business previously reported
as a business segment. Effective in the fourth quarter of 2002,
the companys consolidated financial statements and notes
thereto were restated to reflect the discontinuation of the
Encoder Division for all periods presented. On May 2, 2003,
the company completed the sale of its Encoder Division assets to
GSI Lumonics Inc. (GSI) in Billerica,
Massachusetts.

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Unless otherwise indicated, all financial
information contained in this Annual Report on Form 10-K
refers to continuing operations.

CRITICAL ACCOUNTING POLICIES

There are business risks specific to the
industries in which the company operates. These risks include,
but are not limited to, estimates of costs to complete contract
obligations, changes in government policies and procedures,
government contracting issues and risks associated with
technological development. The preparation of financial
statements requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of
the financial statements. Estimates and assumptions also affect
the amount of revenue and expenses during the reported period.
Actual results could differ from those estimates.

The company believes the following critical
accounting policies affect the more significant judgments made
and estimates used in the preparation of its consolidated
financial statements.

Revenue Recognition

The companys systems and services business
provides its services under time and materials, cost
reimbursable and fixed-price contracts, including service-type
contracts.

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

For cost reimbursable contracts, revenue is
recognized as costs are incurred and include a proportionate
amount of the fee earned. Cost reimbursable contracts specify
the contract fee in dollars or as a percentage of estimated
costs. The primary risk on a cost reimbursable contract is that
a government audit of direct and indirect costs could result in
the disallowance of certain costs, which would directly impact
revenue and margin on the contract. Historically, such audits
have had no material impact on the companys revenue and
operating income.

Under fixed-price contracts, other than
service-type contracts, revenue is recognized under the
percentage of completion method, on the basis of costs incurred
in relation to estimated total costs to complete the contract.
Under service-type contracts, costs incurred are not indicative
of progression toward completion of the contract. Revenue from
service-type fixed price contracts is recognized ratably over
the contract period or by other appropriate output methods to
measure service provided, and contract costs are expensed as
incurred. The risk to the company on a fixed-price contract is
that if actual costs exceed the estimated costs to complete the
contract, then profit is eroded or losses are incurred.

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

Unbilled expenditures and fees on contracts in
process are the amounts of recoverable contract revenue that
have not been billed at the balance sheet date. Most of the
companys unbilled expenditures and fees relate to revenue
that is billed in the month after services are performed. In
certain instances, billing is deferred in compliance with
contract terms, such as milestone billing arrangements and
withholdings. Costs related to United States Government
contracts, including applicable indirect costs, are subject to
audit by the government. Revenue from such contracts has been
recorded at amounts the company expects to realize upon final
settlement.

Valuation Allowances

The company provides for potential losses against
specifically identified accounts receivable and unbilled
expenditures and fees on contracts in process based on the
companys expectation of a customers inability to
pay. These reserves are based primarily upon specific
identification of potential uncollectible accounts. In addition,
payments to the company for performance on United States
Government contracts are subject to audit by the Defense
Contract Audit Agency. If necessary, the company provides an
estimated reserve for adjustments resulting from rate
negotiations and audit findings. The company routinely provides
for these items when they are identified and can be reasonably
estimated.

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Intangible and Other Long-lived
Assets

The company uses assumptions in establishing the
carrying value, fair value and estimated lives of intangible and
other long-lived assets. Long-lived assets are reviewed for
impairment whenever events or changes in circumstances indicate
that the asset carrying value may not be recoverable.
Recoverability is measured by a comparison of the assets
continuing ability to generate positive income from operations
and positive cash flow in future periods compared to the
carrying value of the asset. If assets are considered to be
impaired, the impairment is recognized in the period of
identification and is measured as the amount by which the
carrying value of the asset exceeds the fair value of the asset.

The useful lives and related amortization of
intangible assets are based on their estimated residual value in
proportion to the economic benefit consumed. The useful lives
and related depreciation of other long-lived assets are based on
the companys estimate of the period over which the asset
will generate revenue or otherwise be used by the company.

Goodwill

The company assesses goodwill for impairment at
the segment level at least once each year by applying a fair
value test. Goodwill could be impaired due to market declines,
reduced expected future cash flows, or other factors or events.
Should the fair value of goodwill, as determined by the company
at any measurement date, fall below its carrying value, a charge
for impairment of goodwill would occur in that period.

Business Combinations

During 2002, the company acquired two companies,
ANDRULIS and HJ Ford. The company has determined and
recorded the fair values of assets acquired and liabilities
assumed as of the dates of acquisition. The company utilized an
independent valuation specialist to determine the fair values of
identifiable intangible assets acquired in order to allocate a
portion of the purchase price to these assets. The results of
operations of these acquired entities are included in the
companys consolidated financial statements from the dates
of their respective acquisitions.

Deferred Taxes

The company records a valuation allowance to
reduce its deferred tax assets to the amount that is more likely
than not to be realized. The company has considered future
taxable income and ongoing prudent and feasible tax planning
strategies in assessing the need for the valuation allowance. In
the event it is determined that the company would be able to
realize its deferred tax assets in excess of their net recorded
amount, an adjustment to the deferred tax asset would increase
income in the period such determination was made. Likewise,
should the company determine it would not be able to realize all
or part of its net deferred tax asset in the future, an
adjustment to the deferred tax asset would be charged to income
in the period such determination was made.

Pensions

Accounting and reporting for the companys
pension plans require the use of assumptions, including but not
limited to, discount rate, rate of compensation increases and
expected return on assets. If these assumptions differ
materially from actual results, the companys obligations
under the pension plan could also differ materially, potentially
requiring the company to record an additional pension liability.
An actuarial valuation is performed each year. The results of
this actuarial valuation are reflected in the accounting for the
pension plan upon determination.

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RESULTS OF OPERATIONS

Operating results expressed as a percentage of
total revenues for the years ended December 31, 2003, 2002
and 2001 are as follows:

|                                                                        |                       |                         |      |       |   |      |      |       |   |  |      |       |  
|----------------------------------------------------------------------- | --------------------- | ----------------------- | ---- | ----- | - | ---- | ---- | ----- | - |  | ---- | ----- | -
|                                                                        |                       |                        
|                                                                        |                       | Year ended December 31,
|                                                                        |                       |                        
|                                                                        |                       | 2003                    |      | 2002  |   | 2001
|                                                                        |                       |                         |      |       |   |     
|Contract revenue                                                        |                       |                         | 97.2 | %     |   |      | 96.0 | %     |   |  | 94.3 | %    
|Product sales                                                           |                       |                         | 2.8  | %     |   |      | 4.0  | %     |   |  | 5.7  | %    
|                                                                        |                       |                         |      |       |   |      |      |       |   |  |      |      
|                                                                        | Total revenue         |                         |      | 100.0 | % |      |      | 100.0 | % |  |      | 100.0 | %
|                                                                       
|Gross margin on contract revenue(1)                                     |                       |                         | 16.1 | %     |   |      | 15.4 | %     |   |  | 13.4 | %    
|Gross margin on product sales(1)                                        |                       |                         | 26.4 | %     |   |      | 31.2 | %     |   |  | 46.7 | %    
|                                                                        | Total gross margin(1) |                         |      | 16.4  | % |      |      | 16.1  | % |  |      | 15.3  | %
|                                                                       
|Selling, general and administrative expenses                            |                       |                         | 9.4  | %     |   |      | 9.3  | %     |   |  | 8.5  | %    
|Amortization of intangible assets                                       |                       |                         | 0.7  | %     |   |      | 0.2  | %     |   |  |     |      
|                                                                       
|Operating income                                                        |                       |                         | 6.3  | %     |   |      | 6.6  | %     |   |  | 6.8  | %    
|Interest expense, net                                                   |                       |                         | (0.3 | )%    |   |      | (0.2 | )%    |   |  | (0.4 | )%   
|Other income (expense), net                                             |                       |                         | 0.1  | %     |   |      |     |       |   |  | (0.1 | )%   
|                                                                       
|Income from continuing operations before
    provision for income taxes |                       |                         | 6.1  | %     |   |      | 6.4  | %     |   |  | 6.3  | %    



---



|    |                                                                                                               
|--- | --------------------------------------------------------------------------------------------------------------
|(1) | These amounts represent a percentage of contract
    revenues, product sales and total revenues, respectively.

Revenue

The company reported revenues from continuing
operations of $244.8 million, $192.6 million and
$190.3 million in 2003, 2002 and 2001, respectively. These
revenues represent an increase from the respective prior year of
27.1% in 2003 and 1.2% in 2002.

Contract revenue

Contract revenues in the companys Systems
and Services segment were $237.9 million in 2003,
$185.0 million in 2002 and $179.4 million in 2001,
representing increases from the respective prior years of 28.6%
and 3.1% in 2003 and 2002. The increase in the current year was
primarily attributable to the companys acquisitions.
Through its acquisitions of ANDRULIS and HJ Ford, the company
acquired federal government annual revenue bases of
approximately $36 million and $28 million,
respectively. In 2003, revenues grew on an organic basis by
approximately 2.1%. Reductions in subcontractor pass-through
revenue with the Air Force Electronic Systems Center and in Navy
Strategic Systems guidance work reduced 2003 revenues in the
aggregate by an estimated $9 million, or 3.8%.

Defense revenues in 2003, 2002 and 2001 were
$191.7 million, $154.2 million and $147.6 million,
respectively. The $37.5 million increase in 2003 from 2002
was primarily attributable to the companys acquisitions,
coupled with organic growth of the companys core business.
The 2003 increase was net of the $9 million reduction in
subcontractor pass-through revenues and Navy Strategic Systems
guidance work discussed above. Revenues in 2002 increased
$6.6 million from 2001, reflecting the effects of
additional acquisition-related revenue of approximately $18
million; a reduction in low margin subcontract revenue with the
Electronic Systems Center Combat Air Force program of
approximately $10 million, spread over the last three quarters
of the year, and estimated at $13 million on an annualized
basis; and a reduction of $2.6 million over the second half
of the year in work on the United States Navys guidance
system for Strategic Systems, estimated at $5 million on an
annualized basis.

Revenues from federal civilian agencies were
$35.2 million, $17.8 million and $11.7 million in
2003, 2002 and 2001, respectively. These revenues virtually
doubled in 2003, compared to the prior year, primarily as a
result of the acquisition of ANDRULIS. Revenues in this sector
increased $6.1 million, or 51.9%, in 2002 compared to 2001,
primarily from services performed under a contract with the
Internal Revenue Service. The companys contract with the
Bureau of Citizenship and Immigration Services ended in January
2004. Re-competition of the contract for these services has been
indefinitely delayed.

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State and local government revenues were
$11.0 million in 2003, $12.9 million in 2002 and
$20.1 million in 2001. Significant state spending cutbacks
in response to state budget deficits have been the primary cause
of reduced state and local revenues in 2003. In recent months,
the company has seen an increase in requests by states to submit
proposals for services. The decrease in revenues in this sector
in 2002 from 2001 was primarily the result of the expected
completion of work for the Colorado Department of Human Services
and cutbacks in infrastructure support staff for the State of
Ohio in the first half of 2002.

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

|                                              |  |                         |      |      |  |      |      |  |  |  |      | 
|--------------------------------------------- |  | ----------------------- | ---- | ---- |  | ---- | ---- |  |  |  | ---- | 
|                                              |  |                        
|                                              |  | Year ended December 31,
|                                              |  |                        
|                                              |  | 2003                    |      | 2002 |  | 2001
|                                              |  |                         |      |      |  |     
|Time and materials                            |  |                         | 64%  |      |  |      | 58%  |  |  |  | 52%  | 
|Cost reimbursable                             |  |                         | 23%  |      |  |      | 31%  |  |  |  | 31%  | 
|Fixed price, including service-type contracts |  |                         | 13%  |      |  |      | 11%  |  |  |  | 17%  | 
|                                              |  |                         |      |      |  |      |      |  |  |  |      | 
|                                              |  |                         | 100% |      |  |      | 100% |  |  |  | 100% | 
|                                              |  |                         |      |      |  |      |      |  |  |  |      | 

Product sales

Product sales for the Metrigraphics segment
decreased in both 2003 and 2002 from the respective prior year.
These decreases are the result of continuing weak economic
conditions and customer product life cycle shifts. The company
remains concerned that these economic conditions could continue
to exert pressure on this segments revenues and margins.

Funded backlog

The companys funded backlog, excluding
discontinued operations, was $123.9 million,
$111.1 million and $90.4 million at December 31,
2003, 2002 and 2001, respectively. In 2003, the acquisitions of
ANDRULIS and HJ Ford contributed significantly to the increase
in backlog, coupled with organic growth of the companys
core business. In 2002, the companys business acquisitions
fully accounted for the increase in backlog. The funded backlog
generally is subject to possible termination at the convenience
of the contracting counter party. A portion of the
companys backlog is based on annual purchase contracts and
subject to annual governmental approvals or appropriations
legislation. The amount of backlog as of any date may be
affected by the timing of order receipts and associated
deliveries. Backlog does not necessarily equate to future
revenues.

Gross profit and margin

The companys gross profit was
$40.0 million, $30.9 million and $29.1 million for
2003, 2002 and 2001, respectively, representing 16.4% of revenue
in 2003, 16.1% of and 2002, and 15.3% of total revenue in 2001.

Gross profits on contract revenues were
$38.2 million, $28.6 million and $24.0 million
for 2003, 2002 and 2001, respectively, representing 16.1%, 15.4%
and 13.4% of contract revenues. The improved performance in 2003
was attributable to efficiencies realized from the integration
of the recent acquisitions into the companys operations,
contract mix and lower overhead costs as a percentage of
revenues. The increase in both the contract revenue gross profit
and margin in 2002, compared to 2001, was partly due to improved
contract mix and included the effect of the completion of the
Colorado contract.

In 1997, the company entered into a fixed-price
software development contract with the Colorado Department of
Human Services. During the period of performance, this contract
incurred cost overruns, and management anticipated additional
overruns that were appropriately provided for in the
companys results of operations. The company provided
$3.9 million in 2001 for current and anticipated losses.
Implementation of the project was completed on April 12,
2002. The maintenance period expired in the fourth quarter of
2002 and the warranty period expired in the second quarter of
2003. At the completion of the project in 2002, the company
reduced contract reserves by $0.6 million, as the actual
costs were less than previously estimated.

In December 2001, the Board of Directors approved
actions to proceed with amendments limiting future increases in
benefits under the companys Defined Benefit Pension Plan,
freezing membership in the Plan, and providing for improvements
to the companys 401(k) Plan. Accordingly, the approval to
amend the Defined Benefit Pension Plan resulted in a curtailment
loss of $0.8 million that was charged to cost of contract
revenue in the fourth quarter of 2001.

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In 2003, 2002 and 2001, gross margins on
Metrigraphics segment sales were $1.8 million,
$2.4 million and $5.1 million, respectively,
representing 26.4%, 31.2% and 46.7%, respectively, of product
sales. The continued decline in product sales gross margin is
due to decreased product sales resulting from continued weak
economic conditions and customer product life cycle shifts,
partially offset by cost reductions.

Selling, general and administrative
expenses

Selling, general and administrative costs
increased to $22.9 million in 2003, compared to
$17.9 million in 2002 and $16.0 million in 2001. The
overall increase from year to year is in part attributable to
the absorption of general and administrative expenses of the
companys 2002 acquisitions, as the companys 2003
results include a full year of expenses for these entities.
Higher employee benefit costs also contributed to the increase
in selling, general and administrative costs in 2003. The
companys 2002 results reflect the absorption of HJ
Fords general and administrative expenses for the period
subsequent to its acquisition. The acquisition of ANDRULIS was
not consummated until December 20, 2002; accordingly, the
expenses absorbed by the company for this entity in 2002 were
immaterial. During 2002, the company continued with its 2001
initiative to expand its marketing resources. The 2002 results
also include $0.7 million of additional legal expenses
incurred in the fourth quarter of 2002, primarily related to the
production of documents in response to a subpoena by the
Department of Justice on October 15, 2002. The
companys legal expenses related to this matter were
$0.7 million in 2003.

The company reports its research and development
expenses as a component of Selling, general and administrative
costs in its Consolidated Statements of Operations. The company
did not incur any research and development costs during 2003.
Exclusive of discontinued operations, the company expended
$0.2 million, including overhead and indirect costs, on
research and development related to web-based capabilities
during 2002. Research and development expenditures of
$0.4 million in 2001 primarily relate to the development of
MedTeams training products.

In response to lower than expected demand in
certain sectors of the companys business, as well as the
need to maintain a competitive cost structure, the company
incurred involuntary separation costs for 85 employees,
excluding discontinued operations, in 2002. All operating groups
and functions of the company were affected. Costs associated
with these terminations totaled $0.8 million and are
included in reported operating results for 2002, with
$0.6 million charged to Cost of contract revenue and
$0.2 million charged to Selling, general and administrative
expenses. The remaining accrual of $0.2 million at
December 31, 2002 was paid in the first half of 2003.

Amortization of intangible assets

Amortization expense of $1.7 million and
$0.4 million in 2003 and 2002, respectively, reflects the
amortization of identifiable intangible assets associated with
the 2002 HJ Ford and ANDRULIS acquisitions. The company did not
record any amortization expense for identifiable intangible
assets in 2001.

The company is required to perform an annual
impairment test of its goodwill under the provisions of SFAS
No. 142, Goodwill and Other Intangible Assets(SFAS 142). Impairment exists when the carrying
value of goodwill is not recoverable and its carrying amount
exceeds its fair value. As a result of the annual impairment
test performed as of December 31, 2003, the company
determined that the carrying amount of goodwill did not exceed
its fair value and, accordingly, did not record a charge for
impairment. However, there can be no assurance that goodwill
will not be impaired in subsequent periods.

Operating income

Operating income for the Systems and Services
segment was $14.8 million, or 6.2% of contract revenue, in
2003, compared to $11.5 million, or 6.2% of contract
revenue, in 2002, and $9.5 million, or 5.3% of contract
revenue, in 2001.

Operating income for the Metrigraphics segment
was $0.6 million, or 9.2% of product revenue, in 2003,
compared to $1.1 million, or 14.9% of product revenue, in
2002 and $3.5 million, or 32.4% of product revenue, in 2001.

The companys operating income was
$15.4 million, or 6.3% of revenue, $12.6 million, or
6.6% of revenue, and $13.0 million, or 6.8% of revenue, in
2003, 2002 and 2001, respectively. The decrease in operating
margin in the current year is primarily attributable to higher
selling, general and administrative expenses, coupled with
amortization expense for the companys acquired intangible
assets.

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Interest income and expense

Interest expense of $0.9 million,
$0.6 million and $1.0 million in 2003, 2002 and 2001,
respectively, was partially offset by interest income of $27,000
in 2003 and $0.2 million in both 2002 and 2001. The
decrease in interest income in both 2003 and 2002, compared to
the respective prior years, is attributable to lower average
investment interest rates, while the increase in interest
expense in both years is attributable to the companys debt
levels, in particular, the outstanding balances on the
companys revolving credit facility throughout 2003 and
2002.

Other income and expense

The company reported $0.5 million of net
other income in 2003, of which $0.2 million is attributable
to gains on the companys deferred compensation plan
investments. The company reported other income of $0.1 million
in 2002. On June 1, 2001, the company completed the sale of
its Tactical Communications Group (TCG) and the
transfer of related employees and assets. TCG developed and sold
communications software for defense applications. For the first
six months of 2001, TCG recorded revenues of approximately
$0.8 million and a loss of $0.5 million. The sale
resulted in a net loss of $0.2 million, reported as Other
expense in the companys Consolidated Statement of
Operations for the year ended December 31, 2001. Proceeds
from the transaction were $0.1 million in cash.

Income taxes

Income tax expense was recorded at rates of
42.3%, 40.2% and 40.7% of income from continuing operations
before taxes in 2003, 2002 and 2001, respectively. The increase
in 2003 is due to amortization of acquired intangible assets
that is not deductible for income tax purposes. These rates
reflect the statutory federal rate of 34%, combined with an
average state income tax rate, net of federal income tax benefit.

Discontinued operations

On May 2, 2003, the company completed the
sale of its Encoder Division assets and certain liabilities to
GSI for $3.3 million in cash, subject to post-closing
adjustments related to a valuation of the net assets of the
Encoder Division and assumption by GSI of certain of DRCs
liabilities with respect to the assets acquired.

The company recognized a loss of
$0.6 million before taxes, or a loss of $0.3 million,
net of $0.3 million of income tax benefit, on the disposal
of discontinued operations in 2003. This loss is attributable to
a $1.3 million pre-tax loss related to the sale of the Encoder
division, net of $0.7 million received as the final royalty
payment associated with the 1999 sale of its discontinued
Telecommunications Fraud Control business (the Fraud
Control business). The company recognizes this royalty
income on a cash basis. In connection with the sale of the
Encoder Division, the company recorded charges of
$0.2 million and $1.1 million before taxes as a loss
on the disposal of discontinued operations in the fourth and
first quarters of 2003, respectively. The fourth quarter charges
represent additional facility costs related to the sale. The
components of the first quarter charges were $0.3 million
of professional fees and $0.8 million of exit costs,
comprised of $0.5 million for severance costs for
approximately 45 Encoder Division employees and $0.3 million for
future lease costs, net of contractual sublease income from GSI
for the Encoder facility.

The company reported a gain of $0.1 million,
net of taxes, on the disposal of discontinued operations in
2001. This amount is attributable to royalty income associated
with the Fraud Control business.

The companys loss from discontinued
operations, net of taxes, was $1.6 million, or $0.18 per diluted
share, in 2003. This amount includes four months of operating
loss from the Encoder division, as well as costs incurred
subsequent to the transaction related to certain liabilities
that GSI did not assume, including $1.5 million of accrued
lease costs, net of estimated sublease income for the Encoder
facility.

The companys loss from discontinued
operations was $1.1 million, or $0.13 per diluted share, in
2002 and $0.6 million, or $0.08 per diluted share, in 2001.
Due to the companys decision on October 18, 2002, to
divest the Encoder Division, it became necessary to restate the
companys results in order to reflect the Encoder Division
as a discontinued operation. Because Arthur Andersen LLP was no
longer able to provide current assurance as to the validity of
its previously issued opinions on the companys financial
statements for the fiscal years prior to 2002, it became
necessary to engage KPMG LLP, who served as the companys
independent auditors through November 2003, to re-audit results
for the years ended December 31, 2001 and 2000 in order to
obtain a current independent auditor opinion for those years.
The 2002 loss from discontinued operations includes
$0.4 million in fees to re-audit the 2001 and 2000 results.

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Shares used in computing earnings
(loss) per share

Changes in the companys stock price and an
increased level of options granted have resulted in a greater
number of employee stock options counted as outstanding common
equivalent shares and included in the dilutive effect of options
for the purpose of computing diluted earnings per share.
Weighted average common shares outstanding and common equivalent
shares increased from 8.1 million at December 31,
2001, to 8.8 million and 8.9 million at December 31,
2003 and 2002, respectively. The slight decrease in 2003 from
2002 is primarily attributable to lower stock prices in the
current year.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 2003 and 2002, the company
had cash and cash equivalents aggregating $2.7 million and
$1.1 million, respectively. The increase in cash and cash
equivalents is primarily the result of $11.8 million of net
cash provided by operating activities, including
$1.4 million used in discontinued operations, and
$2.9 million of net cash proceeds from the sale of the
companys discontinued Encoder Division. These amounts were
partially offset by $8.8 million and $4.2 million of
net cash used in continuing operations investing and financing
activities, respectively.

Cash provided by operating activities was
$11.8 million, and is primarily attributable to
$8.7 million of income from continuing operations,
depreciation and amortization expenses aggregating
$4.7 million, a $1.6 million decrease in accounts
receivable and $3.8 million and $1.0 million of
increased payroll and employee benefit accruals, and accounts
payable, respectively. These amounts were partially offset by a
$7.6 million increase in unbilled expenditures and fees on
contracts in process and a $1.3 million decrease in other
accrued expenses, coupled with $1.4 million of net cash
used in discontinued operations.

At December 31, 2003, unbilled expenditures and
fees on contracts in process included subcontractor costs for
the month of December, for which invoices had not been received
and for which revenues were not recognized, estimated at
$2.4 million. Related liabilities have been recorded as
accounts payable.

Receivables days sales outstanding
(DSO) was 89 at December 31, 2003, excluding
the aforementioned subcontractor cost accrual, an increase of
one day from the end of 2002, and an increase of five days from
the end of the third quarter of 2003, principally due to the
companys focus on its PeopleSoft system implementation. In
the first quarter of 2004, also due to the PeopleSoft system
start-up, the company expects DSO to be between 110 and
120 days, followed by a decline into the low-80s by
the end of 2004. Management believes the increase in accounts
receivable is a function of temporary resource allocation and
system start-up, and has no indication of collectibility
concerns.

Cash used in investing activities for continuing
operations was $8.8 million, primarily attributable to
$8.2 million of capital expenditures, including
approximately $5 million related to the implementation of
the companys enterprise business system and approximately
$2 million for facility renovation costs for its corporate
headquarters in Andover, Massachusetts.

Selective acquisitions are an important component
of the companys growth strategy. The company may acquire,
from time to time, firms or properties that are aligned with the
companys core capabilities and which complement the
companys customer base.

Cash used in financing activities for continuing
operations is comprised of $6.1 million of net payments
under the companys revolving credit agreement and notes
payable and $0.5 million of principal payments on the
mortgage of the companys corporate headquarters facility.
These amounts were partially offset by cash proceeds aggregating
$2.4 million from the exercise of stock options and the
issuance of shares under the employee stock purchase plan.

At December 31, 2002, the company had
$12.4 million in notes payable associated with the purchase
of ANDRULIS. The notes had an interest rate of 4.0% and a
maturity date of January 2, 2003. In January 2003, the
notes were paid in full with proceeds from the companys
revolving credit agreement.

On December 26, 2002, the company entered
into an installment payment agreement in connection with the
purchase of its enterprise business system software. The company
made the first payment on January 26, 2003, with the second
and last payment due and paid on January 26, 2004. The
company recorded the liability using an imputed interest rate of
3.38%, which was its effective borrowing rate at
December 31, 2002. The obligation is reflected in the table
below as a purchase commitment.

Effective June 28, 2002, the company
obtained a $50.0 million revolving credit agreement (the
Revolver), replacing the previous revolving credit
facility. The Revolver has a three-year term and is available to
the company for general corporate purposes, including strategic
acquisitions. The fee on the unused portion of the Revolver
ranges from 0.25% to

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0.50%, depending on the companys most
recently reported leverage ratio, and is payable quarterly in
arrears. The company has the option to elect a fixed 30, 60 or
90-day term, an interest rate of LIBOR plus 2.0% to 3.0%,
depending on the companys most recently reported leverage
ratio, or the prime rate on any outstanding balance. Interest on
the outstanding balance of the Revolver is payable monthly under
the prime rate option or at the end of the elected term for the
LIBOR rate option. At December 31, 2003, the outstanding
balance under the Revolver was $8.5 million. At
December 31, 2003, the interest rate on $7.5 million of
this outstanding amount was 3.17% under a 60-day LIBOR option
elected on December 15, 2003. The interest rate on the
remaining $1.0 million of the outstanding balance was 3.16% on
December 31, 2003, under a 30-day LIBOR option elected on
December 15, 2003.


The company has a 10-year mortgage loan (the
Mortgage), dated June 12, 2000, as amended and
restated on June 28, 2002, on the corporate office facility
in Andover, Massachusetts. The outstanding balance of the
mortgage was $8.3 million at December 31, 2003. The
agreement requires quarterly principal payments of $125,000,
with a final payment of $5.0 million in May 2010. The interest
rate on the outstanding Mortgage balance at December 31,
2003 was 3.15% under the 90-day LIBOR option, elected on
October 14, 2003.

The Revolver and Mortgage agreements, as
currently amended, require the company to meet certain financial
covenants including maintaining a minimum net worth, cash flow
and debt coverage ratios, and limit the companys ability
to incur additional debt, pay dividends, purchase capital
assets, sell or dispose of assets, make additional acquisitions
or investments, or enter into new leases, among other
restrictions. In addition, the loan agreements contain a
subjective acceleration clause allowing the lender to require
payment upon the occurrence of a material adverse change.

On December 23, 2003, the Revolver was
amended to increase the capital expenditure limits in 2003 and
2004 to $9.0 million and $7.0 million, respectively,
to allow for adjustments to the scheduled renovations of the
companys Andover, Massachusetts corporate office facility
and the companys investment in its new enterprise business
system. On March 26, 2003, the Revolver was amended to base
the covenant on total net worth and to exclude any adjustments
to accumulated other comprehensive loss from the covenant
calculation. Management believes the company was in compliance
with all loan covenants on December 31, 2003.

The companys results of operations, cash
flows and financial condition are subject to certain trends,
events and uncertainties, including demands for capital to
support growth, economic conditions, government payment
practices and contractual matters. The companys capital
expenditures, excluding business acquisitions, are expected to
be in the range of $6 million to $7 million in 2004,
primarily for facilities infrastructure consolidation and
improvements.

The companys need for, cost of and access
to funds are dependent on future operating results, the
companys growth and acquisition activity, as well as
conditions external to the company. In 2002, the company
increased the capacity of its revolving credit facility from
$20.0 million to $50.0 million to facilitate the
companys acquisition strategy. The company will continue
to consider acquisition opportunities that align with its
strategic objectives, along with the possibility of utilizing
the revolving credit facility as a source of financing.

Based upon its present business plan and
operating performance, the company believes that cash provided
by operating activities, combined with amounts available for
borrowing under the Revolver, will be adequate to fund the
capital requirements of its existing operations during 2004 and
for the foreseeable future and that it will be able to obtain
replacement financing on competitive terms when the terms of the
Revolver expire on June 27, 2005. However, the development
of adverse economic or business conditions could significantly
affect the need for and availability of capital resources.

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Commitments and Contingencies

The companys contractual obligations as of
December 31, 2003 consist of the following (in thousands):

|                     |                               |                        |       |             |  |            |       |            |  |       |       |       |  |   |       |       |  |   |        |        | 
|-------------------- | ----------------------------- | ---------------------- | ----- | ----------- |  | ---------- | ----- | ---------- |  | ----- | ----- | ----- |  | - | ----- | ----- |  | - | ------ | ------ | 
|                     |                               |                       
|                     |                               | Payments due by period
|                     |                               |                       
|                     |                               | Less than              |       | Two to      |  | Four to    |       |           
|                     |                               | one year               |       | three years |  | five years |       | Thereafter |  | Total
|                     |                               |                        |       |             |  |            |       |            |  |      
|Revolver             |                               | $                      | 8,500 |             |  | $          |      |            |  | $     |      |       |  | $ |      |       |  | $ | 8,500  |       
|Long-term debt       |                               |                        | 500   |             |  |            | 1,000 |            |  |       | 1,000 |       |  |   | 5,750 |       |  |   | 8,250  |       
|Operating leases     |                               |                        | 4,771 |             |  |            | 5,549 |            |  |       | 3,293 |       |  |   | 3,288 |       |  |   | 16,901 |       
|Purchase commitments |                               |                        | 554   |             |  |            |      |            |  |       |      |       |  |   |      |       |  |   | 554    |       
|                     |                               |                        |       |             |  |            |       |            |  |       |       |       |  |   |       |       |  |   |        |       
|                     | Total contractual obligations |                        | $     | 14,325      |  |            | $     | 6,549      |  |       | $     | 4,293 |  |   | $     | 9,038 |  |   | $      | 34,205 | 
|                     |                               |                        |       |             |  |            |       |            |  |       |       |       |  |   |       |       |  |   |        |       

As part of the HJ Ford purchase, the company
acquired a 40% ownership interest in a small disadvantaged
business, as defined by the United States Government. This
business is accounted for using the equity method. The company
has continuing business relationships with this business and has
provided it with a line of credit guarantee in the amount of
$0.2 million. The companys guarantee is indemnified
by the other shareholders of this business. At December 31,
2003, there was an outstanding balance of $0.1 million
under this line of credit.

The company has change of control agreements with
certain of its employees that provide them with benefits should
their employment with the company be terminated other than for
cause or their disability or death, or if they resign for good
reason within a certain period of time from the date of any
change of control of the company.

As a defense contractor, the company is subject
to many levels of audit and review from various government
agencies, including the Defense Contract Audit Agency, various
inspectors general, the Defense Criminal Investigative Service,
the General Accounting Office, the Department of Justice and
congressional committees. Both related to and unrelated to its
defense industry involvement, the company is, from time to time,
involved in audits, lawsuits, claims, administrative proceedings
and investigations. The company accrues for liabilities
associated with these activities when it becomes probable that
future expenditures will be made and such expenditures can be
reasonably estimated. The companys evaluation of the
likelihood of expenditures related to these matters is subject
to change in future periods, depending on then current events
and circumstances, which could have material adverse effects on
the companys business, financial position, results of
operations and cash flows.

As previously disclosed, on October 26,
2000, two former company employees were indicted and charged
with, among other violations, wire fraud and a conspiracy scheme
to defraud the United States Air Force out of approximately
$10 million through kickbacks and overcharging for computer
components and services. The former employees collected the
kickbacks and overcharges through separate and independent
businesses. The company received no money from their scheme.
When notified by the government of the employees
conspiracy, the company fired the two employees and voluntarily
cooperated with the governments investigation. The company
was not charged in the criminal case. Both former employees pled
guilty and were sentenced to prison. The company believes that
the government has recovered a substantial portion of the
defrauded funds from the co-conspirators. Notwithstanding the
companys efforts to settle any claims against the company
arising from the employees scheme, on October 9, 2003
the United States Attorney filed a civil complaint against the
company in the United States District Court for the District of
Massachusetts based in substantial part upon the actions and
omissions of the former employees which gave rise to the
criminal cases against them. In the civil action, the United
States Attorney is asserting on behalf of the government claims
against the company based upon the False Claims Act and the
Anti-Kickback Act, in addition to certain common law and
equitable claims. The United States Attorney seeks to recover up
to three times its actual damages and penalties under the False
Claims Act and double damages and penalties under the
Anti-Kickback Act and to recover costs and interest. The company
disputes the claims, believes it has substantive defenses, and
intends to vigorously defend itself. However, the outcome of
such litigation, if unfavorable, could have a material adverse
effect on the companys business, financial position,
results of operations and cash flows. The company has filed a
third party complaint, as part of the United States Attorney
Generals civil action, including an affirmative multiple
damage claim for unfair and deceptive practices, against Storage
Engine, Inc. (Storage Engine), formerly known as
ECCS, Inc., and its president and director. The complaint
alleges that Storage Engine directly benefited from the kickback
scheme alleged by the United States Attorney. Storage Engine, a
supplier of computer components for the Air Force, made illegal
payments to the companys two former employees through
separate and independent businesses. Storage Engine and its
president deny the allegations.

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On September 5, 2002, Genesis Tactical Group
LLC (Genesis) asserted a cross-claim against
Lockheed Martin Corporation (Lockheed) in the State
of New York Supreme Court, County of Onondaga seeking
$50.0 million in damages and against the company seeking
$35.0 million in damages. These cross-claims arise out of a
suit filed on July 30, 2002 by Lockheed against Tactical
Communications Group LLC, Genesis and the company in the State
of New York Supreme Court, County of Onondaga. The Lockheed suit
relates to a contract for services that was sold to Genesis by
the company pursuant to an asset purchase agreement in 2001. By
the terms of the asset purchase agreement, the companys
liability to Genesis is limited to $300,000, other than for
intentional misrepresentation, willful breach or fraud. Lockheed
and Genesis have settled their outstanding issues, including a
software ownership issue, and filed a stipulation of dismissal
with prejudice. The Genesis claim for $35.0 million against the
Company was related to the software ownership issue that was
settled in favor of Genesis. Lockheeds settlement demand
to the company was $495,679 plus interest. The company believes
that $311,679 of the demanded amount is for extra work and
materials procured by Lockheed from Genesis and disputes the
balance due to other mutually agreed contract changes between
Lockheed and Genesis. The company will continue to defend
against any and all claims by Lockheed and/or Genesis. While the
company believes that the possibility of a material adverse
effect on the companys business, financial position,
results of operations and cash flows is remote, there can be no
assurance as to the outcome.

The company has provided documents in response to
a previously disclosed grand jury subpoena issued on
October 15, 2002 by the United States District Court for
the District of Massachusetts directing the company to produce
specified documents dating back to 1996. The subpoena relates to
an investigation, currently focused on the period from 1996 to
1999, by the Antitrust Division of the Department of Justice
into bidding and procurement activities involving the company
and several other defense contractors who have received similar
subpoenas and may also be subjects of the investigation.

Although the company is cooperating in the
investigation, it does not have a sufficient basis to predict
the outcome of the investigation. Should the company be found to
have violated the antitrust laws, the matter could have a
material adverse effect on the companys business,
financial position, results of operations and cash flows.

NEW ACCOUNTING PRONOUNCEMENTS

In December 2003, the staff of the Securities and
Exchange Commission issued Staff Accounting Bulletin
(SAB) No. 104 (SAB 104).
SAB 104 revises or rescinds certain portions of the
interpretative guidance related to revenue recognition as
previously interpreted in SAB No. 101, Revenue
Recognition in Financial Statements(SAB 101). The company does not expect the
implementation of the interpretative guidance in SAB 104 to
have a material effect on its financial position, results of
operations or cash flows.

In December 2003, the FASB issued
SFAS No. 132R (SFAS 132R), a revision
of its original SFAS No. 132, Employers
Disclosures About Pensions and Other Postretirement Benefits(SFAS 132). SFAS 132R revises
employers disclosures about pension plans and other
postretirement benefit plans. It does not change the measurement
or recognition of those plans required by SFAS No. 87,
Employers Accounting for Pensions,
SFAS No. 88, Employers Accounting for
Settlements and Curtailments of Defined Benefit Pension Plans
and for Termination Benefitsand SFAS No. 106,
Employers Accounting for Postretirement Benefits Other
than Pensions. SFAS 132R retains the disclosure
requirements contained in SFAS 132 and requires additional
disclosures about the assets, obligations, cash flows and net
periodic benefit cost of defined benefit pension plans and other
defined benefit postretirement plans. The company has adopted
this statement for the year ended December 31, 2003.

In May 2003, the Emerging Issues Task Force
(EITF) reached a consensus on EITF Issue
No. 00-21, Revenue Arrangements with Multiple
Deliverables (EITF 00-21). EITF 00-21
addresses when an arrangement with multiple deliverables should
be divided into separate units of accounting. The company
adopted the consensus in the third quarter of 2003. The adoption
of EITF 00-21 did not have a material impact on the
companys financial position, results of operations or cash
flows.

In May 2003, the FASB issued
SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and
Equity. SFAS 150 requires issuers to classify as
liabilities (or assets in some circumstances) three classes of
freestanding financial instruments that embody obligations for
the issuer. Generally, SFAS 150 is effective for financial
instruments entered into or modified after May 31, 2003 and
is otherwise effective at the beginning of the first interim
period beginning after June 15, 2003. The company adopted
the provisions of SFAS 150 on July 1, 2003. The
company did not have any financial instruments within the scope
of SFAS 150 at December 31, 2003, and, accordingly,
the adoption of SFAS 150 has not had any effect on its
financial position, results of operations or cash flows.

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In April 2003, the FASB issued
SFAS No. 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities(SFAS 149). SFAS 149 amends and
clarifies financial accounting and reporting for derivative
instruments and hedging activities under SFAS 133,
Accounting for Derivative Instruments and Hedging Activities(SFAS 133), for decisions made: (a) as
part of the Derivative Implementation Group process that
requires amendment to SFAS 133; (b) in connection with
other FASB projects dealing with financial instruments; and
(c) in connection with the implementation issues raised
related to the application of the definition of derivative.
SFAS 149 is effective for contracts entered into or
modified after June 30, 2003 and for designated hedging
relationships after June 30, 2003. SFAS 149 is
required to be applied prospectively. The company does not
currently have any derivative instruments and, accordingly, the
adoption of SFAS 149 did not have any effect on its
financial position, results of operations or cash flows.

In January 2003, the FASB issued FASB
Interpretation No. (FIN) 46, Consolidation
of Variable Interest Entities, an interpretation of ARB No. 51(FIN 46). In December 2003, the FASB issued
FIN No. 46R (FIN 46R), to clarify some of
the provisions of FIN 46 and to exempt certain entities
from its requirements. The primary objectives of FIN 46 are
to provide guidance on the identification of entities for which
control is achieved through means other than through voting
rights (variable interest entities) and how to
determine when and which business enterprise should consolidate
the variable interest entity. This new model for consolidation
applies to an entity in which either: (a) the equity
investors (if any) do not have a controlling financial interest;
or (b) the equity investment at risk is insufficient to
finance that entitys activities without receiving
additional subordinated financial support from other parties. In
addition, FIN 46 requires that both the primary and all
other enterprises with a significant variable interest in a
variable interest entity make additional disclosures.
FIN 46 is effective immediately for variable interest
entities created after January 31, 2003. FIN 46 had
previously been effective for interim periods beginning after
June 15, 2003, for variable interests in place prior to
February 1, 2003; however, on October 10, 2003, the
FASB issued a statement deferring the implementation of
FIN 46 for these variable interests until the first
reporting period beginning after December 15, 2003. The
company acquired, as part of the May 31, 2003 purchase of
HJ Ford, a 40% ownership interest in a small disadvantaged
business, as defined by the United States Government, which has
been accounted for using the equity method. The company provided
the business with a line of credit guarantee, under which its
maximum exposure is $0.2 million. The company has evaluated
this investment and determined that it does not fall under the
scope of FIN 46. Accordingly, the company will continue to
account for this investment under the equity method; there is no
impact on the companys financial position, results of
operations or cash flows as a result of the adoption of
FIN 46 in the fourth quarter of 2003. The company currently
has no other investments subject to the provisions of
FIN 46.

In December 2002, the FASB issued
SFAS No. 148, Accounting for Stock-Based
Compensation-Transition and Disclosure-An Amendment of SFAS
No. 123(SFAS 148). SFAS 148
amends SFAS No. 123, Accounting for Stock-Based
Compensation(SFAS 123), to provide
alternative methods of transition for a voluntary change to the
fair-value-based method of accounting for stock-based employee
compensation. Also, this Statement amends the disclosure
requirements of SFAS 123 to require prominent disclosures
in interim financial statements in addition to the annual
disclosures about the effect the fair value method would have
had on reported results. The transition and annual disclosure
requirements of SFAS 148 are effective for fiscal years
ending after December 15, 2002. The interim disclosure
requirements are effective for interim periods beginning after
December 15, 2002. As permitted by SFAS 148, the
company continues to apply the disclosure-only alternative
adopted under SFAS 123 to account for its stock option
grants to employees, under which compensation expense is not
typically recognized. The company adopted the interim disclosure
provisions of SFAS 148 in its Form 10-Q for the
quarterly period ended March 31, 2003.

In November 2002, the FASB issued
FIN No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of others, an Interpretation of
SFAS No. 5, 57, and 107 and Rescission of FASB
Interpretation No. 34(FIN 45).
FIN 45 clarifies the requirements relating to the
guarantors accounting for, and disclosure of, the issuance
of certain types of guarantees. FIN 45 requires that, upon
issuance of a guarantee, the company recognize a liability for
the fair value of the obligation it assumes under that
guarantee. The company adopted the annual disclosure provisions
of FIN 45 in the year ended December 31, 2002. The company
adopted the provisions for initial recognition and measurement
and interim disclosures during the first quarter of 2003. The
adoption of FIN 45 did not have a material effect on the
companys financial position, results of operations or cash
flows.

In June 2002, the FASB issued
SFAS No. 146, Accounting for Costs Associated with
Exit or Disposal Activities(SFAS 146).
SFAS 146 requires companies to recognize costs associated
with exit or disposal activities when they are incurred rather
than at the date of a commitment to the exit or disposal plan.
The adoption of SFAS 146 on January 1, 2003, did not
have a material effect on the companys financial position,
results of operations or cash flows.

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In April 2002, the FASB issued
SFAS No. 145, Rescission of FASB Statements
No. 4, 44 and 64, Amendment of FASB Statement No. 13
and Technical Corrections(SFAS 145).
SFAS 145 rescinds SFAS No. 4, Reporting Gains
and Losses from Extinguishment of Debt,
SFAS No. 44, Accounting for Intangible Assets of
Motor Carriersand SFAS No. 64, Extinguishment
of Debt Made to Satisfy Sinking-Fund Requirements. SFAS 145
also amends SFAS No. 13, Accounting for Leases,
to eliminate the inconsistency in the required accounting for
sale-leaseback transactions. SFAS 145 also amends other
existing authoritative pronouncements to make various technical
corrections, clarify meanings or describe their applicability
under changed conditions. The company adopted the provisions of
SFAS 145 on January 1, 2003. The adoption of
SFAS 145 did not have a material effect on the
companys financial position, results of operations or cash
flows.

IMPACT OF INFLATION AND CHANGING
PRICES

Overall, inflation has not had a material impact
on the companys operations. Additionally, the terms of
Department of Defense contracts, which accounted for
approximately 78% of revenue in 2003, are generally one year and
include salary increase factors for future years, thus reducing
the potential impact of inflation on the company.

FACTORS THAT MAY AFFECT FUTURE
RESULTS

You should carefully consider the risks described
below before deciding to invest in shares of our common stock.
These are risks and uncertainties we believe are most important
for you to consider. Additional risks and uncertainties not
presently known to us, or which we currently deem immaterial, or
which are similar to those faced by other companies in our
industry or business in general, may also impair our business
operations. If any of the following risks or uncertainties
actually occurs, our business, financial condition, results of
operations or cash flows would likely suffer. In that event, the
market price of our common stock could decline.

Our Revenue is Highly Dependent on the
Department of Defense and Other Federal Agencies. Decreases in
Their Budgets, Changes in Program Priorities or Military Base
Closures Could Affect Our Results.

In the years ended December 31, 2003 and
2002, approximately 93% and 89% of our revenue, respectively,
was derived from United States government agencies, primarily
the Department of Defense. Our revenue could be adversely
affected by significant changes in defense spending during
periods of declining United States defense budgets. Among the
effects of this general decline has been increased competition
within a consolidating defense industry.

Under procedures established by the Base
Realignment and Closure Act, the Department of Defense has
announced its intention to identify in 2005 certain military
installations for closure. Should an installation at which the
company has significant business be selected for closure, the
companys business, financial condition, results of
operations and cash flows could be adversely affected.

It is not possible for us to predict whether
defense budgets will increase or decline in the future. Further,
changing missions and priorities in the defense budget may have
adverse effects on our business. Funding limitations could
result in a reduction, delay or cancellation of existing or
emerging programs. We anticipate there will continue to be
significant competition when our defense contracts are re-bid,
as well as significant competitive pressure to lower prices,
which may reduce profitability in this area of our business,
which would adversely affect our business, financial condition,
results of operations and cash flows.

We Must Bear the Risk of Various Pricing
Structures Associated With
Government Contracts.

We historically have derived a substantial
portion of our revenue from contracts and subcontracts with the
United States Government. A significant portion of our federal
and state government contracts are undertaken on a time and
materials nature, with fixed hourly rates that are intended to
cover salaries, benefits, other indirect costs of operating the
business and profit. The pricing of such contracts is based upon
estimates of future costs and assumptions as to the aggregate
volume of business that we will perform in a given business
division or other relevant unit.

Alternatively, we undertake various government
projects on a fixed-price basis, as distinguished from billing
on a time and materials basis. Under a fixed-price contract, the
government pays an agreed upon price for our services or
products, and we bear the risk that increased or unexpected
costs may reduce our profits or cause us to incur a loss.
Significant cost overruns can occur if we fail to:



| |   |                                                                      
| | - | ---------------------------------------------------------------------
| |  | adequately estimate the resources required to
    complete a project;

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| |   |                                                                                      
| | - | -------------------------------------------------------------------------------------
| |  | properly determine the scope of an engagement; or                                    
|
| |  | complete our contractual obligation in a manner
    consistent with the project plan.

For fixed price contracts, we must estimate the
costs necessary to complete the defined statement of work and
recognize revenue or losses in accordance with such estimates.
Actual costs may vary materially from the estimates made from
time to time, necessitating adjustments to reported revenue and
net income. Underestimates of the costs associated with a
project could adversely affect our overall profitability and
could have a material adverse effect on our business, financial
condition, results of operations and cash flows. While we
endeavor to maintain and improve contract profitability, we
cannot be certain that any of our existing or future time and
materials or fixed-price projects will be profitable.

A substantial portion of our United States
Government business is as a subcontractor. In such
circumstances, we generally bear the risk that the prime
contractor will meet its performance obligations to the United
States Government under the prime contract and that the prime
contractor will have the financial capability to pay us amounts
due under the subcontract. The inability of a prime contractor
to perform or make required payments to us could have a material
adverse effect on the companys business, financial
condition, results of operations and cash flows.

Our Contracts and Subcontracts with
Government Agencies are Subject to a Competitive Bidding Process
and to Termination Without Cause by
the Government.

A significant portion of our federal and state
government contracts are renewable on an annual basis, or are
subject to the exercise of contractual options. Multi-year
contracts often require funding actions by the United States
Government, state legislature or others on an annual or more
frequent basis. As a result, our business could experience
material adverse consequences should such funding actions or
other approvals not be taken.

Recent federal regulations and renewed
congressional interest in small business set aside contracts is
likely to influence decisions pertaining to contracting methods
for many of the companys customers. These regulations
require more frequent review and certification of small business
contractor status, so as to ensure that companies competing for
contracts intended for small business are qualified as such at
the time of the competition. In the years ended
December 31, 2003 and 2002, the company derived
$42.4 million and $17.1 million, respectively, of
revenue from a small business set aside contract held by its
HJ Ford subsidiary and due for re-competition in 2005. The
customer has currently indicated that the re-competition will
continue to be set aside, or reserved, to include only prime
contractors that qualify as small businesses under regulations
established by the Small Business Administration. Because we
anticipate the company will not qualify as a small business, the
company is endeavoring to retain its current work by moving work
to other contract vehicles to the extent possible and by
partnering with firms that will qualify as small businesses. To
the extent these efforts are not successful, the companys
business, financial condition, results of operations and cash
flows could be adversely affected.

The companys contracts with the Internal
Revenue Service and the U.S. Army Aviation and Missile
Command, which represented revenues of approximately
$15 million and $6 million, respectively, in 2003, are
subject to re-competition in 2005.

Governmental awards of contracts are subject to
regulations and procedures that permit formal bidding procedures
and protests by losing bidders. Such protests may result in
significant delays in the commencement of expected contracts,
the reversal of a previous award decision or the reopening of
the competitive bidding process, which could have a material
adverse effect on our business, financial condition, results of
operations and cash flows.

Because of the complexity and scheduling of
contracting with government agencies, from time to time we may
incur costs before receiving contractual funding by the United
States Government. In some circumstances, we may not be able to
recover such costs in whole or in part under subsequent
contractual actions. Failure to collect such amounts may have
material adverse consequences on our business, financial
condition, results of operations and cash flows.

In addition, the United States Government has the
right to terminate contracts for convenience. If the government
terminated contracts with us, we would generally recover costs
incurred up to termination, costs required to be incurred in
connection with the termination and a portion of the fee earned
commensurate with the work we have performed to termination.
However, significant adverse effects on our indirect cost pools
may not be recoverable in connection with a termination for
convenience. Contracts with state and other governmental
entities are subject to the same or similar risks.

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We Are Subject to a High Level of
Government Regulations and Audits Under Our Government Contracts
and Subcontracts.

As a defense contractor, we are subject to many
levels of audit and review, including by the Defense Contract
Audit Agency, the various inspectors general, the Defense
Criminal Investigative Service, the General Accounting Office,
the Department of Justice and congressional committees. These
audits, reviews and the pending grand jury investigation and
civil suit in the United States District Court for the District
of Massachusetts could result in the termination of contracts,
the imposition of fines or penalties, the withholding of
payments due to us or prohibition from participating in certain
United States government contracts for a specified period of
time. Any such action could have a material adverse effect on
our business, financial condition, results of operations and
cash flows.

Loss of Key Personnel Could Limit Our
Growth.

We are dependent on our ability to attract and
retain highly skilled technical personnel. Many of our technical
personnel may have specific knowledge and experience related to
various government customer operations and these individuals
would be difficult to replace in a timely fashion. In addition,
qualified technical personnel are in high demand worldwide and
are likely to remain a limited resource. The loss of services of
key personnel could impair our ability to perform required
services under some of our contracts, to retain such business
after the expiration of the existing contract, or to win new
business in the event that we lost the services of individuals
who have been identified in a given proposal as key personnel in
the proposal. Any of these situations could have a material
adverse effect on our business, financial condition, results of
operations and cash flows.

Our Failure to Obtain and Maintain
Necessary Security Clearances May Limit Our Ability to Perform
Classified Work for Government Clients, Which Could Harm Our
Business.

Some government contracts require us to maintain
facility security clearances, and require some of our employees
to maintain individual security clearances. If our employees
lose or are unable to obtain security clearances on a timely
basis, or we lose a facility clearance, the government client
can terminate the contract or decide not to renew the contract
upon its expiration. As a result, to the extent that we cannot
obtain the required security clearances for our employees
working on a particular contract, or we fail to obtain them on a
timely basis, we may not derive the revenue anticipated from the
contract, which could have a material adverse effect on our
business, financial condition, results of operations and cash
flows.

Security Breaches in Sensitive Government
Systems Could Harm Our
Business.

Many of the systems we develop, install and
maintain involve managing and protecting information involved in
intelligence, national security, and other sensitive or
classified government functions. A security breach in one of
these systems could cause serious harm to our business, damage
our reputation, and prevent us from being eligible for further
work on sensitive or classified systems for federal government
clients. We could incur losses from such a security breach that
could exceed the policy limits under our errors and omissions
and product liability insurance. Damage to our reputation or
limitations on our eligibility for additional work resulting
from a security breach in one of our systems could have a
material adverse effect on our business, financial condition,
results of operations and cash flows.

Our Employees May Engage in Misconduct or
Other Improper Activities, Which Could Harm Our
Business.

We are exposed to the risk that employee fraud or
other misconduct could occur. Misconduct by employees could
include intentional failures to comply with federal government
procurement regulations, engaging in unauthorized activities, or
falsifying time records. Employee misconduct could also involve
the improper use of our clients sensitive or classified
information, which could result in regulatory sanctions against
us and serious harm to our reputation. It is not always possible
to deter employee misconduct, and the precautions we take to
prevent and detect this activity may not be effective in
controlling unknown or unmanaged risks or losses, which could
have a material adverse effect on our business, financial
condition, results of operations and cash flows.

We Are Involved in Various Litigation
Matters Which, If Not Resolved in Our Favor, Could Harm Our
Business.

On October 26, 2000, two former company
employees were indicted and charged with conspiracy to defraud
the United States, and wire fraud, among other charges, arising
out of a scheme to defraud the United States out of
approximately $10 million. Both men subsequently pled
guilty to the principal charges against them. On October 9,
2003, the United States Attorneys office filed a civil
complaint in the District Court of Massachusetts against the
company based in substantial part

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upon the actions and omissions of the former
executives that gave rise to the criminal cases against them. In
the civil action, the United States is asserting claims against
the company based on the False Claims Act and the Anti-Kickback
Act, in addition to certain common law and equitable claims. The
United States seeks to recover up to three times its actual
damages and penalties under the False Claims Act and double
damages and penalties under the Anti-Kickback Act. The United
States also seeks to recover its costs and interest in this
action. The company believes it has substantive defenses to
these claims and intends to vigorously defend itself. However,
the outcome of this litigation and other proceedings to which
the company is a part, if unfavorable, could have a material
adverse effect on the companys business, financial
position, results of operations and cash flows.


Additionally, the Antitrust Division of the
Department of Justice is engaged in an investigation, currently
focused on the period from 1996 to 1999, into bidding and
procurement activities involving the company and several other
defense contractors who may also be subjects of the
investigation. Although the company is cooperating in the
investigation, it does not have a sufficient basis to predict
the outcome of the investigation. Should the company be found to
have violated antitrust laws, the matter could have a material
adverse effect on the companys business, financial
position, results of operations and cash flows.

If We Are Unable to Effectively and
Efficiently Eliminate the Significant Deficiencies That Have
Been Identified in Our Internal Controls and Procedures, There
Could Be a Material Adverse Effect On Our Operations or
Financial Results.

In March 2004, our management and Audit Committee
were notified by our independent accountants, Grant Thornton
LLP, of two significant deficiencies in our internal controls
and procedures regarding, first, the accrual of subcontractor
work performed and, second, our manually intensive financial
reporting process. In 2003, our management and Audit Committee
were notified by our then engaged independent accountants, KPMG
LLP, of three significant deficiencies relating to contract
initiation and set-up for certain fixed price contracts,
inefficiencies in our quarterly and year-end closing procedures
and consolidation and the level of SEC and GAAP experience of
our personnel responsible for accounting and financial
reporting. Although we are committed to addressing these
deficiencies, we cannot assure you that we will be able to
successfully implement the revised controls and procedures or
that our revised controls and procedures will be effective in
remedying all of the identified significant deficiencies. Our
inability to successfully eliminate these significant
deficiencies could have a material adverse effect on our
business, financial condition, results of operations and cash
flows.

We Operate in Highly Competitive Markets
and May Have Difficulties Entering New
Markets.

The markets for our services are highly
competitive. The government contracting business is subject to
intense competition from numerous companies, many of which have
significantly greater financial, technical and marketing
resources than we do. The principal competitive factors are
prior performance, previous experience, technical competence and
price.

Competition in the market for our commercial
products is also intense. There is a significant lead-time for
developing such business, and it involves substantial capital
investment including development of prototypes and investment in
manufacturing equipment. Principal competitive factors are
product quality, the ability to specialize our engineering in
order to meet our customers specific system requirements
and price. Our precision products business has a number of
competitors, many of which have significantly greater financial,
technical and marketing resources than we do. Competitive
pressures in our government and commercial businesses could have
a material adverse effect on our business, financial condition,
results of operations and cash flows.

In our efforts to enter new markets, including
commercial markets and United States Government agencies other
than the Department of Defense, we generally face significant
competition from other companies that have prior experience with
such potential customers, as well as significantly greater
financial, technical and marketing resources than we have. As a
result, we may not achieve the level of success that we expect
in our efforts to enter such new markets.

Our Business is Highly Concentrated and a
Significant Portion of Our Revenue is Derived From a Few
Customers.

Our revenue from contracts with the Department of
Defense, either as prime contractor or subcontractor, accounted
for approximately 78% and 80% of our total revenue during the
years ended December 31, 2003 and 2002, respectively.
Within the Department of Defense, certain individual programs
account for a significant portion of our United States
Government business. We cannot provide any assurance that any of
these programs will continue as such or will continue at current
levels. A decrease in orders from the Department of Defense or
any of these customers would have an adverse effect on our

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profitability, and the loss of any large customer
could have a material adverse effect on our business, financial
condition, results of operations and cash flows.


We May Be Subject to Product Liability
Claims.

Our precision manufactured products are generally
designed to operate as important components of complex systems
or products. Defects in our products could cause our
customers product or systems to fail or perform below
expectations. Although we attempt to contractually limit our
liability for such defects or failures, we cannot assure you
that our attempts to limit our liability will be successful.
Like other manufacturing companies, we may be subject to claims
for alleged performance issues related to our products. Such
claims, if made, could damage our reputation and could have a
material adverse effect on our business, financial condition,
results of operations and cash flows.

Economic Events May Affect Our Business
Segments.

Many of our precision products are components of
commercial products. Factors that affect the production and
demand for such products, including economic events both
domestically and in other regions of the world, competition,
technological change and production disruption, could adversely
affect demand for our products. Many of our products are
incorporated into capital equipment, such as machine tools and
other automated production equipment, used in the manufacture of
other products. As a result, this portion of our business may be
subject to fluctuations in the manufacturing sector of the
overall economy. An economic recession, either in the United
States or elsewhere in the world, could have a material adverse
effect on the rate of orders received by the commercial
division. Significantly lower production volumes resulting in
under-utilization of our manufacturing facilities would
adversely affect our business, financial condition, results of
operations and cash flows.

Our Products and Services Could Become
Obsolete Due to Rapid Technological Changes in the
Industry.

We offer sophisticated products and services in
areas in which there have been and are expected to continue to
be significant technological changes. Many of our products are
incorporated into sophisticated machinery, equipment or
electronic systems. Technological changes may be incorporated
into competitors products that may adversely affect the
market for our products. If our competitors introduce superior
technologies or products, we cannot assure you that we will be
able to respond quickly enough to such changes or to offer
services that satisfy our customers requirements at a
competitive price. Further, we cannot provide any assurance that
our research and product development efforts will be successful
or result in new or improved products that may be required to
sustain our market position.

Our Financing Requirements May Increase and
We Could Have Limited Access to Capital
Markets.

While we believe that our current resources and
access to capital markets are adequate to support operations
over the near term and foreseeable future, we cannot assure you
that these circumstances will remain unchanged. Our need for
capital is dependent on operating results and may be greater
than expected. Our ability to maintain our current sources of
debt financing depends on our ability to remain in compliance
with certain covenants contained in our financing agreements,
including, among other requirements, maintaining a minimum total
net worth and minimum cash flow and debt coverage ratios. If
changes in capital markets restrict the availability of funds or
increase the cost of funds, we may be required to modify, delay
or abandon some of our planned expenditures, which could have a
material adverse effect on our business, financial condition,
results of operations and cash flows.

Accounting System Upgrades and Conversions
May Delay Billing and Collections of our Accounts
Receivable.

We have recently installed a new enterprise
business system, and from time to time, we may be required to
make changes to that system as we integrate businesses or
upgrade to new technologies. The implementation of the
companys new enterprise business system has caused certain
delays in billing and collection of accounts receivable, which
are currently being addressed by the company. Future accounting
system conversions and upgrades could cause delays in billing
and collection of accounts receivable under our contracts, which
could adversely affect our business, financial condition,
results of operations and cash flows.

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Our Quarterly Operating Results May Vary
Significantly From Quarter to
Quarter.

Our revenue and earnings may fluctuate from
quarter to quarter depending on a number of factors, including:



| |   |                                                                                             
| | - | --------------------------------------------------------------------------------------------
| |  | the number, size and timing of client projects
    commenced and completed during a quarter;
|
| |  | bid and proposal efforts undertaken;                                                        
|
| |  | progress on fixed-price projects during a given
    quarter;                                
|
| |  | employee productivity and hiring, attrition and
    utilization rates;                      
|
| |  | accuracy of estimates of resources required to
    complete ongoing projects; and           
|
| |  | general economic conditions.                                                                

Demand for our products and services in each of
the markets we serve can vary significantly from quarter to
quarter due to revisions in customer budgets or schedules and
other factors beyond our control. In addition, because a high
percentage of our expenses is fixed and does vary relative to
revenue, a decrease in revenue may cause a significant variation
in our operating results.

We May Not Make or Complete Future Mergers,
Acquisitions or Strategic Alliances or
Investments.

In 2002, we acquired HJ Ford Associates, Inc. and
Andrulis Corporation and we may seek to continue to expand our
operations through mergers, acquisitions or strategic alliances
with businesses that will complement our existing business.
However, we may not be able to find attractive candidates, or
enter into acquisitions on terms that are favorable to us, or
successfully integrate the operations of companies that we
acquire. In addition, we may compete with other companies for
these acquisition candidates, which could make an acquisition
more expensive for us. If we are able to successfully identify
and complete an acquisition or similar transaction, it could
involve a number of risks, including, among others:



| |   |                                                                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the difficulty of assimilating the acquired
    operations and personnel;                                                                           
|
| |  | the potential disruption of our ongoing business
    and diversion of resources and management time;                                                
|
| |  | the potential failure to retain key personnel of
    the acquired business;                                                                         
|
| |  | the difficulty of integrating systems, operations
    and cultures; and                                                                             
|
| |  | the potential impairment of relationships with
    customers as a result of changes in management or otherwise
    arising out of such transactions.

We cannot assure you that any acquisition will be
made, that we will be able to obtain financing needed to fund
such acquisitions and, if any acquisitions are so made, that the
acquired business will be successfully integrated into our
operations or that the acquired business will perform as
expected. In addition, if we were to proceed with one or more
significant strategic alliances, acquisitions or investments in
which the consideration consists of cash, a substantial portion
of our available cash could be used to consummate the strategic
alliances, acquisitions or investments. The financial impact of
acquisitions, investments and strategic alliances could have a
material adverse effect on our business, financial condition,
results of operations and cash flows and could cause substantial
fluctuations in our quarterly and annual operating results.

The Market Price of Our Common Stock May Be
Volatile.

The market price of securities of technology
companies historically has faced significant volatility. The
stock market in recent years has also experienced significant
price and volume fluctuations that often have been unrelated or
disproportionate to the operating performance of particular
companies. Many factors that have influenced trading prices will
vary from period to period, including:



| |   |                                                                          
| | - | -------------------------------------------------------------------------
| |  | decreases in our earnings and revenue or
    quarterly operating results;
|
| |  | changes in estimates by analysts;                                        
|
| |  | market conditions in the industry;                                       
|
| |  | announcements and new developments by
    competitors; and               
|
| |  | regulatory reviews.                                                      

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Any of these events could have a material adverse
effect on the market price of our common stock.






|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
    MARKET RISK

The company is subject to interest rate risk
associated with our Mortgage and Revolver, where interest
payments are tied to either the LIBOR or prime rate. At any
time, a sharp rise in interest rates could have an adverse
effect on net interest expense as reported in the companys
Consolidated Statements of Operations. An increase of one
percentage point in the interest rate on the balances of the
Mortgage and Revolver at December 31, 2003 would result in
a $0.2 million increase in annual interest expense. The
company does not currently hedge these interest rate exposures.

The company presently has minimal exposure to
market interest rates on its investments. At December 31,
2003, the company had investments of $2.5 million, which
consisted primarily of money market accounts.

The company has no significant exposure to
foreign currency fluctuations. Foreign sales, which are nominal,
are primarily denominated in United States dollars.

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PART II




Item 8. FINANCIAL STATEMENTS AND
SUPPLEMENTARY DATA

|                                                                                                                                                        |  |      |    | 
|------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|                                                                                                                                                        |  | Page
|                                                                                                                                                        |  |     
|Report of Independent Certified Public
    Accountants (Grant Thornton LLP)                                                                             |  |      | 37 | 
|Independent Auditors Report (KPMG LLP)                                                                                                                 |  |      | 38 | 
|Consolidated Balance Sheets as of
    December 31, 2003 and 2002                                                                                        |  |      | 39 | 
|Consolidated Statements of Operations for the
    years ended December 31, 2003, 2002 and 2001                                                          |  |      | 40 | 
|Consolidated Statements of Changes in
    Stockholders Equity and Comprehensive Income (Loss) for
    the years ended December 31, 2003, 2002 and 2001 |  |      | 41 | 
|Consolidated Statements of Cash Flows for the
    years ended December 31, 2003, 2002 and 2001                                                          |  |      | 42 | 
|Notes to Consolidated Financial Statements                                                                                                              |  |      | 43 | 
|Schedule II  Valuation and
    Qualifying Accounts and Reserves                                                                                        |  |      | 70 | 

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REPORT OF INDEPENDENT CERTIFIED PUBLIC
ACCOUNTANTS

The Board of Directors and Stockholders

Dynamics Research Corporation:


We have audited the accompanying Consolidated
Balance Sheet of Dynamics Research Corporation and subsidiaries
(the company) as of December 31, 2003, and the
related Consolidated Statements of Operations, Changes in
Stockholders Equity and Comprehensive Income (Loss) and
Cash Flows for the year then ended December 31, 2003. These
consolidated financial statements are the responsibility of the
companys management. Our responsibility is to express an
opinion on these consolidated financial statements based on our
audit. The consolidated financial statements of the company as
of December 31, 2002 and for the years ended
December 31, 2002 and 2001, were audited by other auditors.
Those auditors expressed an unqualified opinion on those
consolidated financial statements in their report dated March
26, 2003.

We conducted our audit in accordance with
auditing standards generally accepted in the United States of
America. Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit
provides a reasonable basis for our opinion.

In our opinion, the consolidated financial
statements referred to above present fairly, in all material
respects, the consolidated financial position of the company as
of December 31, 2003, and the results of their operations and
their cash flows for the year then ended December 31, 2003, in
conformity with accounting principles generally accepted in the
United States of America.

We have also audited Schedule II for the year
ended December 31, 2003. In our opinion, this schedule,
when considered in relation to the basic financial statements
taken as a whole, presents fairly, in all material respects, the
information therein.

/s/ Grant Thornton

Boston, Massachusetts


February 20, 2004


37



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##### Table of Contents



INDEPENDENT AUDITORS REPORT

The Board of Directors and Stockholders

Dynamics Research Corporation:


We have audited the accompanying consolidated
balance sheet of Dynamics Research Corporation and subsidiaries
(the company) as of December 31, 2002, and the
related consolidated statements of operations, changes in
stockholders equity and comprehensive income (loss) and
cash flows for each of the years in the two-year period ended
December 31, 2002. These consolidated financial statements
are the responsibility of the Companys management. Our
responsibility is to express an opinion on these consolidated
financial statements based on our audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States of
America. Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

In our opinion, the accompanying financial
statements present fairly, in all material respects, the
consolidated financial position of the company as of
December 31, 2002 and the results of their operations and
their cash flows for each of the years in the two-year period
ended December 31, 2002, in conformity with accounting
principles generally accepted in the United States of America.



| |             
| | ------------
| | /s/ KPMG LLP

Boston, Massachusetts

March 26, 2003


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##### Table of Contents



DYNAMICS RESEARCH CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share
data)


|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |        |      |         | 
|---------------------------------------- | ----------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------- | ------------------------------------------ | ------ | ---- | ------- | - | ------ | ---- | ------- | 
|                                         |                                                                                     |                                                                                        
|                                         |                                                                                     | December 31,                                                                           
|                                         |                                                                                     |                                                                                        
|                                         |                                                                                     | 2003                                                                                    |                                            | 2002  
|                                         |                                                                                     |                                                                                         |                                            |       
|ASSETS                                  
|Current assets                           |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|                                         | Cash and cash equivalents                                                           |                                                                                         | $                                          | 2,724  |      |         | $ | 1,076  |     
|                                         | Accounts receivable, net of allowances of $321
    and $373, respectively           |                                                                                         |                                            | 28,251 |      |         |   | 29,819 |     
|                                         | Unbilled expenditures and fees on contracts in
    process                          |                                                                                         |                                            | 34,257 |      |         |   | 26,614 |     
|                                         | Prepaid expenses and other current assets                                           |                                                                                         |                                            | 2,145  |      |         |   | 1,727  |     
|                                         | Discontinued operations                                                             |                                                                                         |                                            |       |      |         |   | 3,432  |     
|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|                                         |                                                                                     |                                                                                         | Total current assets                       |        |      | 67,377  |   |        |      | 62,668  | 
|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|Noncurrent assets                        |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|                                         | Property, plant and equipment, net                                                  |                                                                                         |                                            | 20,672 |      |         |   | 15,608 |     
|                                         | Deferred income taxes                                                               |                                                                                         |                                            | 2,337  |      |         |   | 1,559  |     
|                                         | Goodwill                                                                            |                                                                                         |                                            | 26,711 |      |         |   | 26,169 |     
|                                         | Intangible assets, net                                                              |                                                                                         |                                            | 2,343  |      |         |   | 4,066  |     
|                                         | Other noncurrent assets                                                             |                                                                                         |                                            | 1,630  |      |         |   | 1,275  |     
|                                         | Discontinued operations                                                             |                                                                                         |                                            |       |      |         |   | 331    |     
|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|                                         |                                                                                     |                                                                                         | Total noncurrent assets                    |        |      | 53,693  |   |        |      | 49,008  | 
|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|                                         |                                                                                     |                                                                                         | Total assets                               |        | $    | 121,070 |   |        | $    | 111,676 | 
|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|LIABILITIES AND STOCKHOLDERS
    EQUITY
|Current liabilities                      |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|                                         | Current portion of long-term debt                                                   |                                                                                         | $                                          | 500    |      |         | $ | 500    |     
|                                         | Notes payable and revolver                                                          |                                                                                         |                                            | 8,500  |      |         |   | 14,644 |     
|                                         | Accounts payable                                                                    |                                                                                         |                                            | 13,351 |      |         |   | 12,334 |     
|                                         | Accrued payroll and employee benefits                                               |                                                                                         |                                            | 15,657 |      |         |   | 11,898 |     
|                                         | Deferred income taxes                                                               |                                                                                         |                                            | 9,698  |      |         |   | 6,524  |     
|                                         | Other accrued expenses                                                              |                                                                                         |                                            | 2,371  |      |         |   | 3,531  |     
|                                         | Discontinued operations                                                             |                                                                                         |                                            | 778    |      |         |   | 1,009  |     
|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|                                         |                                                                                     |                                                                                         | Total current liabilities                  |        |      | 50,855  |   |        |      | 50,440  | 
|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|Long-term liabilities                    |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|                                         | Long-term debt, less current portion                                                |                                                                                         |                                            | 7,750  |      |         |   | 8,250  |     
|                                         | Accrued pension liability                                                           |                                                                                         |                                            | 12,030 |      |         |   | 11,778 |     
|                                         | Other long-term liabilities                                                         |                                                                                         |                                            | 1,386  |      |         |   | 1,399  |     
|                                         | Discontinued operations                                                             |                                                                                         |                                            | 398    |      |         |   |       |     
|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|                                         |                                                                                     |                                                                                         | Total long-term liabilities                |        |      | 21,564  |   |        |      | 21,427  | 
|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|                                         |                                                                                     |                                                                                         | Total liabilities                          |        |      | 72,419  |   |        |      | 71,867  | 
|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|Commitments and contingencies            |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|Stockholders equity                     |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|                                         | Preferred stock, $0.10 par value, 5,000,000
    shares authorized, no shares issued |                                                                                         |                                            |       |      |         |   |       |     
|                                         | Common stock, $0.10 par value, 30,000,000 shares
    authorized:                    |                                                                                         |                                            |        |      |         |   |        |     
|                                         |                                                                                     | Issued  9,822,508 and 9,543,606 shares
    at December 31, 2003 and 2002, respectively |                                            |        | 982  |         |   |        | 954  |        
|                                         |                                                                                     | Treasury stock  1,379,426 shares at
    both December 31, 2003 and 2002, respectively  |                                            |        | (138 | )       |   |        | (138 | )      
|                                         | Capital in excess of par value                                                      |                                                                                         |                                            | 36,642 |      |         |   | 33,844 |     
|                                         | Unearned compensation                                                               |                                                                                         |                                            | (797   | )    |         |   | (816   | )   
|                                         | Accumulated other comprehensive loss                                                |                                                                                         |                                            | (7,556 | )    |         |   | (6,881 | )   
|                                         | Retained earnings                                                                   |                                                                                         |                                            | 19,518 |      |         |   | 12,846 |     
|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|                                         |                                                                                     |                                                                                         | Total stockholders equity                 |        |      | 48,651  |   |        |      | 39,809  | 
|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |       
|                                         |                                                                                     |                                                                                         | Total liabilities and stockholders equity |        | $    | 121,070 |   |        | $    | 111,676 | 
|                                         |                                                                                     |                                                                                         |                                            |        |      |         |   |       

The accompanying notes are an integral part of
these consolidated financial statements.

39



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##### Table of Contents



DYNAMICS RESEARCH CORPORATION

CONSOLIDATED STATEMENTS OF
OPERATIONS

(In thousands, except share and per share
data)


|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |   |           |         | 
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------- | ------------------------------------------------------ | ---------------------------------- | ---- | --------- | ------- | ------- | - | --------- | ------- | ------- | - | --------- | ------- | 
|                                                                                                                                                                          |                                     |                                                       
|                                                                                                                                                                          |                                     | Year Ended December 31,                               
|                                                                                                                                                                          |                                     |                                                       
|                                                                                                                                                                          |                                     | 2003                                                   |                                    | 2002 |           | 2001   
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |        
|Contract revenue                                                                                                                                                          |                                     | $                                                      | 237,876                            |      |           | $       | 184,994 |   |           | $       | 179,350 |  
|Product sales                                                                                                                                                             |                                     |                                                        | 6,932                              |      |           |         | 7,616   |   |           |         | 10,914  |  
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|                                                                                                                                                                          |                                     |                                                        | Total revenue                      |      |           | 244,808 |         |   |           | 192,610 |         |   |           | 190,264 | 
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|Cost of contract revenue                                                                                                                                                  |                                     |                                                        | 199,647                            |      |           |         | 156,441 |   |           |         | 155,394 |  
|Cost of product sales                                                                                                                                                     |                                     |                                                        | 5,100                              |      |           |         | 5,238   |   |           |         | 5,813   |  
|Selling, general and administrative expenses                                                                                                                              |                                     |                                                        | 22,948                             |      |           |         | 17,910  |   |           |         | 16,047  |  
|Amortization of intangible assets                                                                                                                                         |                                     |                                                        | 1,724                              |      |           |         | 374     |   |           |         |        |  
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|                                                                                                                                                                          |                                     |                                                        | Total operating costs and expenses |      |           | 229,419 |         |   |           | 179,963 |         |   |           | 177,254 | 
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|Operating income                                                                                                                                                          |                                     |                                                        | 15,389                             |      |           |         | 12,647  |   |           |         | 13,010  |  
|Interest expense, net                                                                                                                                                     |                                     |                                                        | (854                               | )    |           |         | (421    | ) |           |         | (841    | )
|Other income (expense), net                                                                                                                                               |                                     |                                                        | 454                                |      |           |         | 67      |   |           |         | (193    | )
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|Income from continuing operations before
    provision for income taxes                                                                                                   |                                     |                                                        | 14,989                             |      |           |         | 12,293  |   |           |         | 11,976  |  
|Provision for income taxes                                                                                                                                                |                                     |                                                        | 6,334                              |      |           |         | 4,936   |   |           |         | 4,874   |  
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|Income from continuing operations                                                                                                                                         |                                     |                                                        | 8,655                              |      |           |         | 7,357   |   |           |         | 7,102   |  
|Loss from discontinued operations, net of tax
    benefit of $1,058, $741
    and $425 in the years ended December 31, 2003, 2002 and
    2001,
    respectively          |                                     |                                                        | (1,635                             | )    |           |         | (1,124  | ) |           |         | (619    | )
|Gain (loss) on disposal of discontinued
    operations, net of tax benefit of $226 and tax expense of $43 in
    the years ended December 31, 2003 and 2001, respectively |                                     |                                                        | (348                               | )    |           |         |        |   |           |         | 62      |  
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|Net income                                                                                                                                                                |                                     | $                                                      | 6,672                              |      |           | $       | 6,233   |   |           | $       | 6,545   |  
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|Earnings (loss) per common share                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|                                                                                                                                                                          | Basic                               |                                                        |                                    |      |           |         |         |   |           |         |         |   |          
|                                                                                                                                                                          |                                     | Income from continuing operations                      |                                    | $    | 1.05      |         |         | $ | 0.92      |         |         | $ | 0.92      |        
|                                                                                                                                                                          |                                     | Loss from discontinued operations                      |                                    |      | (0.20     | )       |         |   | (0.14     | )       |         |   | (0.08     | )      
|                                                                                                                                                                          |                                     | Gain (loss) on disposal of discontinued
    operations |                                    |      | (0.04     | )       |         |   |          |         |         |   | 0.01      |        
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|                                                                                                                                                                          |                                     |                                                        | Net earnings per common share      |      | $         | 0.81    |         |   | $         | 0.78    |         |   | $         | 0.85    | 
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|                                                                                                                                                                          | Diluted                             |                                                        |                                    |      |           |         |         |   |           |         |         |   |          
|                                                                                                                                                                          |                                     | Income from continuing operations                      |                                    | $    | 0.98      |         |         | $ | 0.83      |         |         | $ | 0.88      |        
|                                                                                                                                                                          |                                     | Loss from discontinued operations                      |                                    |      | (0.18     | )       |         |   | (0.13     | )       |         |   | (0.08     | )      
|                                                                                                                                                                          |                                     | Gain (loss) on disposal of discontinued
    operations |                                    |      | (0.04     | )       |         |   |          |         |         |   | 0.01      |        
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|                                                                                                                                                                          |                                     |                                                        | Net earnings per common share      |      | $         | 0.76    |         |   | $         | 0.70    |         |   | $         | 0.81    | 
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|                                                                                                                                                                          | Weighted average shares outstanding |                                                        |                                    |      |           |         |         |   |           |         |         |   |          
|                                                                                                                                                                          |                                     | Weighted average shares outstanding 
    basic        |                                    |      | 8,226,225 |         |         |   | 7,989,793 |         |         |   | 7,674,608 |        
|                                                                                                                                                                          |                                     | Dilutive effect of options                             |                                    |      | 615,818   |         |         |   | 887,376   |         |         |   | 414,477   |        
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  
|                                                                                                                                                                          |                                     | Weighted average shares outstanding 
    diluted      |                                    |      | 8,842,043 |         |         |   | 8,877,169 |         |         |   | 8,089,085 |        
|                                                                                                                                                                          |                                     |                                                        |                                    |      |           |         |         |   |           |         |         |  

The accompanying notes are an integral part of
these consolidated financial statements.

40



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##### Table of Contents



DYNAMICS RESEARCH CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN
STOCKHOLDERS EQUITY AND COMPREHENSIVE INCOME
(LOSS)

(in thousands)


|                                         |  |                 |   |           |  |                |   |              |  |          |       |               |  |          |     |              |  |      |        |          |  |       |      |   |  |   |        |   |  |   |        |   |  |   |        |   |  |   |        |  |  |   |        |  
|---------------------------------------- |  | --------------- | - | --------- |  | -------------- | - | ------------ |  | -------- | ----- | ------------- |  | -------- | --- | ------------ |  | ---- | ------ | -------- |  | ----- | ---- | - |  | - | ------ | - |  | - | ------ | - |  | - | ------ | - |  | - | ------ |  |  | - | ------ | -
|                                         |  |                 |   |           |  |                |   |              |  |          |       |               |  |          |     |              |  |      |        |         
|                                         |  |                 |   |           |  |                |   | Common Stock |  |          |       |               |  |          |     |              |  |      |        |         
|                                         |  |                 |   |           |  |                |   |              |  |          |       |               |  |          |     |              |  |      |        |         
|                                         |  |                 |   |           |  |                |   | Capital in   |  |          |       | Accumulated   |  |          |     |             
|                                         |  | Preferred Stock |   | Issued    |  | Treasury Stock |   | Excess       |  |          |       | Other         |  |          |     |             
|                                         |  |                 |   |           |  |                |   | of Par       |  | Unearned |       | Comprehensive |  | Retained |     |             
|                                         |  | Shares          |   | Par Value |  | Shares         |   | Par Value    |  | Shares   |       | Par Value     |  | Value    |     | Compensation |  | Loss |        | Earnings |  | Total
|                                         |  |                 |   |           |  |                |   |              |  |          |       |               |  |          |     |              |  |      |        |          |  |      
|Balance December 31, 2000                |  |                 |  |           |  | $              |  |              |  |          | 8,981 |               |  | $        | 898 |              |  |      | (1,379 | )        |  | $     | (138 | ) |  | $ | 28,461 |   |  | $ |       |   |  | $ |       |   |  | $ | 68     |  |  | $ | 29,289 |  
|Issuance of common stock                 |  |                 |  |           |  |                |  |              |  |          | 194   |               |  |          | 20  |              |  |      |       |          |  |       |     |   |  |   | 1,329  |   |  |   |       |   |  |   |       |   |  |   |       |  |  |   | 1,349  |  
|Issuance of restricted stock             |  |                 |  |           |  |                |  |              |  |          | 145   |               |  |          | 14  |              |  |      |       |          |  |       |     |   |  |   | 1,330  |   |  |   | (1,082 | ) |  |   |       |   |  |   |       |  |  |   | 262    |  
|Amortization of unearned compensation    |  |                 |  |           |  |                |  |              |  |          |      |               |  |          |    |              |  |      |       |          |  |       |     |   |  |   |       |   |  |   | 90     |   |  |   |       |   |  |   |       |  |  |   | 90     |  
|Accumulated other comprehensive loss (1) |  |                 |  |           |  |                |  |              |  |          |      |               |  |          |    |              |  |      |       |          |  |       |     |   |  |   |       |   |  |   |       |   |  |   | (608   | ) |  |   |       |  |  |   | (608   | )
|Tax benefit from stock options exercised |  |                 |  |           |  |                |  |              |  |          |      |               |  |          |    |              |  |      |       |          |  |       |     |   |  |   | 211    |   |  |   |       |   |  |   |       |   |  |   |       |  |  |   | 211    |  
|Net income                               |  |                 |  |           |  |                |  |              |  |          |      |               |  |          |    |              |  |      |       |          |  |       |     |   |  |   |       |   |  |   |       |   |  |   |       |   |  |   | 6,545  |  |  |   | 6,545  |  
|                                         |  |                 |   |           |  |                |   |              |  |          |       |               |  |          |     |              |  |      |        |          |  |       |      |   |  |   |        |   |  |   |        |   |  |   |        |   |  |   |        |  |  |   |        |  
|Balance December 31, 2001                |  |                 |  |           |  |                |  |              |  |          | 9,320 |               |  |          | 932 |              |  |      | (1,379 | )        |  |       | (138 | ) |  |   | 31,331 |   |  |   | (992   | ) |  |   | (608   | ) |  |   | 6,613  |  |  |   | 37,138 |  
|Issuance of common stock                 |  |                 |  |           |  |                |  |              |  |          | 227   |               |  |          | 22  |              |  |      |       |          |  |       |     |   |  |   | 2,346  |   |  |   |       |   |  |   |       |   |  |   |       |  |  |   | 2,368  |  
|Forfeiture of restricted stock           |  |                 |  |           |  |                |  |              |  |          | (3    | )             |  |          |    |              |  |      |       |          |  |       |     |   |  |   | (27    | ) |  |   | 27     |   |  |   |       |   |  |   |       |  |  |   |       |  
|Amortization of unearned compensation    |  |                 |  |           |  |                |  |              |  |          |      |               |  |          |    |              |  |      |       |          |  |       |     |   |  |   |       |   |  |   | 149    |   |  |   |       |   |  |   |       |  |  |   | 149    |  
|Accumulated other comprehensive loss (1) |  |                 |  |           |  |                |  |              |  |          |      |               |  |          |    |              |  |      |       |          |  |       |     |   |  |   |       |   |  |   |       |   |  |   | (6,273 | ) |  |   |       |  |  |   | (6,273 | )
|Tax benefit from stock options exercised |  |                 |  |           |  |                |  |              |  |          |      |               |  |          |    |              |  |      |       |          |  |       |     |   |  |   | 194    |   |  |   |       |   |  |   |       |   |  |   |       |  |  |   | 194    |  
|Net income                               |  |                 |  |           |  |                |  |              |  |          |      |               |  |          |    |              |  |      |       |          |  |       |     |   |  |   |       |   |  |   |       |   |  |   |       |   |  |   | 6,233  |  |  |   | 6,233  |  
|                                         |  |                 |   |           |  |                |   |              |  |          |       |               |  |          |     |              |  |      |        |          |  |       |      |   |  |   |        |   |  |   |        |   |  |   |        |   |  |   |        |  |  |   |        |  
|Balance December 31, 2002                |  |                 |  |           |  |                |  |              |  |          | 9,544 |               |  |          | 954 |              |  |      | (1,379 | )        |  |       | (138 | ) |  |   | 33,844 |   |  |   | (816   | ) |  |   | (6,881 | ) |  |   | 12,846 |  |  |   | 39,809 |  
|Issuance of common stock                 |  |                 |  |           |  |                |  |              |  |          | 255   |               |  |          | 26  |              |  |      |       |          |  |       |     |   |  |   | 2,373  |   |  |   |       |   |  |   |       |   |  |   |       |  |  |   | 2,399  |  
|Issuance of restricted stock             |  |                 |  |           |  |                |  |              |  |          | 23    |               |  |          | 2   |              |  |      |       |          |  |       |     |   |  |   | 228    |   |  |   | (230   | ) |  |   |       |   |  |   |       |  |  |   |       |  
|Amortization of unearned compensation    |  |                 |  |           |  |                |  |              |  |          |      |               |  |          |    |              |  |      |       |          |  |       |     |   |  |   |       |   |  |   | 249    |   |  |   |       |   |  |   |       |  |  |   | 249    |  
|Accumulated other comprehensive loss (1) |  |                 |  |           |  |                |  |              |  |          |      |               |  |          |    |              |  |      |       |          |  |       |     |   |  |   |       |   |  |   |       |   |  |   | (675   | ) |  |   |       |  |  |   | (675   | )
|Tax benefit from stock options exercised |  |                 |  |           |  |                |  |              |  |          |      |               |  |          |    |              |  |      |       |          |  |       |     |   |  |   | 197    |   |  |   |       |   |  |   |       |   |  |   |       |  |  |   | 197    |  
|Net income                               |  |                 |  |           |  |                |  |              |  |          |      |               |  |          |    |              |  |      |       |          |  |       |     |   |  |   |       |   |  |   |       |   |  |   |       |   |  |   | 6,672  |  |  |   | 6,672  |  
|                                         |  |                 |   |           |  |                |   |              |  |          |       |               |  |          |     |              |  |      |        |          |  |       |      |   |  |   |        |   |  |   |        |   |  |   |        |   |  |   |        |  |  |   |        |  
|Balance December 31, 2003                |  |                 |  |           |  | $              |  |              |  |          | 9,822 |               |  | $        | 982 |              |  |      | (1,379 | )        |  | $     | (138 | ) |  | $ | 36,642 |   |  | $ | (797   | ) |  | $ | (7,556 | ) |  | $ | 19,518 |  |  | $ | 48,651 |  
|                                         |  |                 |   |           |  |                |   |              |  |          |       |               |  |          |     |              |  |      |        |          |  |       |      |   |  |   |        |   |  |   |        |   |  |   |        |   |  |   |        |  |  |   |        |  



---



|    |                                                          
|--- | ---------------------------------------------------------
|(1) | Comprehensive income (loss) is calculated as
    follows:

|                                                                                                                                                                             |  |                         |       |      |  |      |        |   |  |   |       |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ----- | ---- |  | ---- | ------ | - |  | - | ----- | -
|                                                                                                                                                                             |  |                        
|                                                                                                                                                                             |  | Year Ended December 31,
|                                                                                                                                                                             |  |                        
|                                                                                                                                                                             |  | 2003                    |       | 2002 |  | 2001
|                                                                                                                                                                             |  |                         |       |      |  |     
|Net income                                                                                                                                                                   |  | $                       | 6,672 |      |  | $    | 6,233  |   |  | $ | 6,545 |  
|Minimum pension liability adjustment, net of tax
    effect and adjustments of $1,732, $4,059 and $405 in the years
    ended December 31, 2003, 2002 and 2001, respectively |  |                         | (675  | )    |  |      | (6,273 | ) |  |   | (608  | )
|                                                                                                                                                                             |  |                         |       |      |  |      |        |   |  |   |       |  
|Comprehensive income (loss)                                                                                                                                                  |  | $                       | 5,997 |      |  | $    | (40    | ) |  | $ | 5,937 |  
|                                                                                                                                                                             |  |                         |       |      |  |      |        |   |  |   |       |  

The accompanying notes are an integral part of
these consolidated financial statements.

41



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##### Table of Contents



DYNAMICS RESEARCH CORPORATION

CONSOLIDATED STATEMENTS OF CASH
FLOWS

(in thousands)


|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |        |        |        |        |  
|------------------------------------------------------------------------- | ---------------------------------------------------------------------------------- | ---------------------------------------------------------- | ---------------------------------------------------------- | ------------------------------------------------------- | ------ | ------ | ------- | ------- | ------ | ------- | ------- | ------ | ------ | ------ | ------ | -
|                                                                          |                                                                                    |                                                           
|                                                                          |                                                                                    | Year Ended December 31,                                   
|                                                                          |                                                                                    |                                                           
|                                                                          |                                                                                    | 2003                                                       |                                                            | 2002                                                    |        | 2001  
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |       
|Operating activities                                                      |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|                                                                          | Net income                                                                         |                                                            | $                                                          | 6,672                                                   |        |        | $       | 6,233   |        |         | $       | 6,545  |       
|                                                                          | Loss from discontinued operations                                                  |                                                            |                                                            | (1,635                                                  | )      |        |         | (1,124  | )      |         |         | (619   | )     
|                                                                          | Gain (loss) on disposal of discontinued operations                                 |                                                            |                                                            | (348                                                    | )      |        |         |        |        |         |         | 62     |       
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|                                                                          | Income from continuing operations                                                  |                                                            |                                                            | 8,655                                                   |        |        |         | 7,357   |        |         |         | 7,102  |       
|                                                                          | Adjustments to reconcile net cash provided by
    (used in) operating activities   |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |        |       
|                                                                          |                                                                                    | Depreciation                                               |                                                            |                                                         | 3,007  |        |         |         | 3,192  |         |         |        | 2,989  |       
|                                                                          |                                                                                    | Loss on disposal of assets                                 |                                                            |                                                         | 2      |        |         |         |       |         |         |        | 193    |       
|                                                                          |                                                                                    | Non-cash interest expense                                  |                                                            |                                                         | 137    |        |         |         | 92     |         |         |        | 97     |       
|                                                                          |                                                                                    | Investment income from equity interest                     |                                                            |                                                         | (198   | )      |         |         | (46    | )       |         |        |       |       
|                                                                          |                                                                                    | Stock compensation expense                                 |                                                            |                                                         | 249    |        |         |         | 149    |         |         |        | 90     |       
|                                                                          |                                                                                    | Tax benefit from stock options exercised                   |                                                            |                                                         | 197    |        |         |         | 194    |         |         |        | 211    |       
|                                                                          |                                                                                    | Amortization of intangible assets                          |                                                            |                                                         | 1,724  |        |         |         | 374    |         |         |        |       |       
|                                                                          |                                                                                    | Deferred income taxes provision                            |                                                            |                                                         | 2,733  |        |         |         | 343    |         |         |        | 1,568  |       
|                                                                          | Change in operating assets and liabilities, net
    of effect of acquisitions      |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |        |       
|                                                                          |                                                                                    | Accounts receivable, net                                   |                                                            |                                                         | 1,568  |        |         |         | 3,422  |         |         |        | 7,600  |       
|                                                                          |                                                                                    | Unbilled expenditures and fees on contracts in
    process |                                                            |                                                         | (7,643 | )      |         |         | 3,961  |         |         |        | 1,757  |       
|                                                                          |                                                                                    | Prepaid expenses and other current assets                  |                                                            |                                                         | (729   | )      |         |         | (205   | )       |         |        | 2,584  |       
|                                                                          |                                                                                    | Accounts payable                                           |                                                            |                                                         | 1,017  |        |         |         | (8,734 | )       |         |        | (161   | )     
|                                                                          |                                                                                    | Accrued payroll and employee benefits                      |                                                            |                                                         | 3,759  |        |         |         | (1,695 | )       |         |        | 1,109  |       
|                                                                          |                                                                                    | Deferred income taxes                                      |                                                            |                                                         |       |        |         |         |       |         |         |        | 33     |       
|                                                                          |                                                                                    | Other accrued expenses                                     |                                                            |                                                         | (1,292 | )      |         |         | 1,511  |         |         |        | (1,618 | )     
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|                                                                          |                                                                                    |                                                            | Net cash provided by continuing operations                 |                                                         |        | 13,186 |         |         |        | 9,915   |         |        |        | 23,554 |       
|                                                                          |                                                                                    |                                                            | Net cash provided by (used in) discontinued
    operations |                                                         |        | (1,425 | )       |         |        | 379     |         |        |        | 948    |       
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|                                                                          |                                                                                    |                                                            |                                                            | Net cash provided by operating activities               |        |        | 11,761  |         |        |         | 10,294  |        |        |        | 24,502 |  
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|Investing activities                                                      |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|                                                                          | Purchase of property, plant and equipment                                          |                                                            |                                                            | (8,163                                                  | )      |        |         | (3,347  | )      |         |         | (3,595 | )     
|                                                                          | Proceeds from the sale of assets                                                   |                                                            |                                                            |                                                        |        |        |         |        |        |         |         | 100    |       
|                                                                          | Purchase of businesses, net of cash acquired                                       |                                                            |                                                            | (376                                                    | )      |        |         | (24,321 | )      |         |         |       |       
|                                                                          | Increase in other assets                                                           |                                                            |                                                            | (279                                                    | )      |        |         | (434    | )      |         |         | (422   | )     
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|                                                                          |                                                                                    |                                                            | Net cash used in continuing operations                     |                                                         |        | (8,818 | )       |         |        | (28,102 | )       |        |        | (3,917 | )     
|                                                                          |                                                                                    |                                                            | Net cash provided by (used in) discontinued
    operations |                                                         |        | 2,950  |         |         |        | (177    | )       |        |        | 3      |       
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|                                                                          |                                                                                    |                                                            |                                                            | Net cash used in investing activities                   |        |        | (5,868  | )       |        |         | (28,279 | )      |        |        | (3,914 | )
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|Financing activities                                                      |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|                                                                          | Net borrowings (repayments) under revolving
    credit agreement and notes payable |                                                            |                                                            | (6,144                                                  | )      |        |         | 2,240   |        |         |         | (5,784 | )     
|                                                                          | Repayments under loan agreement                                                    |                                                            |                                                            |                                                        |        |        |         | (700    | )      |         |         |       |       
|                                                                          | Principal payments under mortgage agreement                                        |                                                            |                                                            | (500                                                    | )      |        |         | (500    | )      |         |         | (500   | )     
|                                                                          | Proceeds from the issuance of common stock                                         |                                                            |                                                            | 2,399                                                   |        |        |         | 2,368   |        |         |         | 1,349  |       
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|                                                                          |                                                                                    |                                                            |                                                            | Net cash provided by (used in) financing
    activities |        |        | (4,245  | )       |        |         | 3,408   |        |        |        | (4,935 | )
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|Net increase (decrease) in cash and cash
    equivalents                  |                                                                                    |                                                            | 1,648                                                      |                                                         |        |        | (14,577 | )       |        |         | 15,653  |       
|Cash and cash equivalents, beginning of period                            |                                                                                    |                                                            | 1,076                                                      |                                                         |        |        | 15,653  |         |        |         |        |       
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|Cash and cash equivalents, end of period                                  |                                                                                    | $                                                          | 2,724                                                      |                                                         |        | $      | 1,076   |         |        | $       | 15,653  |       
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|Supplemental disclosure of cash flow information                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|                                                                          | Cash paid during the year for interest                                             |                                                            | $                                                          | 711                                                     |        |        | $       | 440     |        |         | $       | 858    |       
|                                                                          | Cash paid during the year for income taxes, net
    of refunds                     |                                                            | $                                                          | 2,403                                                   |        |        | $       | 4,001   |        |         | $       | 2,185  |       
|Supplemental disclosure of noncash financing and
    investing activities |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|                                                                          | Restricted stock issued                                                            |                                                            | $                                                          | 230                                                     |        |        | $       |        |        |         | $       | 1,344  |       
|Supplemental disclosure  acquisitions                                    |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|                                                                          | Assets acquired                                                                    |                                                            | $                                                          |                                                        |        |        | $       | 21,498  |        |         |         |        |       
|                                                                          | Cash payments, net of cash acquired                                                |                                                            |                                                            | (376                                                    | )      |        |         | (24,321 | )      |         |         |        |       
|                                                                          | Issuance of notes payable to sellers                                               |                                                            |                                                            |                                                        |        |        |         | (12,404 | )      |         |         |        |       
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       
|                                                                          | Liabilities assumed                                                                |                                                            | $                                                          | (376                                                    | )      |        | $       | (15,227 | )      |         |         |        |       
|                                                                          |                                                                                    |                                                            |                                                            |                                                         |        |        |         |         |        |         |         |       

The accompanying notes are an integral part of
these consolidated financial statements.

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DYNAMICS RESEARCH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

NOTE 1. BASIS OF PRESENTATION AND
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of the Business

Dynamics Research Corporation (DRC or
the company), founded in 1955 and headquartered in
Andover, Massachusetts, provides information technology,
engineering and other services focused on defense, public safety
and citizen services for federal, state and local governments.
DRCs core capabilities are focused on information
technology, engineering and technical subject matter expertise
that pertain to the knowledge domains relevant to the
companys core customers. These capabilities include
design, development, operation and maintenance of information
technology systems, engineering services, complex logistics
planning systems and services, defense acquisition management
services, simulation, modeling, training systems and services,
and custom built electronic test equipment and services.

Principles of Consolidation and Basis of
Presentation

The unaudited quarterly interim financial
information of the company and its subsidiaries included herein
has been prepared in accordance with accounting principles
generally accepted in the United States of America. In the
opinion of management, all material adjustments that are of a
normal and recurring nature necessary for a fair presentation of
the results for the periods presented have been reflected. All
material intercompany transactions and balances have been
eliminated in consolidation. Certain amounts in previously
issued financial statements have been reclassified to conform
with the current year presentation.

On October 18, 2002, the company announced
that it was actively pursuing the divestiture of the Encoder
Division, a manufactured products business previously reported
as a business segment, due to continued weakness in the
manufacturing sector. In accordance with Financial Accounting
Standards Board (FASB) Statement of Financial
Accounting Standards (SFAS) No. 144,
Accounting for the Impairment or Disposal of Long-Lived
Assets(SFAS 144), effective in the fourth
quarter of fiscal 2002, the companys consolidated
financial statements and notes thereto were restated to reflect
the discontinuation of the Encoder Division for all periods
presented. On May 2, 2003, the company completed the sale
of its Encoder Division assets and certain liabilities to GSI
Lumonics Inc. (GSI) in Billerica, Massachusetts.

Unless otherwise indicated, all financial
information refers to continuing operations.

On December 20, 2002, the company completed
its acquisition of ANDRULIS. ANDRULIS provides information
technology and engineering solutions to federal government
customers in the defense and federal civilian sectors. On
May 31, 2002, the company completed its acquisition of HJ
Ford. HJ Ford helps its clients manage operational processes and
acquisition programs by drawing on core competencies of systems
and information engineering, information technology, enterprise
engineering and acquisition program support. These transactions
were recorded using the purchase method of accounting in
accordance with SFAS No. 141, Business Combinations(SFAS 141). Accordingly, the results of these
acquired entities are included in the companys
Consolidated Statements of Operations and of Cash Flows for the
periods subsequent to their respective acquisitions.

As part of the HJ Ford purchase, the company
acquired a 40% ownership interest in a small disadvantaged
business, as defined by the United States Government. This
business is accounted for using the equity method. This
ownership interest is reported as a component of Other
noncurrent assets in the companys Consolidated
Balance Sheets.

Risks, Uncertainties and Use of
Estimates

There are business risks specific to the
industries in which the company operates. These risks include,
but are not limited to, estimates of costs to complete contract
obligations, changes in government policies an procedures,
government contracting issues and risks associated with
technological development. The preparation of financial
statements requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of
the financial statements. Estimates and assumptions also affect
the amount of revenue and expenses during the reported period.
Actual results could differ from those estimates.

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Revenue Recognition

The companys systems and services business
provides its services under time and materials, cost
reimbursable and fixed-price contracts including service-type
contracts.

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

For cost reimbursable contracts, revenue is
recognized as costs are incurred and include a proportionate
amount of the fee earned. Cost reimbursable contracts specify
the contract fee in dollars or as a percentage of estimated
costs. The primary risk on a cost reimbursable contract is that
a government audit of direct and indirect costs could result in
the disallowance of certain costs, which would directly impact
revenue and margin on the contract. Historically, such audits
have had no material impact on the companys revenue and
operating income.

Under fixed-price contracts, other than
service-type contracts, revenue is recognized under the
percentage of completion method, on the basis of costs incurred
in relation to estimated total costs to complete the contract.
Under service-type contracts, costs incurred are not indicative
of progression toward completion of the contract. Revenue from
service-type fixed price contracts is recognized ratably over
the contract period or by other appropriate output methods to
measure service provided, and contract costs are expensed as
incurred. The risk to the company on a fixed-price contract is
that if actual costs exceed the estimated costs to complete the
contract, operating income is negatively impacted.

The company does not recognize revenue associated
with amounts claimed under a contract that are not agreed to by
the customer. For all types of contracts, the company recognizes
anticipated contract losses as soon as they become known and
estimable. Out-of-pocket expenses that are reimbursable by the
customer are included in contract revenue and cost of contract
revenue. The company recognizes revenue related to subcontractor
costs when these costs are known and determinable, generally, in
the month following the month in which the services are provided.

The companys Metrigraphics segment
generally recognizes revenue from product sales, less estimated
returns, upon transfer of title and risk of loss to the
customer, generally the time of shipment, provided there is
evidence of an arrangement, fees are fixed or determinable, no
significant obligations remain, collection of the related
receivable is reasonably assured and customer acceptance
criteria have been successfully demonstrated.

Income Taxes

The company accounts for income taxes using the
asset and liability method in accordance with SFAS No. 109,
Accounting for Income Taxes (SFAS 109),
pursuant to which deferred income taxes are recognized based on
temporary differences between the financial statement and tax
basis of assets and liabilities using enacted tax rates in
effect for the current year. Valuation allowances are provided
if, based upon the weight of available evidence, it is more
likely than not that some or all of the deferred tax assets will
not be realized.

Cash and Cash Equivalents

All cash investments, which consist primarily of
money market accounts, have original maturities of three months
or less and are classified as cash equivalents.

Unbilled Expenditures and Fees on Contracts in
Process

Unbilled expenditures and fees on contracts in
process include work in process which will be billed in
accordance with contract terms and delivery schedules, as well
as amounts billable upon final execution of contracts, contract
completion, milestones or completion of rate negotiations. At
December 31, 2003, unbilled costs and fees included
subcontractor costs for the month of December, for which
invoices had not been received and for which revenues were not
recognized, estimated at $2.4 million. Related liabilities
have been recorded as accounts payable. Generally, unbilled
expenditures and fees on

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

contracts in process are expected to be collected
within one year. Payments to the company for performance on
certain United States Government contracts are subject to audit
by the Defense Contract Audit Agency. Revenue has been recorded
at amounts the company expects to realize upon final settlement.

Concentration of Risk

A majority of the companys revenue is
derived from United Sates Government agencies, primarily the
Department of Defense. Any cancellations or modifications of the
companys significant contracts or subcontracts, or failure
by the government to exercise option periods relating to those
contracts or subcontracts, could adversely affect the
companys business, financial condition, results of
operations and cash flows. It is not possible to predict whether
defense budgets will increase or decline, but any significant
decline in defense spending could negatively affect our
business, financial condition, results of operations and cash
flows. A significant portion of the companys federal
government contracts are renewable on an annual basis, or are
subject to the exercise of contractual options. The government
has the right to terminate contracts for convenience. Multi-year
contracts often require funding actions by the government on an
annual or more frequent basis. The company could experience
material adverse consequences should such funding actions or
other approvals not be taken. In addition to contract
cancellations and declines in government budgets, the
companys business, financial condition, results of
operations and cash flows may be adversely affected by
competition within a consolidating defense industry, increased
government regulation and general economic conditions.

Inventories

Inventories are stated at the lower of cost
(first-in, first-out) or market, and consist of materials, labor
and overhead. There are no amounts in inventories relating to
contracts having production cycles longer than one year.
Work-in-process, raw materials and subassemblies aggregated
$40,000 and $58,000 at December 31, 2003 and 2002,
respectively.

Property, Plant and Equipment

Property, plant and equipment are stated at cost.
Plant and equipment are depreciated principally on the
straight-line basis over their estimated useful lives. Useful
lives for equipment range from three to ten years. The corporate
office building has a useful life of 31 years. Leasehold
improvements are amortized over the shorter of the remaining
term of the lease or the life of the related asset. The
components of Property, plant and equipment, net, in the
Consolidated Balance Sheets are as follows (in thousands):

|                                               |                                   |              |        |        |  |   |        |        | 
|---------------------------------------------- | --------------------------------- | ------------ | ------ | ------ |  | - | ------ | ------ | 
|                                               |                                   |             
|                                               |                                   | December 31,
|                                               |                                   |             
|                                               |                                   | 2003         |        | 2002  
|                                               |                                   |              |        |       
|Land                                           |                                   | $            | 1,126  |        |  | $ | 1,126  |       
|Building                                       |                                   |              | 10,535 |        |  |   | 9,109  |       
|Machinery and equipment                        |                                   |              | 39,182 |        |  |   | 32,837 |       
|Leasehold improvements                         |                                   |              | 2,363  |        |  |   | 2,390  |       
|                                               |                                   |              |        |        |  |   |        |       
|Total property, plant and equipment, at cost   |                                   |              | 53,206 |        |  |   | 45,462 |       
|Less accumulated depreciation and amortization |                                   |              | 32,534 |        |  |   | 29,854 |       
|                                               |                                   |              |        |        |  |   |        |       
|                                               | Net property, plant and equipment |              | $      | 20,672 |  |   | $      | 15,608 | 
|                                               |                                   |              |        |        |  |   |        |       

At December 31, 2003 and 2002, the company
had construction in progress (CIP) of
$6.7 million and $1.2 million, respectively, which has
been reclassified to the applicable property, plant and
equipment captions for presentation purposes. The companys
CIP balances include $6.1 million and $0.7 million at
December 31, 2003 and 2002, respectively, included in the
caption Machinery and equipment. These amounts
represent capitalized costs related to the companys new
PeopleSoft-based enterprise business system, which was placed
into service effective January 1, 2004. The remainder of the

45



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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

CIP balances are principally comprised of costs
related to renovations to the companys corporate
headquarters facility in Andover, Massachusetts. The company
does not depreciate CIP until it is placed into service.

During 2003 and 2002, the company recorded
disposals, excluding discontinued operations, of
$0.5 million and $12.1 million, respectively, of fully
depreciated machinery, equipment and leasehold improvements, and
the associated accumulated depreciation.

Goodwill and Intangible Assets

Goodwill is recorded when the consideration paid
for acquisitions exceeds the fair value of net tangible and
identifiable intangible assets acquired. In June 2001, the FASB
issued SFAS 141 and SFAS No. 142, Goodwill and Other
Intangible Assets(SFAS 142). SFAS 141 requires
that the purchase method of accounting be used for all business
combinations completed after June 30, 2001. SFAS 142
requires that goodwill and other intangible assets with
indefinite useful lives no longer be amortized, but rather, be
tested annually for impairment. In accordance with SFAS 141,
goodwill recorded in conjunction with the companys
acquisitions of HJ Ford and ANDRULIS, in May 2002 and December
2002, respectively, was not amortized.

Impairment of Goodwill and Long-Lived
Assets

Goodwill and intangible assets with indefinite
lives are tested annually for impairment in accordance with the
goodwill provisions of SFAS 142. The companys
impairment review is based on a fair value test. The company
uses its judgment in assessing whether assets may have become
impaired between annual impairment tests. Indicators such as
unexpected adverse business conditions, economic factors,
unanticipated technological change or competitive activities,
loss of key personnel and acts by governments and courts may
signal that an asset has been impaired. Should the fair value of
goodwill, as determined by the company at any measurement date,
fall below its carrying value, a charge for impairment of
goodwill will be recorded in the period.

Intangible assets with estimated lives and other
long-lived assets are reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an
asset or asset group may not be recoverable in accordance with
SFAS 144. Recoverability of intangible assets with estimated
lives and other long-lived assets is measured by a comparison of
the carrying amount of an asset or asset group to future net
undiscounted pretax cash flows expected to be generated by the
asset or asset group. If these comparisons indicate that an
asset is not recoverable, the company will recognize an
impairment loss in the amount by which the carrying value of the
asset or asset group exceeds the related estimated fair value.
Estimated fair value is based on either discounted future pretax
operating cash flows or appraised values, depending on the
nature of the asset. The company determines the discount rate
for this analysis based on the expected internal rate of return
of the related business and does not allocate interest charges
to the asset or asset group being measured. Considerable
judgment is required to estimate discounted future operating
cash flows.

Fair Value of Financial Instruments

The carrying values of cash and cash equivalents,
accounts receivable, unbilled expenditures and fees on contracts
in process, and accounts payable approximate fair value because
of the short-term nature of these instruments. The fair value of
each of the debt instruments approximates carrying value because
these agreements bear interest at variable market rates.

Stock-Based Compensation

The company accounts for stock option plans under
Accounting Principles Board (APB) Opinion
No. 25, Accounting for Stock Issued to Employees
(APB 25), and related Interpretations. The following
table illustrates the effect of net earnings per common share as
if the company had applied the fair value based method of SFAS
No. 123, Accounting for

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Stock-Based Compensation(SFAS 123), to all
outstanding and unvested awards in each period for the purpose
of recording expense for stock option compensation (in thousands
of dollars, except per share data).

|                                                                                                                                                    |                      |                         |        |      |  |      |        |      |  |   |        |      | 
|--------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------- | ----------------------- | ------ | ---- |  | ---- | ------ | ---- |  | - | ------ | ---- | 
|                                                                                                                                                    |                      |                        
|                                                                                                                                                    |                      | Year ended December 31,
|                                                                                                                                                    |                      |                        
|                                                                                                                                                    |                      | 2003                    |        | 2002 |  | 2001
|                                                                                                                                                    |                      |                         |        |      |  |     
|Net income as reported                                                                                                                              |                      | $                       | 6,672  |      |  | $    | 6,233  |      |  | $ | 6,545  |     
|Deduct: Total stock-based employee compensation
    expense determined under fair value based method for all awards,
    net of related tax effects |                      |                         | (2,092 | )    |  |      | (3,895 | )    |  |   | (2,662 | )   
|                                                                                                                                                    |                      |                         |        |      |  |      |        |      |  |   |        |     
|Pro forma net income                                                                                                                                |                      | $                       | 4,580  |      |  | $    | 2,338  |      |  | $ | 3,883  |     
|                                                                                                                                                    |                      |                         |        |      |  |      |        |      |  |   |        |     
|Net earnings per share:                                                                                                                             |                      |                         |        |      |  |      |        |      |  |   |        |     
|                                                                                                                                                    | Basic, as reported   |                         | $      | 0.81 |  |      | $      | 0.78 |  |   | $      | 0.85 | 
|                                                                                                                                                    | Basic, pro forma     |                         | $      | 0.56 |  |      | $      | 0.29 |  |   | $      | 0.51 | 
|                                                                                                                                                    | Diluted, as reported |                         | $      | 0.76 |  |      | $      | 0.70 |  |   | $      | 0.81 | 
|                                                                                                                                                    | Diluted, pro forma   |                         | $      | 0.52 |  |      | $      | 0.28 |  |   | $      | 0.51 | 

The weighted average fair values of options
granted were $8.49 in 2003, $13.69 in 2002 and $7.02 in 2001.
The fair value of each option for the companys plans is
estimated on the date of the grant using the Black-Scholes
option pricing model, with the following weighted average
assumptions:

|                        |  |                         |       |      |  |      |       |   |  |  |       |  
|----------------------- |  | ----------------------- | ----- | ---- |  | ---- | ----- | - |  |  | ----- | -
|                        |  |                        
|                        |  | Year ended December 31,
|                        |  |                        
|                        |  | 2003                    |       | 2002 |  | 2001
|                        |  |                         |       |      |  |     
|Expected volatility     |  |                         | 64.43 | %    |  |      | 63.68 | % |  |  | 73.19 | %
|Dividend yield          |  |                         |      |      |  |      |      |   |  |  |      |  
|Risk-free interest rate |  |                         | 3.9   | %    |  |      | 5.0   | % |  |  | 5.4   | %
|Expected life in years  |  |                         | 8.0   |      |  |      | 8.3   |   |  |  | 8.6   |  

Earnings (Loss) Per Share

Basic earnings (loss) per share is computed
by dividing net income (loss) by the weighted average number of
shares of common stock outstanding during the period. For
periods in which there is net income, diluted earnings per share
is determined by using the weighted average number of common and
dilutive common equivalent shares outstanding during the period
unless the effect is antidilutive.

Due to their antidilutive effect, approximately
72,100, 75,600 and 7,500 options to purchase common stock were
excluded from the calculation of diluted earnings per share for
the years ended December 31, 2003, 2002 and 2001,
respectively. However, these options could become dilutive in
future periods.

Recent Accounting Pronouncements

In December 2003, the staff of the Securities and
Exchange Commission issued Staff Accounting Bulletin
(SAB) No. 104 (SAB 104).
SAB 104 revises or rescinds certain portions of the
interpretative guidance related to revenue recognition as
previously interpreted in SAB No. 101, Revenue
Recognition in Financial Statements(SAB 101). The company does not expect the
implementation of the interpretative guidance in SAB 104 to
have a material effect on its financial position, results of
operations or cash flows.

In December 2003, the FASB issued SFAS
No. 132R (SFAS 132R), a revision of its
original SFAS No. 132, Employers Disclosures About
Pensions and Other Postretirement Benefits(SFAS 132). SFAS 132R revises
employers disclosures about pension plans and other
postretirement benefit plans. It does not change the measurement
or recognition of those plans required by SFAS No. 87,
Employers Accounting for Pensions, SFAS
No. 88, Employers Accounting for

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Settlements and Curtailments of Defined
Benefit Pension Plans and for Termination Benefitsand SFAS No. 106,
Employers Accounting for Postretirement Benefits Other
than Pensions. SFAS 132R retains the disclosure
requirements contained in SFAS 132 and requires additional
disclosures about the assets, obligations, cash flows and net
periodic benefit cost of defined benefit pension plans and other
defined benefit postretirement plans. The company has adopted
this statement for the year ended December 31, 2003.

In May 2003, the Emerging Issues Task Force
(EITF) reached a consensus on EITF Issue
No. 00-21, Revenue Arrangements with Multiple
Deliverables (EITF 00-21). EITF 00-21
addresses when an arrangement with multiple deliverables should
be divided into separate units of accounting. The company
adopted the consensus in the third quarter of 2003. The adoption
of EITF 00-21 did not have a material impact on the
companys financial position, results of operations or cash
flows.

In May 2003, the FASB issued SFAS No. 150,
Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity
(SFAS 150). SFAS 150 requires issuers to
classify as liabilities (or assets in some circumstances) three
classes of freestanding financial instruments that embody
obligations for the issuer. Generally, SFAS 150 is
effective for financial instruments entered into or modified
after May 31, 2003 and is otherwise effective at the
beginning of the first interim period beginning after
June 15, 2003. The company adopted the provisions of
SFAS 150 on July 1, 2003. The company did not have any
financial instruments within the scope of SFAS 150 at
December 31, 2003, and, accordingly, the adoption of
SFAS 150 has not had any effect on its financial position,
results of operations or cash flows.

In April 2003, the FASB issued SFAS No. 149,
Amendment of Statement 133 on Derivative Instruments and
Hedging Activities(FAS 149). SFAS 149
amends and clarifies financial accounting and reporting for
derivative instruments and hedging activities under SFAS
No. 133, Accounting for Derivative Instruments and
Hedging Activities(SFAS 133), for
decisions made: (a) as part of the Derivative
Implementation Group process that requires amendment to
SFAS 133; (b) in connection with other FASB projects
dealing with financial instruments; and (c) in connection
with the implementation issues raised related to the application
of the definition of derivative. SFAS 149 is effective for
contracts entered into or modified after June 30, 2003 and
for designated hedging relationships after June 30, 2003.
SFAS 149 is required to be applied prospectively. The
company does not currently have any derivative instruments and,
accordingly, the adoption of SFAS 149 did not have any
effect on its financial position, results of operations or cash
flows.

In January 2003, the FASB issued FASB
Interpretation No. (FIN) 46,
Consolidation of Variable Interest Entities, an
interpretation of ARB No. 51(FIN 46).
In December 2003, the FASB issued FIN No. 46R
(FIN 46R), to clarify some of the provisions of
FIN 46 and to exempt certain entities from its
requirements. The primary objectives of FIN 46 are to
provide guidance on the identification of entities for which
control is achieved through means other than through voting
rights (variable interest entities) and how to
determine when and which business enterprise should consolidate
the variable interest entity. This new model for consolidation
applies to an entity in which either: (a) the equity
investors (if any) do not have a controlling financial
interest; or (b) the equity investment at risk is
insufficient to finance that entitys activities without
receiving additional subordinated financial support from other
parties. In addition, FIN 46 requires that both the primary and
all other enterprises with a significant variable interest in a
variable interest entity make additional disclosures.
FIN 46 is effective immediately for variable interest
entities created after January 31, 2003. FIN 46 had
previously been effective for interim periods beginning after
June 15, 2003, for variable interests in place prior to
February 1, 2003; however, on October 10, 2003, the
FASB issued a statement deferring the implementation of
FIN 46 for these variable interests until the first
reporting period beginning after December 15, 2003. The
company acquired, as part of the May 31, 2002 purchase of
HJ Ford, a 40% ownership interest in a small disadvantaged
business, as defined by the United States Government, which has
been accounted for using the equity method. The company provided
the business with a line of credit guarantee, under which its
maximum exposure is $0.2 million. The company has evaluated
this investment and determined that it does not fall under the
scope of FIN 46. Accordingly, the company will continue to
account for this investment under the equity method, with no
impact on the companys financial position, results of
operations or cash flows as a result of the adoption of
FIN 46 in the fourth quarter of 2003. The company currently
has no other investments subject to the provisions of
FIN 46.

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

In December 2002, the FASB issued SFAS
No. 148, Accounting for Stock-Based
Compensation  Transition and
Disclosure  An Amendment of SFAS No. 123(SFAS 148). SFAS 148 amends
SFAS 123 to provide alternative methods of transition for a
voluntary change to the fair-value-based method of accounting
for stock-based employee compensation. SFAS 148 also amends
the disclosure requirements of SFAS 123 to require
prominent disclosures in interim financial statements in
addition to the annual disclosures about the effect the fair
value method would have had on reported results. The transition
and annual disclosure requirements of SFAS 148 are
effective for fiscal years ending after December 15, 2002.
The interim disclosure requirements are effective for interim
periods beginning after December 15, 2002. As permitted by
SFAS 148, the company continues to apply the
disclosure-only alternative adopted under SFAS 123 to account
for its stock option grants to employees, under which
compensation expense is not typically recognized. The company
adopted the interim disclosure provisions of FAS 148 in its
Form 10-Q for the quarterly period ended March 31,
2003.

In November 2002, the FASB issued FIN
No. 45, Guarantors Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of others, an Interpretation of SFAS No. 5,
57, and 107 and Rescission of FASB Interpretation
No. 34(FIN 45). FIN 45 clarifies
the requirements relating to the guarantors accounting
for, and disclosure of, the issuance of certain types of
guarantees. FIN 45 requires that, upon issuance of a
guarantee, the company recognize a liability for the fair value
of the obligation it assumes under that guarantee. The company
adopted the annual disclosure provisions of FIN 45 in the year
ended December 31, 2002. The company adopted the provisions
for initial recognition and measurement and interim disclosures
during the first quarter of 2003. The adoption of FIN 45
did not have a material effect on the companys financial
position, results of operations or cash flows.

In June 2002, the FASB issued SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal
Activities(SFAS 146). SFAS 146
requires companies to recognize costs associated with exit or
disposal activities when they are incurred rather than at the
date of a commitment to the exit or disposal plan. The adoption
of SFAS 146 on January 1, 2003, did not have a
material effect on the companys financial position,
results of operations or cash flows.

In April 2002, the FASB issued SFAS No. 145,
Rescission of FASB Statements No. 4, 44 and 64,
Amendment of FASB Statement No. 13 and Technical
Corrections(SFAS 145). SFAS 145
rescinds SFAS No. 4, Reporting Gains and Losses from
Extinguishment of Debt, SFAS No. 44, Accounting for
Intangible Assets of Motor Carriersand SFAS No. 64,
Extinguishment of Debt Made to Satisfy Sinking-Fund
Requirements. SFAS 145 also amends SFAS No. 13,
Accounting for Leases, to eliminate the inconsistency in
the required accounting for sale-leaseback transactions.
SFAS 145 also amends other existing authoritative
pronouncements to make various technical corrections, clarify
meanings or describe their applicability under changed
conditions. The company adopted the provisions of SFAS 145
on January 1, 2003. The adoption of SFAS 145 did not
have a material effect on the companys financial position,
results of operations or cash flows.



|        |                                                      
|------- | -----------------------------------------------------
|NOTE 2. | CONTRACTS IN PROCESS AND CONTRACT LOSS
    PROVISIONS

The companys unbilled expenditures and fees
on contracts in process with the United States Government were
$25.4 million and $17.0 million at December 31,
2003 and 2002, respectively. At December 31, 2003 and 2002,
accounts receivable balances for United States Government
contracts were $17.7 million and $7.5 million,
respectively.

In 1997, the company entered into a fixed price
software development contract with the Colorado Department of
Human Services. During the period of performance, this contract
incurred cost overruns, and management anticipated additional
overruns that were provided for in the companys results or
operations. The company provided $3.9 million in 2001 for
current and anticipated losses. Implementation of the project
was completed on April 12, 2002. The maintenance period
expired in the fourth quarter of 2002 and the warranty period
expired in the second quarter of 2003. At the completion of the
project in 2002, the company reduced contract reserves by
$0.6 million, as the actual costs were less than previously
estimated.

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

NOTE 3. RESTRUCTURING

In response to lower than expected demand in
certain sectors of the companys business, as well as the
need to maintain a competitive cost structure, the company
incurred involuntary separation costs for 85 employees,
excluding discontinued operations, in 2002. All operating groups
and functions of the company were affected. Costs associated
with these terminations totaled $0.8 million and are
included in reporting operating results for 2002, with
$0.6 million charged to cost of contract revenue and
$0.2 million charged to selling, general and administrative
expenses. The accrual of $0.2 million that remained at
December 31, 2002 was paid in the first half of 2003.



|        |                        
|------- | -----------------------
|NOTE 4. | DISCONTINUED OPERATIONS

On October 18, 2002, the company announced
that it was actively pursuing the divestiture of the Encoder
Division. Effective in the fourth quarter of 2002, and in
accordance with SFAS 144, the companys consolidated
financial statements and notes thereto were restated to reflect
the discontinuation of the Encoder Division. Accordingly, the
revenue, costs, expenses, assets, liabilities and cash flows of
the Encoder Division are reported separately in the Consolidated
Statements of Operations, Consolidated Balance Sheets and
Consolidated Statements of Cash Flows for all periods presented.
The results of discontinued operations do not reflect any
interest expense or any allocation of corporate general and
administrative expense.

On May 2, 2003, the company completed the
sale of the Encoder Division assets and certain liabilities to
GSI for $3.3 million in cash, subject to post-closing
adjustments related to a valuation of the net assets of the
Encoder Division and the assumption by GSI of certain of
DRCs liabilities with respect to the assets acquired.

In connection with this transaction, the company
recorded $1.3 million of pre-tax charges for the disposal
of discontinued operations. Of this amount, $0.2 million
was charged in the fourth quarter and represents additional
facility costs related to the sale. The company recorded charges
aggregating $1.1 million before taxes in the first quarter,
comprised of $0.3 million of professional fees and
$0.8 million of exit costs. The exit costs are comprised of
$0.5 million for severance costs for approximately 45
Encoder Division employees and $0.3 million for future
lease costs, net of contractual sublease income, from GSI for
the Encoder facility.

During the first quarter of 2003, the company
recognized, on a cash basis, $0.7 million received as the
final royalty payment associated with the 1999 sale of its
discontinued Telecommunications Fraud Control business, which
was recorded against the loss on the disposal of discontinued
operations. This income, net of the $1.3 million of charges
described above, resulted in a loss on the disposal of
discontinued operations of $0.6 million before taxes, or a
loss of $0.3 million, net of $0.3 million of income
tax benefit.

In 2001, the company recognized royalty income
related to the Telecommunications Fraud Control business and, as
a result, reported a gain from the disposal of discontinued
operations of $0.1 million, net of taxes.

The companys loss from discontinued
operations in 2003 of $1.6 million, or $0.18 per diluted
share, reflects four months of operating loss from the Encoder
Division, as well as costs incurred subsequent to the
transaction related to certain liabilities that GSI did not
assume, primarily, $1.5 million of accrued lease costs, net
of estimated sublease income, for the Encoder facility. The
company reported losses from discontinued operations of
$1.1 million, or $0.13 per diluted share, and
$0.6 million, or $0.08 per diluted share in 2002 and 2001,
respectively. Due to the companys decision to divest the
Encoder Division, it became necessary to restate the
companys results in order to reflect the Encoder Division
as a discontinued operation. Because Arthur Andersen LLP was no
longer able to provide current assurance as to the validity of
its previously issued opinions on the companys financial
statements for the fiscal years prior to 2002, it became
necessary to engage KPMG LLP, who served as the companys
independent auditors through November 2003, to re-audit results
for the years ended December 31, 2001 and 2000 in order to
obtain a current independent auditor opinion for those years.
The 2002 loss from discontinued operations includes
$0.4 million in fees to re-audit the 2001 and 2000 results.

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The activity for the year ended December 31,
2003, related to the companys exit cost accrual is as
follows (in thousands):

|          |  |                                         |   |           |  |             |       |                 |  |              |     |  |  |   |        |   |  |   |       | 
|--------- |  | --------------------------------------- | - | --------- |  | ----------- | ----- | --------------- |  | ------------ | --- |  |  | - | ------ | - |  | - | ----- | 
|          |  |                                        
|          |  | Activity  Year Ended December 31, 2003
|          |  |                                        
|          |  | Balance                                 |   |           |  | Adjustments |       | Expenditures    |  | Balance     
|          |  | December 31,                            |   |           |  | for changes |       | charged against |  | December 31,
|          |  | 2002                                    |   | Provision |  | in estimate |       | accrual         |  | 2003        
|          |  |                                         |   |           |  |             |       |                 |  |             
|Severance |  | $                                       |  |           |  | $           | 544   |                 |  | $            |    |  |  | $ | (470   | ) |  | $ | 74    | 
|Lease     |  |                                         |  |           |  |             | 1,325 |                 |  |              | 420 |  |  |   | (813   | ) |  |   | 932   | 
|          |  |                                         |   |           |  |             |       |                 |  |              |     |  |  |   |        |   |  |   |       | 
|          |  | $                                       |  |           |  | $           | 1,869 |                 |  | $            | 420 |  |  | $ | (1,283 | ) |  | $ | 1,006 | 
|          |  |                                         |   |           |  |             |       |                 |  |              |     |  |  |   |        |   |  |   |       | 

In addition to the exit cost accruals described
above, liabilities of discontinued operations also include
$0.2 million related to liabilities of the Encoder Division
not assumed by GSI in the purchase transaction.

The balance sheet captions for discontinued
operations include the following (in thousands):

|                      |                                           |                           |   |      |     |  |   |       |       | 
|--------------------- | ----------------------------------------- | ------------------------- | - | ---- | --- |  | - | ----- | ----- | 
|                      |                                           |                          
|                      |                                           | December 31,             
|                      |                                           |                          
|                      |                                           | 2003                      |   | 2002
|                      |                                           |                           |   |     
|Current assets        |                                           |                           |   |      |     |  |   |      
|                      | Accounts receivable, net                  |                           | $ |     |     |  | $ | 1,111 |      
|                      | Inventory, net                            |                           |   |     |     |  |   | 2,316 |      
|                      | Prepaid expenses and other current assets |                           |   |     |     |  |   | 5     |      
|                      |                                           |                           |   |      |     |  |   |      
|                      |                                           | Total current assets      |   | $    |    |  |   | $     | 3,432 | 
|                      |                                           |                           |   |      |     |  |   |      
|Noncurrent assets     |                                           |                           |   |      |     |  |   |      
|                      | Property, plant and equipment, net        |                           | $ |     |     |  | $ | 331   |      
|                      |                                           |                           |   |      |     |  |   |      
|Current liabilities   |                                           |                           |   |      |     |  |   |      
|                      | Accounts payable                          |                           | $ |     |     |  | $ | 233   |      
|                      | Accrued payroll and employee benefits     |                           |   | 74   |     |  |   | 127   |      
|                      | Other accrued expenses                    |                           |   | 704  |     |  |   | 649   |      
|                      |                                           |                           |   |      |     |  |   |      
|                      |                                           | Total current liabilities |   | $    | 778 |  |   | $     | 1,009 | 
|                      |                                           |                           |   |      |     |  |   |      
|Long-term liabilities |                                           |                           |   |      |     |  |   |      
|                      | Other long-term liabilities               |                           | $ | 398  |     |  | $ |      |      
|                      |                                           |                           |   |      |     |  |   |      

The lease on the Encoder facility will expire in
August 2005; accordingly, lease payments and payments for other
associated costs will be made and charged to the accrual through
that date. The difference between the fair value of the total
lease costs and the total cash payments will be charged to
discontinued operations as expense through the expiration of the
lease term, including sublease income initially estimated at the
time the accrual was recorded, but not subsequently realized.
The company has paid substantially all of the expected severance
costs associated with the Encoder Division.

In accordance with SFAS 144, the company had
reviewed the possible impairment of assets associated with the
Encoder Division as of December 31, 2002, and determined
that an impairment charge was not required.

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|        |             
|------- | ------------
|NOTE 5. | INCOME TAXES

Total income tax expense (benefit) was allocated
as follows (in thousands):

|                                                                                                                                        |  |                         |        |      |  |      |        |   |  |   |       |  
|--------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------ | ---- |  | ---- | ------ | - |  | - | ----- | -
|                                                                                                                                        |  |                        
|                                                                                                                                        |  | Year ended December 31,
|                                                                                                                                        |  |                        
|                                                                                                                                        |  | 2003                    |        | 2002 |  | 2001
|                                                                                                                                        |  |                         |        |      |  |     
|Income from continuing operations                                                                                                       |  | $                       | 6,334  |      |  | $    | 4,936  |   |  | $ | 4,874 |  
|Discontinued operations                                                                                                                 |  |                         | (1,284 | )    |  |      | (741   | ) |  |   | (382  | )
|Stockholders equity for compensation
    expense for tax purposes in excess of amounts recognized for
    financial reporting purposes |  |                         | (197   | )    |  |      | (194   | ) |  |   | (211  | )
|Other comprehensive loss                                                                                                                |  |                         | (1,732 | )    |  |      | (4,059 | ) |  |   | (405  | )
|                                                                                                                                        |  |                         |        |      |  |      |        |   |  |   |       |  
|                                                                                                                                        |  | $                       | 3,121  |      |  | $    | (58    | ) |  | $ | 3,876 |  
|                                                                                                                                        |  |                         |        |      |  |      |        |   |  |   |       |  

The components of the provision for federal and
state income taxes from continuing operations are as follows
(in thousands):

|                  |         |                         |       |       |  |      |       |       |  |   |       |       | 
|----------------- | ------- | ----------------------- | ----- | ----- |  | ---- | ----- | ----- |  | - | ----- | ----- | 
|                  |         |                        
|                  |         | Year ended December 31,
|                  |         |                        
|                  |         | 2003                    |       | 2002  |  | 2001
|                  |         |                         |       |       |  |     
|Currently payable |         |                         |       |       |  |      |       |       |  |   |       |      
|                  | Federal |                         | $     | 3,054 |  |      | $     | 3,862 |  |   | $     | 2,702 | 
|                  | State   |                         |       | 547   |  |      |       | 731   |  |   |       | 604   | 
|                  |         |                         |       |       |  |      |       |       |  |   |       |      
|                  |         |                         | 3,601 |       |  |      | 4,593 |       |  |   | 3,306 |      
|                  |         |                         |       |       |  |      |       |       |  |   |       |      
|Deferred          |         |                         |       |       |  |      |       |       |  |   |       |      
|                  | Federal |                         |       | 2,138 |  |      |       | 208   |  |   |       | 1,518 | 
|                  | State   |                         |       | 595   |  |      |       | 135   |  |   |       | 50    | 
|                  |         |                         |       |       |  |      |       |       |  |   |       |      
|                  |         |                         | 2,733 |       |  |      | 343   |       |  |   | 1,568 |      
|                  |         |                         |       |       |  |      |       |       |  |   |       |      
|                  |         | $                       | 6,334 |       |  | $    | 4,936 |       |  | $ | 4,874 |      
|                  |         |                         |       |       |  |      |       |       |  |   |       |      

The major items contributing to the difference
between the statutory United States federal income tax rate of
34% and the companys effect tax rate on income from
continuing operations are as follows (in thousands):

|                                               |                            |                         |       |       |  |      |       |       |  |   |       |       | 
|---------------------------------------------- | -------------------------- | ----------------------- | ----- | ----- |  | ---- | ----- | ----- |  | - | ----- | ----- | 
|                                               |                            |                        
|                                               |                            | Year ended December 31,
|                                               |                            |                        
|                                               |                            | 2003                    |       | 2002  |  | 2001
|                                               |                            |                         |       |       |  |     
|Provision at statutory rate                    |                            | $                       | 5,096 |       |  | $    | 4,179 |       |  | $ | 4,072 |      
|State income taxes, net of federal tax benefit |                            |                         | 740   |       |  |      | 569   |       |  |   | 432   |      
|Decrease in valuation allowance                |                            |                         |      |       |  |      | (7    | )     |  |   |      |      
|Amortization of acquired intangible assets     |                            |                         | 320   |       |  |      |      |       |  |   |      |      
|Other, net                                     |                            |                         | 178   |       |  |      | 195   |       |  |   | 370   |      
|                                               |                            |                         |       |       |  |      |       |       |  |   |       |      
|                                               | Provision for income taxes |                         | $     | 6,334 |  |      | $     | 4,936 |  |   | $     | 4,874 | 
|                                               |                            |                         |       |       |  |      |       |       |  |   |       |      

The company carried back $1.1 million of
federal net operating losses in 2003, resulting in an income tax
refund of $0.4 million. In 2002, the company utilized
$0.9 million of federal and state net operating loss
carryforwards to reduce 2002 taxable income.

The company has a valuation allowance that
relates to a capital loss carryforward for which there is a five
year carryforward period that expires in 2004.

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The tax effects of significant temporary
differences that comprise deferred tax assets and liabilities
are as follows (in thousands):

|                                                           |                          |                             |         |         |        |   |         |         |        |  
|---------------------------------------------------------- | ------------------------ | --------------------------- | ------- | ------- | ------ | - | ------- | ------- | ------ | -
|                                                           |                          |                            
|                                                           |                          | December 31,               
|                                                           |                          |                            
|                                                           |                          | 2003                        |         | 2002   
|                                                           |                          |                             |         |        
|Pension liability                                          |                          | $                           | 6,189   |         |        | $ | 4,456   |        
|Accrued expenses                                           |                          |                             | 2,653   |         |        |   | 3,235   |        
|Net operating loss and credit carryforward                 |                          |                             |        |         |        |   | 727     |        
|Inventory reserves                                         |                          |                             | 3       |         |        |   | 651     |        
|Capital loss carryforward                                  |                          |                             | 442     |         |        |   | 442     |        
|Receivables reserves                                       |                          |                             | 182     |         |        |   | 227     |        
|Alternative minimum tax credit carryforward                |                          |                             |        |         |        |   |        |        
|Other                                                      |                          |                             |        |         |        |   |        |        
|                                                           |                          |                             |         |         |        |   |         |        
|                                                           |                          |                             | 9,469   |         |        |   | 9,738   |        
|Valuation allowance                                        |                          |                             | (442    | )       |        |   | (442    | )      
|                                                           |                          |                             |         |         |        |   |         |        
|                                                           | Deferred tax assets, net |                             |         | 9,027   |        |   |         | 9,296   |       
|                                                           |                          |                             |         |         |        |   |         |        
|Unbilled expenditures and fees on contracts in
    process |                          |                             | (12,222 | )       |        |   | (10,205 | )      
|Fixed assets and intangibles                               |                          |                             | (1,766  | )       |        |   | (1,624  | )      
|Domestic International Sales Corporation deferral          |                          |                             | (1,722  | )       |        |   | (1,609  | )      
|Other                                                      |                          |                             | (678    | )       |        |   | (823    | )      
|                                                           |                          |                             |         |         |        |   |         |        
|                                                           | Deferred tax liability   |                             |         | (16,388 | )      |   |         | (14,261 | )     
|                                                           |                          |                             |         |         |        |   |         |        
|                                                           |                          | Deferred tax liability, net |         | $       | (7,361 | ) |         | $       | (4,965 | )
|                                                           |                          |                             |         |         |        |   |         |        

Management believes that it is more likely than
not that net deferred tax assets will be realized.



|        |                          
|------- | -------------------------
|NOTE 6. | EMPLOYEE BENEFIT PROGRAMS

In December 2001, the Board of Directors approved
actions to proceed with amendments limiting future increases in
benefits under the companys Defined Benefit Pension Plan
(the Plan), freezing membership in the Plan, and
providing for improvements to the companys deferred
savings plan (the 401(k) Plan). Accordingly,
the approval to amend the Defined Benefit Pension Plan resulted
in a curtailment loss of $0.8 million in the fourth quarter
of 2001.

In February 2002, the Board of Directors approved
the specific retirement program changes that limited future
increases in benefits under the companys Plan, froze
membership in the Plan, and provided for improvements to the
companys 401(k) Plan. Actual changes to the companys
Plan and 401(k) Plan were effective July 1, 2002.

The companys Plan is non-contributory,
covering substantially all employees of the company who had
completed a year of service prior to July 1, 2002. This
benefit, available to participants, will increase by 3% each
year while an employee is working at the company. Employees must
be actively employed on the last day of the year to realize this
increase in benefits. This increase in benefits is included as a
factor in estimating the companys periodic pension cost
and projected benefit obligation.

In selecting the expected long-term rate of
return on assets, the company considered its investment return
goals stated in the Plans investment policy. The company,
with input from the Plans professional investment
managers, also considered the average rate of earnings expected
on the funds invested or to be invested to provide Plan
benefits. This process included determining expected returns for
the various asset classes that comprise the Plans target
asset allocation. Based on this analysis, the companys
overall expected long-term rate of return on assets is over
9.0%; however, the company determined

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

that the selection of a 9.0% long-term asset
return assumption is more appropriate and prudent. This basis
for selecting the expected long-term asset return assumption is
consistent with the prior year.

The companys funding policy is to
contribute at least the minimum amount required by the Employee
Retirement Income Security Act of 1974. Additional amounts are
contributed to assure that plan assets will be adequate to
provide retirement benefits. Contributions are intended to
provide for benefits earned through the Plan curtailment, as
well as the 3% annual increases thereafter. The company expects
to contribute $3.7 million to the Plan in 2004.

In 2003, the company changed its Plan measurement
date to November 30, 2003 to facilitate its fiscal year-end
accounting for and disclosure of its Plan assets, liabilities,
income and expense. However, the income and expense in 2003 has
been estimated for the entire year.

Periodic Pension Cost(in thousands)

|                                                     |                                                           |                         |        |       |  |      |        |     |  |   |        |       | 
|---------------------------------------------------- | --------------------------------------------------------- | ----------------------- | ------ | ----- |  | ---- | ------ | --- |  | - | ------ | ----- | 
|                                                     |                                                           |                        
|                                                     |                                                           | Year ended December 31,
|                                                     |                                                           |                        
|                                                     |                                                           | 2003                    |        | 2002  |  | 2001
|                                                     |                                                           |                         |        |       |  |     
|Service cost  benefits earned during
    the period |                                                           | $                       |       |       |  | $    | 1,168  |     |  | $ | 2,470  |      
|Interest cost on projected benefit obligation        |                                                           |                         | 3,808  |       |  |      | 3,487  |     |  |   | 3,476  |      
|Expected return on plan assets                       |                                                           |                         | (3,310 | )     |  |      | (3,785 | )   |  |   | (3,684 | )    
|Amortization of prior service cost                   |                                                           |                         |       |       |  |      |       |     |  |   | 220    |      
|Amortization of transition obligation                |                                                           |                         |       |       |  |      |       |     |  |   | 35     |      
|Recognized actuarial loss                            |                                                           |                         | 1,198  |       |  |      | 102    |     |  |   | 72     |      
|                                                     |                                                           |                         |        |       |  |      |        |     |  |   |        |      
|                                                     | Net periodic pension cost                                 |                         |        | 1,696 |  |      |        | 972 |  |   |        | 2,589 | 
|Recognized curtailment loss                          |                                                           |                         |       |       |  |      |       |     |  |   | 819    |      
|                                                     |                                                           |                         |        |       |  |      |        |     |  |   |        |      
|                                                     | Net periodic pension cost, including curtailment
    loss |                         | $      | 1,696 |  |      | $      | 972 |  |   | $      | 3,408 | 
|                                                     |                                                           |                         |        |       |  |      |        |     |  |   |        |      

Changes in Benefit Obligations(in thousands)

|                                                     |  |              |        |              |  |   |        |  
|---------------------------------------------------- |  | ------------ | ------ | ------------ |  | - | ------ | -
|                                                     |  | November 30, |        | December 31,
|                                                     |  | 2003         |        | 2002        
|                                                     |  |              |        |             
|Projected benefit obligation at beginning of year    |  | $            | 55,564 |              |  | $ | 50,712 |  
|Service cost  benefits earned during
    the period |  |              |       |              |  |   | 1,168  |  
|Interest cost on projected benefit obligation        |  |              | 3,808  |              |  |   | 3,487  |  
|Benefits paid                                        |  |              | (1,778 | )            |  |   | (1,641 | )
|Actuarial loss                                       |  |              | 5,823  |              |  |   | 1,838  |  
|                                                     |  |              |        |              |  |   |        |  
|Projected benefit obligation at end of year          |  | $            | 63,417 |              |  | $ | 55,564 |  
|                                                     |  |              |        |              |  |   |        |  

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Change in Plan
Assets(in thousands)

|                                               |  |              |        |              |  |   |        |  
|---------------------------------------------- |  | ------------ | ------ | ------------ |  | - | ------ | -
|                                               |  | November 30, |        | December 31,
|                                               |  | 2003         |        | 2002        
|                                               |  |              |        |             
|Fair value of plan assets at beginning of year |  | $            | 36,940 |              |  | $ | 42,034 |  
|Actual return on plan assets                   |  |              | 5,819  |              |  |   | (5,027 | )
|Employer contributions                         |  |              | 1,576  |              |  |   | 1,609  |  
|Benefits and expenses paid                     |  |              | (1,778 | )            |  |   | (1,676 | )
|                                               |  |              |        |              |  |   |        |  
|Fair value of plan assets at end of year       |  | $            | 42,557 |              |  | $ | 36,940 |  
|                                               |  |              |        |              |  |   |        |  

Funded Status(in
thousands)

|                                                   |  |              |         |              |  |   |         |  
|-------------------------------------------------- |  | ------------ | ------- | ------------ |  | - | ------- | -
|                                                   |  | November 30, |         | December 31,
|                                                   |  | 2003         |         | 2002        
|                                                   |  |              |         |             
|Plan assets less than projected benefit obligation |  | $            | (20,860 | )            |  | $ | (18,624 | )
|Unrecognized net actuarial loss                    |  |              | 18,858  |              |  |   | 16,742  |  
|                                                   |  |              |         |              |  |   |         |  
|Accrued pension liability                          |  | $            | (2,002  | )            |  | $ | (1,882  | )
|                                                   |  |              |         |              |  |   |         |  

Weighted Average Assumptions Used to Determine
Benefit Obligations at Measurement Date

|                              |  |              |      |              |  |  |      |  
|----------------------------- |  | ------------ | ---- | ------------ |  |  | ---- | -
|                              |  | November 30, |      | December 31,
|                              |  | 2003         |      | 2002        
|                              |  |              |      |             
|Discount rate                 |  |              | 6.25 | %            |  |  | 6.75 | %
|Rate of compensation increase |  |              | N/A  |              |  |  | 4.00 | %

Weighted Average Assumptions Used to Determine
Net Periodic Benefit Cost

|                                  |  |                         |      |      |  |  |      |  
|--------------------------------- |  | ----------------------- | ---- | ---- |  |  | ---- | -
|                                  |  |                        
|                                  |  | Year Ended December 31,
|                                  |  |                        
|                                  |  | 2003                    |      | 2002
|                                  |  |                         |      |     
|Discount rate                     |  |                         | 6.25 | %    |  |  | 6.75 | %
|Expected rate of return on assets |  |                         | 9.00 | %    |  |  | 9.00 | %
|Rate of compensation increase     |  |                         | N/A  |      |  |  | 4.00 | %

The companys investment policy includes a
periodic review of the Plans investment in the various
asset classes. The current asset allocation target is 65%
equities, 33% fixed income and 2% cash. The companys asset
allocations as of November 30, 2003 and December 31,
2002 are as follows:

|                  |  |              |     |              |  |  |     |  
|----------------- |  | ------------ | --- | ------------ |  |  | --- | -
|                  |  | November 30, |     | December 31,
|                  |  | 2003         |     | 2002        
|                  |  |              |     |             
|Equity securities |  |              | 67  | %            |  |  | 62  | %
|Debt securities   |  |              | 28  | %            |  |  | 30  | %
|Other             |  |              | 5   | %            |  |  | 8   | %
|                  |  |              |     |              |  |  |     |  
|                  |  |              | 100 | %            |  |  | 100 | %
|                  |  |              |     |              |  |  |     |  

At both November 30, 2003 and
December 31, 2002, the Plan was under-funded relative to
its accumulated benefit obligations. As a result, the company
recorded an additional liability of $2.4 million to reflect
the required minimum pension liability of $13.7 million at
November 30, 2003. In 2002, the company recorded an
additional liability of $10.3 million to

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

reflect the required minimum pension liability of
$11.3 million. These amounts are reflected, net of related
tax effects, in the caption Accumulated other
comprehensive loss in the companys Consolidated
Balance Sheets.

Additional Liability(in thousands)

|                                              |  |              |        |              |  |   |        |  
|--------------------------------------------- |  | ------------ | ------ | ------------ |  | - | ------ | -
|                                              |  | November 30, |        | December 31,
|                                              |  | 2003         |        | 2002        
|                                              |  |              |        |             
|Accumulated benefit obligation at end of year |  | $            | 58,312 |              |  | $ | 50,168 |  
|                                              |  |              |        |              |  |   |        |  
|Unfunded accumulated benefit obligation       |  | $            | 15,755 |              |  | $ | 13,227 |  
|Accrued pension liability                     |  |              | (2,002 | )            |  |   | (1,882 | )
|                                              |  |              |        |              |  |   |        |  
|Additional minimum liability                  |  | $            | 13,753 |              |  | $ | 11,345 |  
|                                              |  |              |        |              |  |   |        |  

The company also maintains a cash or deferred
savings plan, the 401(k) Plan. All employees are eligible to
elect to defer a portion of their salary and contribute the
deferred portion to the 401(k) Plan. Effective July 1,
2002, the company amended the 401(k) Plan, increasing the
matching contribution to 50% of the first 6% of the employee
contribution, adding a core contribution for all employees, in
which the company contributes 1.5% of the employees
eligible wages each pay period, even if the employee does not
contribute to the 401(k) Plan and adding a discretionary profit
sharing component to the 401(k) Plan. Prior to July 1,
2002, the company contributed an amount equal to 25% of the
first 6% of an employees contribution to the 401(k) Plan.

The companys contributions to the 401(k)
Plan aggregated $4.6 million, $2.5 million and
$0.9 million in 2003, 2002 and 2001, respectively. Employee
and company contributions are invested in one or more collective
investment funds at the participants direction. The
companys contributions are subject to forfeitures of any
non-vested portion if termination occurs within the first five
years of employment.

The company has a Supplemental Executive
Retirement Plan, or SERP, for certain former key employees
providing for annual benefits commencing on the sixth
anniversary of the executives retirement. The cost of
these benefits is being charged to expense and accrued using a
projected unit credit method. Expense related to this plan was
$23,800 in 2003, and $22,300 in both 2002 and 2001. The
liability related to the SERP, which is unfunded, was
$0.4 million at both December 31, 2003 and 2002, which
the company believes is the present value of the obligation.

On October 31, 2000, the Board of Directors
approved a deferred compensation plan. The plan provides certain
employees of the company the ability to annually elect to defer
up to 100% of any cash incentive payments from the company and
any salary in excess of the FICA earnings ceiling. Employee
contributions are invested in selected mutual funds held within
a Rabbi Trust. These investments, which the company has
classified as trading securities in accordance with SFAS
No. 115, Accounting for Certain Debt and Equity
Securities (SFAS 115), are recorded at fair
value and reported as a component of Other noncurrent assets in
the companys Consolidated Balance Sheets. Amounts recorded
as deferred compensation liabilities for certain employees are
measured based on the fair value of investments due to
participants. Changes in obligations to participants as a result
of gains or losses on the fair value of the investments are
reflected as a component of compensation expense. At
December 31, 2003 and 2002, $0.9 million and
$0.7 million, respectively, had been deferred under the
plan.

The company also has a deferred compensation plan
under which non-employee directors may elect to defer their
directors fees. Amounts deferred for each participant are
credited to a separate account, and interest at the lowest rate
at which the company borrowed money during each quarter or, if
there was no such borrowing, at the prime rate, is credited to
each account quarterly. The balance in a participants
account is payable in a lump sum or in installments when the
participant ceases to be a director. In 2001, as allowed under
this plan, deferred compensation balances having an aggregate
value of approximately $0.3 million were converted into
23,577 shares of restricted company stock, based upon the fair
market value of the stock at the date of conversion.

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|        |                       
|------- | ----------------------
|NOTE 7. | FINANCING ARRANGEMENTS

The company had outstanding debt of
$16.8 million at December 31, 2003, comprised of
$8.3 million on the mortgage on the companys
headquarters facility in Andover, Massachusetts and
$8.5 million under the companys revolving credit
agreement. The companys outstanding debt at
December 31, 2002 of $23.4 million consisted of the
mortgage on the companys headquarters building in the
amount of $8.8 million, $12.4 million in notes payable
associated with the purchase of ANDRULIS, and an outstanding
balance of $2.2 million on the companys revolving
credit agreement. The $12.4 million in notes payable had an
interest rate of 4.0% and a maturity date of January 3,
2003. In January 2003, the notes payable associated with the
purchase of ANDRULIS were paid in full with proceeds from the
companys revolving credit agreement.

On December 26, 2002, the company entered
into an installment payment agreement in connection with the
purchase of its enterprise business system software. The company
made the first payment on January 26, 2003, with the second
and final payment due on January 26, 2004. The company
recorded the liability using an imputed interest rate of 3.38%,
which was its effective borrowing rate at December 31,
2002. This purchase commitment is reported as a component of
Other accrued expenses in the companys Consolidated
Balance Sheets. On January 26, 2004, the company made the
final payment of $0.6 million.

Effective June 28, 2002, the company
obtained a $50.0 million unsecured revolving credit
agreement (the Revolver), replacing the previous
revolving credit facility. The Revolver has a three-year term
and is available to the company for general corporate purposes,
including strategic acquisitions. The fee on the unused portion
of the Revolver ranges from 0.25% to 0.50%, depending on the
companys most recently reported leverage ratio, and is
payable quarterly in arrears. The company has the option to
elect a fixed 30, 60 or 90-day term, at an interest rate of
LIBOR plus 2.0% to 3.0%, depending on the companys most
recently reported leverage ratio, or the prime rate on any
outstanding balance. Interest on the outstanding balance of the
Revolver is payable monthly under the prime rate option or at
the end of the elected term for the LIBOR rate option. At
December 31, 2003, the outstanding balance under the
Revolver was $8.5 million. The interest rate on the
$7.5 million of this outstanding amount was 3.17% under the
60-day LIBOR rate option elected on December 15, 2003. The
interest rate on the remaining $1.0 million outstanding was
3.16% under a 30-day LIBOR rate option elected on
December 15, 2003. At December 31, 2002, the
outstanding balance under the Revolver was $2.2 million,
which was the maximum outstanding balance for the year. The
interest rate on the balance outstanding under the Revolver was
4.25% based on the prime rate at December 31, 2002.

The company has a 10-year mortgage loan (the
Mortgage), dated June 12, 2000, as amended and
restated on June 28, 2002, on its corporate office
facility. The agreement requires quarterly principal payments of
$125,000, with a final payment of $5.0 million in May 2010.
Interest on the Mortgage accrued at the rate of LIBOR plus 2.5%
through November 5, 2001. Effective November 6, 2001,
the interest rate was reduced to LIBOR plus 2.0%. The interest
rate on the Mortgage under the 90-day option, elected at
October 14, 2003, was 3.15% at December 31, 2003. The
interest rate on the Mortgage at December 31, 2002, was
3.83% under the 90-day option, elected at October 15, 2002.
The companys outstanding balances on the Mortgage at
December 31, 2003 and 2002 were $8.3 million and
$8.8 million, respectively. The average interest rates on
the outstanding balances were 3.22% and 3.97% during 2003 and
2002, respectively.

The Revolver and Mortgage agreements, as
currently amended, require the company to meet certain financial
covenants, including maintaining a minimum net worth and certain
cash flow and debt coverage ratios. The covenants also limit the
companys ability to incur additional debt, pay dividends,
purchase capital assets, sell or dispose of assets, make
additional acquisitions or investments, or enter into new
leases, among other restrictions. In addition, the loan
agreements contain a subjective acceleration clause, allowing
the lender to require payment upon the occurrence of a material
adverse change in the companys financial position.

On December 2003, the Revolver was amended to
increase the capital expenditure limits in 2003 and 2004 to
$9.0 million and $7.0 million, respectively, to allow
for adjustments to the scheduled renovations of the
companys Andover, Massachusetts corporate office facility
and the companys investment in its new enterprise business
system. On March 26, 2003, the Revolver was amended to base
the covenant on total net worth and to exclude any adjustments
to accumulated

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

other comprehensive loss from the covenant
calculation. Management believes the company was in compliance
with all loan covenants on December 31, 2003.

The companys debt repayments and accrued
purchase commitment are due as follows (in thousands):

|                        |            |   |        |       | 
|----------------------- | ---------- | - | ------ | ----- | 
|Year ended December 31, |            |   |        |      
|                        | 2004       |   | $      | 9,554 | 
|                        | 2005       |   |        | 500   | 
|                        | 2006       |   |        | 500   | 
|                        | 2007       |   |        | 500   | 
|                        | 2008       |   |        | 500   | 
|                        | Thereafter |   |        | 5,750 | 
|                        |            |   |        |      
|                        |            | $ | 17,304 |      
|                        |            |   |        |      



|        |            
|------- | -----------
|NOTE 8. | STOCK PLANS

The company has stock option plans, which are
administered by the Compensation Committee of the Board of
Directors (the Committee). The Committee determines
which employees receive options, the number of options granted
and the option prices of the shares covered by each stock option
grant.

The 1993 Equity Incentive Plan (the 1993
Plan) permits the company to grant incentive stock
options, nonqualified stock options, stock appreciation rights,
awards of nontransferable shares of restricted common stock and
deferred grants of common stock. The option price of incentive
stock options will not be less than the fair market value at the
time the option is granted. The option period will not be
greater than 10 years from the date the option is granted.
Normally the stock options have been exercisable in three equal
installments beginning one year from the date of the grant.
Through shareholder approval, 580,800 shares were reserved for
the 1993 Plan. The 1993 Plan expired on April 27, 2003. At
that time, there were 12,808 shares available for future grants
under the 1993 Plan.

The companys 1995 Stock Option Plan for
Non-employee Directors provides for each outside director to
receive options to purchase 5,000 shares of common stock at the
first annual meeting at which the director is elected. As long
as he or she remains an eligible director, the director receives
options to purchase 1,000 shares of common stock at each annual
meeting. These directors cannot be an employee of the company or
one of its subsidiaries or a holder of five percent or more of
the companys common stock. The exercise price of these
options is the fair market value of the common stock on the date
of grant. Each option is not transferable except upon death and
expires 10 years after the date of grant. The options
become exercisable in three equal installments on the first,
second and third anniversaries of the date of grant. A total of
132,000 shares were reserved for issuance. At December 31,
2003, 76,374 shares remained available for future grants. In
2002, the non-employee directors entitled to grants under this
plan consented to forgo their rights to such grants and,
accordingly, no shares were granted under this plan in 2002.
Under the 2000 Plan, discussed below, options to purchase 60,000
shares of the companys common stock, vesting one third
each year over a three year period, were issued to non-employee
directors in 2001.

On January 18, 2000, the companys
shareholders approved the adoption of the 2000 Incentive Plan
(the 2000 Plan). The 2000 Plan allows the company to
grant incentive stock options, nonqualified stock options, stock
appreciation rights, awards of nontransferable shares of
restricted common stock and deferred grants of common stock up
to a total of 1.5 million shares. In the case of incentive
stock options, the option price will not be less than the fair
market value of the stock at the date of grant. The option
period will not exceed 10 years from the date of grant. The
terms of the 2000 Plan are substantially similar to those of the
1993 Plan. A total of 1.5 million shares were reserved for
issuance, of which 97,359 shares remained available at
December 31, 2003.

On January 30, 2001, the companys
shareholders approved the 2000 Employee Stock Purchase Plan (the
ESPP). The ESPP is designed to give eligible
employees an opportunity to purchase common stock of the company
through

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NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

accumulated payroll deductions. The purchase
price of the stock is equal to 85% of the fair market value of a
share of common stock on the first day or last day of each three
month offering period, whichever is lower. All employees of the
company or designed subsidiaries who customarily work at least
20 hours per week and do not own five percent or more of
the companys common stock are eligible to participate in
the purchase plan. A total of 800,000 shares have been reserved
for issuance under the ESPP, which commenced in May 2001. In
2003 and 2002, 171,228 and 126,962 shares were issued,
respectively, under the ESPP.

During 2001, the Board of Directors approved the
Executive Long Term Incentive Program (the ELTIP),
implemented under the provisions of the shareholder-approved
2000 Incentive Plan. The ELTIP provides incentives to program
participants through a combination of stock options and
restricted stock grants, which vest fully in seven years. The
ELTIP allows for accelerated vesting based on the companys
achievement of specified financial performance goals. During the
second quarter of 2001, the company granted under this plan
stock options totaling 750,000 shares of common stock at fair
market value and granted 121,000 shares of restricted common
stock with approximately $1.1 million of compensatory value
that is being amortized over the vesting period of the grant. In
2003, 2002 and 2001, the company recognized approximately
$249,000, $149,000 and $90,000, respectively, of compensation
expense under this plan. In the third quarter of 2002, a
forfeiture of $27,000 occurred under the plan, which was
recorded as a reduction to unearned compensation.

In 2003, the companys shareholders approved
the 2003 Incentive Plan (the 2003 Plan). The 2003
Plan allows the company to grant incentive stock options,
non-qualified stock options, stock appreciation rights, awards
of nontransferable shares of restricted common stock and
deferred grants of common stock up to a total of 400,000 shares
to directors or key employees of the company. In the case of
incentive stock options, the option price may not be less than
the fair market value of the stock at the date of grant. The
option period may not exceed ten years from the date of grant.
There were no options granted during 2003 under this Plan.

Stock option information for 2003, 2002 and 2001
is as follows:

|                                 |           |           |           |          |   |   |      |       | 
|-------------------------------- | --------- | --------- | --------- | -------- | - | - | ---- | ----- | 
|                                 |           |           |           | Weighted
|                                 |           | Number of |           | average 
|                                 |           | shares    |           | price   
|                                 |           |           |           |         
|Outstanding at December 31, 2000 |           |           | 1,076,660 |          |   | $ | 6.62 |      
|                                 | Granted   |           |           | 829,500  |   |   | $    | 9.01  | 
|                                 | Exercised |           |           | (136,127 | ) |   | $    | 6.28  | 
|                                 | Canceled  |           |           | (18,880  | ) |   | $    | 7.52  | 
|                                 |           |           |           |          |   |   |      |      
|Outstanding at December 31, 2001 |           |           | 1,751,153 |          |   | $ | 7.76 |      
|                                 | Granted   |           |           | 98,050   |   |   | $    | 16.50 | 
|                                 | Exercised |           |           | (99,607  | ) |   | $    | 6.84  | 
|                                 | Canceled  |           |           | (35,090  | ) |   | $    | 9.38  | 
|                                 |           |           |           |          |   |   |      |      
|Outstanding at December 31, 2002 |           |           | 1,714,506 |          |   | $ | 9.56 |      
|                                 | Granted   |           |           | 113,500  |   |   | $    | 12.32 | 
|                                 | Exercised |           |           | (84,734  | ) |   | $    | 7.76  | 
|                                 | Canceled  |           |           | (38,386  | ) |   | $    | 11.58 | 
|                                 |           |           |           |          |   |   |      |      
|Outstanding at December 31, 2003 |           |           | 1,704,886 |          |   | $ | 7.47 |      
|                                 |           |           |           |          |   |   |      |      

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following tables summarize information about
stock options outstanding and exercisable at December 31,
2003:

Options Outstanding

|                         |  |        |           |              |  |          |      |  |  |   |       | 
|------------------------ |  | ------ | --------- | ------------ |  | -------- | ---- |  |  | - | ----- | 
|                         |  |        |           | Weighted     |  |         
|                         |  |        |           | average      |  | Weighted
|                         |  |        |           | remaining    |  | average 
|                         |  |        |           | contractual  |  | exercise
|Range of exercise prices |  | Shares |           | life (years) |  | price   
|                         |  |        |           |              |  |         
|$ 3.13  $ 7.50          |  |        | 445,500   |              |  |          | 5.01 |  |  | $ | 5.11  | 
|$ 7.51  $13.68          |  |        | 1,185,292 |              |  |          | 7.42 |  |  | $ | 9.18  | 
|$13.69  $18.60          |  |        | 48,493    |              |  |          | 8.18 |  |  | $ | 18.16 | 
|$18.61  $24.50          |  |        | 25,601    |              |  |          | 8.02 |  |  | $ | 22.14 | 
|                         |  |        |           |              |  |          |      |  |  |   |       | 
|$ 3.13  $24.50          |  |        | 1,704,886 |              |  |          | 6.82 |  |  | $ | 8.57  | 
|                         |  |        |           |              |  |          |      |  |  |   |       | 

Options Exercisable

|                         |  |        |         |          |  |   |       | 
|------------------------ |  | ------ | ------- | -------- |  | - | ----- | 
|                         |  |        |         | Weighted
|                         |  |        |         | average 
|                         |  |        |         | exercise
|Range of exercise prices |  | Shares |         | price   
|                         |  |        |         |         
|$ 3.13  $ 7.50          |  |        | 442,166 |          |  | $ | 5.09  | 
|$ 7.51  $13.68          |  |        | 317,951 |          |  | $ | 8.63  | 
|$13.69  $18.60          |  |        | 14,352  |          |  | $ | 18.53 | 
|$18.61  $24.50          |  |        | 9,203   |          |  | $ | 22.20 | 
|                         |  |        |         |          |  |   |       | 
|$ 3.13  $24.50          |  |        | 783,672 |          |  | $ | 8.34  | 
|                         |  |        |         |          |  |   |       | 

There were 646,691 and 521,386 stock options
exercisable at December 31, 2002 and 2001, respectively.

NOTE 9. COMMITMENTS AND
CONTINGENCIES

The company conducts some of its operations in
facilities that are under long-term operating leases. These
leases expire at various dates through 2011, with various
options to renew as negotiated between the company and its
landlords. It is expected that in the normal course of business,
leases that expire will be renewed or replaced. Rent expense
under these leases (inclusive of real estate taxes and
insurance) was $3.6 million in 2003, $4.2 million in
2002 and $4.1 million in 2001.

On December 26, 2002, the company entered
into an installment payment agreement in connection with the
purchase of its enterprise business system software. The company
made the first payment on January 26, 2003, with the second
and last payment due and paid on January 26, 2004. The
company recorded the liability using an imputed interest rate of
3.38%, which was its effective borrowing rate at
December 31, 2002. The obligation is reflected in the table
below as a purchase commitment.

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Contractual obligations at December 31, 2003
were as follows (in thousands):

|                     |                               |                        |       |             |  |            |       |            |  |       |       |       |  |   |       |       |  |   |        |        | 
|-------------------- | ----------------------------- | ---------------------- | ----- | ----------- |  | ---------- | ----- | ---------- |  | ----- | ----- | ----- |  | - | ----- | ----- |  | - | ------ | ------ | 
|                     |                               |                       
|                     |                               | Payments due by period
|                     |                               |                       
|                     |                               | Less than              |       | Two to      |  | Four to    |       |           
|                     |                               | one year               |       | three years |  | five years |       | Thereafter |  | Total
|                     |                               |                        |       |             |  |            |       |            |  |      
|Revolver             |                               | $                      | 8,500 |             |  | $          |      |            |  | $     |      |       |  | $ |      |       |  | $ | 8,500  |       
|Long-term debt       |                               |                        | 500   |             |  |            | 1,000 |            |  |       | 1,000 |       |  |   | 5,750 |       |  |   | 8,250  |       
|Operating leases     |                               |                        | 4,771 |             |  |            | 5,549 |            |  |       | 3,293 |       |  |   | 3,288 |       |  |   | 16,901 |       
|Purchase commitments |                               |                        | 554   |             |  |            |      |            |  |       |      |       |  |   |      |       |  |   | 554    |       
|                     |                               |                        |       |             |  |            |       |            |  |       |       |       |  |   |       |       |  |   |        |       
|                     | Total contractual obligations |                        | $     | 14,325      |  |            | $     | 6,549      |  |       | $     | 4,293 |  |   | $     | 9,038 |  |   | $      | 34,205 | 
|                     |                               |                        |       |             |  |            |       |            |  |       |       |       |  |   |       |       |  |   |        |       

As part of the HJ Ford purchase, the company
acquired a 40% ownership interest in a small disadvantaged
business, as defined by the United States Government. This
business is accounted for using the equity method. The company
has continuing business relationships with this business and has
provided it with a line of credit guaranteed in the amount of
$0.2 million. The companys guarantee is indemnified
by the other shareholders of this business. At December 31,
2003, there was an outstanding balance of $0.1 million
under this line of credit.

The company has change of control agreements with
certain of its employees that provide them with benefits should
their employment with the company be terminated other than for
cause or their disability or death, or if they resign for good
reason within a certain period of time from the date of any
change of control of the company.

As a defense contractor, the company is subject
to many levels of audit and review from various government
agencies, including the Defense Contract Audit Agency, various
inspectors general, the Defense Criminal Investigative Service,
the General Accounting Office, the Department of Justice and
congressional committees. Both related to and unrelated to its
defense industry involvement, the company is, from time to time,
involved in audits, lawsuits, claims, administrative proceedings
and investigations. The company accrues for liabilities
associated with these activities when it becomes probable that
future expenditures will be made and such expenditures can be
reasonably estimated. The companys evaluation of the
likelihood of expenditures related to these matters is subject
to change in future periods, depending on then current events
and circumstances, which could have material adverse effects on
the companys business, financial position, results of
operations and cash flows.

As previously disclosed, on October 26,
2000, two former company employees were indicted and charged
with, among other violations, wire fraud and a conspiracy scheme
to defraud the United States Air Force out of approximately
$10 million through kickbacks and overcharging for computer
components and services. The former employees collected the
kickbacks and overcharges through separate and independent
businesses. The company received no money from their scheme.
When notified by the government of the employees
conspiracy, the company fired the two employees and voluntarily
cooperated with the governments investigation. The company
was not charged in the criminal case. Both former employees pled
guilty and were sentenced to prison. The company believes that
the government has recovered a substantial portion of the
defrauded funds from the co-conspirators. Notwithstanding the
companys efforts to settle any claims against the company
arising from the employees scheme, on October 9, 2003
the United States Attorney filed a civil complaint against the
company in the United States District Court for the District of
Massachusetts based in substantial part upon the actions and
omissions of the former employees which gave rise to the
criminal cases against them. In the civil action, the United
States Attorney is asserting on behalf of the government claims
against the company based upon the False Claims Act and the
Anti-Kickback Act, in addition to certain common law and
equitable claims. The United States Attorney seeks to recover up
to three times its actual damages and penalties under the False
Claims Act and double damages and penalties under the
Anti-Kickback Act and to recover costs and interest. The company
disputes the claims, believes it has substantive defenses, and
intends to vigorously defend itself. However, the outcome of
such litigation, if unfavorable, could have a material adverse
effect on the companys business, financial position,
results of operations and cash flows. The company has filed a
third party complaint, as part of the United States
Attorneys civil action, including an affirmative multiple
damage claim for unfair and deceptive practices, against Storage
Engine, Inc. (Storage Engine), formerly known as
ECCS, Inc., and its president and director.

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NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The complaint alleges that Storage Engine
directly benefited from the kickback scheme alleged by the
United States Attorney. Storage Engine, a supplier of computer
components for the Air Force, made payments to the
companys two former employees through separate and
independent businesses. Storage Engine and its president deny
the allegations.

On September 5, 2002, Genesis Tactical Group
LLC (Genesis) asserted a cross-claim against
Lockheed Martin Corporation (Lockheed) in the State
of New York Supreme Court, County of Onondaga seeking
$50.0 million in damages and against the company seeking
$35.0 million in damages. These cross-claims arise out of a
suit filed on July 30, 2002 by Lockheed against Tactical
Communications Group LLC, Genesis and the company in the State
of New York Supreme Court, County of Onondaga. The Lockheed suit
relates to a contract for services that was sold to Genesis by
the company pursuant to an asset purchase agreement in 2001. By
the terms of the asset purchase agreement, the companys
liability to Genesis is limited to $300,000, other than for
intentional misrepresentation, willful breach or fraud. Lockheed
and Genesis have settled their outstanding issues, including a
software ownership issue, and filed a stipulation of dismissal
with prejudice. The Genesis claim for $35.0 million against
the Company was related to the software ownership issue that was
settled in favor of Genesis. Lockheeds settlement demand
to the company was $495,679 plus interest. The company believes
that $311,679 of the demanded amount is for extra work and
materials procured by Lockheed from Genesis and disputes the
balance due to other mutually agreed contract changes between
Lockheed and Genesis. The company will continue to defend
against any and all claims by Lockheed and/or Genesis. While the
company believes that the possibility of a material adverse
effect on the companys business, financial position,
results of operations and cash flows is remote, there can be no
assurance as to the outcome.

The company has provided documents in response to
a previously disclosed grand jury subpoena issued on
October 15, 2002 by the United States District Court for
the District of Massachusetts directing the company to produce
specified documents dating back to 1996. The subpoena relates to
an investigation, currently focused on the period from 1996 to
1999, by the Antitrust Division of the Department of Justice
into bidding and procurement activities involving the company
and several other defense contractors who have received similar
subpoenas and may also be subjects of the investigation.

In 2003, approximately 93% of the companys
revenues were derived from sales to United States Government
agencies, primarily the Department of Defense. All of the
companys United States Government contracts are subject to
termination for convenience in accordance with government
regulations. In 2003, sales to agencies of state and local
governments comprised approximately 5% of revenues. Many of the
contracts the company has won are multi-year efforts. In
accordance with state laws, funding must be approved annually by
the states legislatures.

NOTE 10. PREFERRED STOCK PURCHASE
RIGHTS

On February 17, 1998, the company declared a
dividend distribution of one preferred stock purchase right (the
Right) for every outstanding share of common stock,
effective July 27, 1998. The Rights attach to all
outstanding shares of common stock, and no separate right
certificates will be issued. The Rights will become exercisable
upon the tenth business day following the earlier of:
(a) the date of a public announcement that a person or
group of affiliated or associated persons has acquired, or
obtained the right to acquire, beneficial ownership of 15% or
more of the outstanding shares of common stock of the company;
or (b) the commencement or announcement of an intention to
make a tender offer or exchange offer that would result in a
person or group owning 15% or more of the outstanding common
stock of the company.

When exercisable, each Right entitles the
registered holder to purchase from the company one-twelfth of a
share of its Series B Participating Preferred Stock, $0.10
par value, at a price of $54.17 per each one-twelfth share of
preferred stock. Until a Right is exercised, the holder thereof,
as such, will have no rights as a shareholder of the company,
including, without limitation, the right to vote or to receive
dividends. Under certain circumstances, each share of the
Series B Participating Preferred Stock would be convertible
into a number of shares of the companys common stock
having a value equal to twice the exercise price of the
preferred stock purchase right. The Rights may be redeemed by
the company at the discretion of the Board of Directors at a
price of $0.0083 per Right. The Rights expire on July 27,
2008.

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NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

NOTE 11. BUSINESS
ACQUISITIONS

ANDRULIS

On December 20, 2002, the company completed
the acquisition of all of the outstanding shares of capital
stock of ANDRULIS, a provider of information technology and
engineering solutions to federal government customers in the
defense and federal civilian sectors. The transaction was
accounted for as a purchase transaction in accordance with
SFAS 141. In consideration, the company paid the selling
stockholders $12.2 million of net cash and issued three
separate promissory notes payable aggregating
$12.4 million, due January 2, 2003, at an interest
rate of 4.0%. In addition, the company incurred
$1.1 million of transaction costs and $0.7 million of
exit costs. The notes were settled in January 2003. The company
used cash on hand and its $50.0 million revolving credit
facility to fund the cash payments to the selling stockholders.
The purchase price was finalized upon the completion of
independent appraisals and determination of the fair values of
the assets acquired and liabilities assumed, in accordance with
the purchase agreement, during the third quarter of 2003. As a
result of this process, the company made an additional payment
of $0.3 million to the selling stockholders for the amount
that the acquired net assets exceeded the target asset value as
stipulated in the purchase agreement.

A portion of the excess of purchase price over
the fair value of net tangible assets acquired has been
allocated to identifiable intangible assets with estimated
useful lives ranging between two and five years, based upon an
independent appraisal. These assets are being amortized based
upon an analysis of expected cash flows. The balance of the
excess purchase price was recorded as goodwill.

A summary of the transaction and the allocation
of the purchase price is as follows (in thousands):

|                                                                            |                                                    |                                                  |        |        |        | 
|--------------------------------------------------------------------------- | -------------------------------------------------- | ------------------------------------------------ | ------ | ------ | ------ | 
|Consideration:                                                              |                                                    |                                                  |        |       
|                                                                            | Cash, net of cash acquired of $1,709               |                                                  | $      | 12,172 |       
|                                                                            | Notes payable issued to selling stockholders       |                                                  |        | 12,400 |       
|                                                                            | Transaction costs                                  |                                                  |        | 1,116  |       
|                                                                            | Exit costs                                         |                                                  |        | 705    |       
|                                                                            |                                                    |                                                  |        |       
|                                                                            |                                                    | Total consideration                              |        |        | 26,393 | 
|                                                                            |                                                    |                                                  |        |       
|Allocation of consideration to assets
    acquired/(liabilities assumed):   |                                                    |                                                  |        |       
|                                                                            | Working capital, excluding cash acquired of $1,709 |                                                  |        | 4,459  |       
|                                                                            | Property and equipment                             |                                                  |        | 649    |       
|                                                                            | Other noncurrent assets                            |                                                  |        | 30     |       
|                                                                            | Other liabilities                                  |                                                  |        | (1,934 | )     
|                                                                            |                                                    |                                                  |        |       
|                                                                            |                                                    | Total fair value of net tangible assets acquired |        |        | 3,204  | 
|                                                                            |                                                    |                                                  |        |       
|Excess of consideration over fair value of net
    tangible assets acquired |                                                    |                                                  | 23,189 |       
|                                                                            |                                                    |                                                  |        |       
|Allocation of excess consideration to
    identifiable intangible assets:   |                                                    |                                                  |        |       
|                                                                            | Customer relationships                             |                                                  |        | 1,300  |       
|                                                                            | Non-competition agreements                         |                                                  |        | 1,340  |       
|                                                                            |                                                    |                                                  |        |       
|                                                                            |                                                    |                                                  | 2,640  |       
|                                                                            |                                                    |                                                  |        |       
|Allocation of excess consideration to goodwill                              |                                                    | $                                                | 20,549 |       
|                                                                            |                                                    |                                                  |        |       

HJ Ford

On May 31, 2002, the company completed the
acquisition of all of the outstanding voting common stock of HJ
Ford. HJ Ford helps its clients manage operational process and
acquisition programs through systems and information
engineering, information technology, enterprise engineering and
acquisition program support. The transaction was accounted for
as a

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NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

purchase in accordance with SFAS No. 141. In
consideration, the company paid the HJ Ford stockholders
$10.2 million of net cash and incurred $0.4 million
and $0.1 million of transaction costs and exit costs,
respectively, for a total purchase price of $10.7 million.
The net cash payment to the selling stockholders includes
$1.3 million for the sellers consent to treat the
transaction as an asset purchase for tax purposes, under
Section 338(h)(10) of the Internal Revenue Code. This tax
treatment enables the company to take future tax deductions for
the amortization of goodwill for tax purposes related to the
transaction.

The purchase agreement also requires the company
to pay the sellers an additional $1.0 million in 2005,
contingent upon the occurrence of certain events related to
contract renewals. The contingent consideration will be recorded
as an addition to the purchase price at the time it becomes
probable that a payment will be required.

As part of this purchase, the company acquired a
40% ownership interest in a small disadvantaged business. This
business is accounted for using the equity method. The company
has continuing business relationships with this business and has
provided it with a line of credit guarantee in the amount of
$0.2 million. The companys guarantee is indemnified
by the other shareholders. At December 31, 2003, there was
an outstanding balance of $0.1 million under this line of
credit.

A portion of the excess of purchase price over
the fair value of net tangible assets acquired has been
allocated to identifiable intangible assets with estimated
useful lives ranging between two and four years, based upon an
independent appraisal. These assets are being amortized based
upon analysis of expected cash flows. The balance of the excess
purchase price was recorded as goodwill.

A summary of the transaction and the allocation
of the purchase price is as follows (in thousands):

|                                                                            |                                                  |                                                  |       |        |        | 
|--------------------------------------------------------------------------- | ------------------------------------------------ | ------------------------------------------------ | ----- | ------ | ------ | 
|Consideration:                                                              |                                                  |                                                  |       |       
|                                                                            | Cash, net of cash acquired of $554               |                                                  | $     | 10,251 |       
|                                                                            | Transaction costs                                |                                                  |       | 342    |       
|                                                                            | Exit costs                                       |                                                  |       | 140    |       
|                                                                            |                                                  |                                                  |       |       
|                                                                            |                                                  | Total consideration                              |       |        | 10,733 | 
|                                                                            |                                                  |                                                  |       |       
|Allocation of consideration to assets
    acquired/(liabilities assumed):   |                                                  |                                                  |       |       
|                                                                            | Working capital, excluding cash acquired of $554 |                                                  |       | 3,054  |       
|                                                                            | Property and equipment                           |                                                  |       | 195    |       
|                                                                            | Other noncurrent assets                          |                                                  |       | 222    |       
|                                                                            | Long-term debt                                   |                                                  |       | (700   | )     
|                                                                            |                                                  |                                                  |       |       
|                                                                            |                                                  | Total fair value of net tangible assets acquired |       |        | 2,771  | 
|                                                                            |                                                  |                                                  |       |       
|Excess of consideration over fair value of net
    tangible assets acquired |                                                  |                                                  | 7,962 |       
|                                                                            |                                                  |                                                  |       |       
|Allocation of excess consideration to
    identifiable intangible assets:   |                                                  |                                                  |       |       
|                                                                            | Customer relationships                           |                                                  |       | 1,400  |       
|                                                                            | Non-competition agreements                       |                                                  |       | 400    |       
|                                                                            |                                                  |                                                  |       |       
|                                                                            |                                                  |                                                  | 1,800 |       
|                                                                            |                                                  |                                                  |       |       
|Allocation of excess consideration to goodwill                              |                                                  | $                                                | 6,162 |       
|                                                                            |                                                  |                                                  |       |       

The company fully paid the long-term debt of
$0.7 million in the second quarter of 2002 and canceled the
related loan agreement.

Pro forma results of operations

The following pro forma results of operations for
the year ended December 31, 2002 have been prepared as if
the ANDRULIS and HJ Ford acquisitions had occurred as of
January 1, 2002. These pro forma results include
adjustments for

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

the amortization of intangible assets with finite
useful lives, the elimination of intercompany transactions and
adjustments for the effect of income taxes. The pro forma
information should be read in conjunction with the related
historical information, and does not purport to be indicative of
the results of operations that would have been attained had the
acquisitions been made as of January 1, 2002, or of results
of operations that may occur in the future (in thousands, except
per share data):

|                               |  |              |         | 
|------------------------------ |  | ------------ | ------- | 
|                               |  | Year ended  
|                               |  | December 31,
|                               |  | 2002        
|                               |  |             
|Revenue                        |  | $            | 240,513 | 
|Net income                     |  | $            | 7,390   | 
|Net income per share  basic   |  | $            | 0.92    | 
|Net income per share  diluted |  | $            | 0.83    | 

NOTE 12.     GOODWILL
AND INTANGIBLE ASSETS

Components of the companys identifiable
intangible assets are as follows (in thousands):

|                           |  |                   |       |                   |  |      |       |              |  |   |       |  |  |   |     | 
|-------------------------- |  | ----------------- | ----- | ----------------- |  | ---- | ----- | ------------ |  | - | ----- |  |  | - | --- | 
|                           |  |                   |       |                  
|                           |  | December 31, 2003 |       | December 31, 2002
|                           |  |                   |       |                  
|                           |  |                   |       | Accumulated       |  |      |       | Accumulated 
|                           |  | Cost              |       | amortization      |  | Cost |       | amortization
|                           |  |                   |       |                   |  |      |       |             
|Customer relationships     |  | $                 | 2,700 |                   |  | $    | 1,187 |              |  | $ | 2,700 |  |  | $ | 257 | 
|Non-competition agreements |  |                   | 1,740 |                   |  |      | 910   |              |  |   | 1,740 |  |  |   | 117 | 
|                           |  |                   |       |                   |  |      |       |              |  |   |       |  |  |   |     | 
|                           |  | $                 | 4,440 |                   |  | $    | 2,097 |              |  | $ | 4,440 |  |  | $ | 374 | 
|                           |  |                   |       |                   |  |      |       |              |  |   |       |  |  |   |     | 

The company recorded amortization expense for its
identifiable intangible assets of $1.7 million and
$0.4 million in the years ended December 31, 2003 and
2002, respectively. Estimated future amortization expense for
the identifiable intangible assets recorded by the company as of
December 31, 2003 is as follows (in thousands):

|     |  |   |       | 
|---- |  | - | ----- | 
|2004 |  | $ | 1,520 | 
|2005 |  | $ | 489   | 
|2006 |  | $ | 167   | 
|2007 |  | $ | 167   | 
|2008 |  | $ |      | 

The changes in the carrying amount of goodwill
for the year ended December 31, 2003 are as follows (in
thousands):

|                                                                 |  |             |        |               |  |       |   |  |  |   |        | 
|---------------------------------------------------------------- |  | ----------- | ------ | ------------- |  | ----- | - |  |  | - | ------ | 
|                                                                 |  | Systems and |        |               |  |      
|                                                                 |  | Services    |        | Metrigraphics |  | Total
|                                                                 |  |             |        |               |  |      
|Balance at December 31, 2002                                     |  | $           | 26,169 |               |  | $     |  |  |  | $ | 26,169 | 
|Purchase accounting adjustments on prior period
    acquisitions |  |             | 542    |               |  |       |  |  |  |   | 542    | 
|                                                                 |  |             |        |               |  |       |   |  |  |   |        | 
|Balance at December 31, 2003                                     |  | $           | 26,711 |               |  | $     |  |  |  | $ | 26,711 | 
|                                                                 |  |             |        |               |  |       |   |  |  |   |        | 

Purchase accounting adjustments are primarily
comprised of $0.3 million of additional consideration to
the former stockholders of ANDRULIS related to the fair value of
assets acquired, $0.1 million of additional transaction
costs incurred and $0.1 million of net final adjustments to
liabilities assumed, including $0.3 million to increase
liabilities for changes in estimate for transaction cost and
severance accruals, and $0.2 million to reverse liabilities
for which accruals are no longer required. The company is
required to perform an annual impairment test of its goodwill
under the provisions of SFAS 142. Impairment exists when
the carrying value of goodwill is not recoverable and its
carrying amount exceeds its fair value. SFAS 142 requires a
two-step impairment testing approach. Companies must first
determine whether goodwill is impaired

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

and if so, they must value that impairment based
on the amount by which the book value exceeds the estimated fair
value. As a result of the annual impairment test performed as of
December 31, 2003, the company determined that the carrying
amount of goodwill did not exceed its fair value and,
accordingly, did not record a charge for impairment. However,
there can be no assurance that goodwill will not be impaired in
subsequent periods.

NOTE 13.     BUSINESS
SEGMENT, GEOGRAPHIC, MAJOR CUSTOMER AND RELATED PARTY
INFORMATION

The company has two reportable business segments:
Systems and Services, and Metrigraphics.

The Systems and Services segment provides
technical and information technology services to government
customers. The segment is comprised of five operating groups
that provide similar services and are subject to similar
regulations. These services included the design, development,
operation and maintenance of information technology systems,
engineering services, complex logistics planning systems and
services, defense program administrative support services,
simulation, modeling, training systems and services, and custom
built electronic test equipment and services.

The Metrigraphics segment develops and builds
components for original equipment manufacturers in the computer
peripheral device, medical electronics, telecommunications and
other industries, with the focus on the custom design and
manufacture of miniature electronic parts that meet high
precision requirements through the use of electroforming, thin
film deposition and photolithography technologies.

The company evaluates performance and allocates
resources based on operating income. The operating income for
each segment includes amortization of intangible assets and
selling, general and administrative expenses directly
attributable to the segment. All corporate operating expenses
are allocated between the segments based on segment revenues,
including depreciation. However, depreciation related to
corporate assets that is subsequently allocated to the segment
operating results is included in the table below. Sales between
segments represent less than 1% of total revenue and are
accounted for at cost. Corporate assets are primarily comprised
of cash and cash equivalents, the companys corporate
headquarters facility in Andover, Massachusetts, the deferred
tax asset, certain corporate prepaid expenses and other current
assets, and valuation allowances.

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Results of operations information for the
companys business segments for the years ended
December 31, 2003, 2002 and 2001 is as follows (in
thousands):

|                     |                                  |                                |         |         |       |      |         |         |       |   |         |         |       | 
|-------------------- | -------------------------------- | ------------------------------ | ------- | ------- | ----- | ---- | ------- | ------- | ----- | - | ------- | ------- | ----- | 
|                     |                                  |                               
|                     |                                  | Year ended December 31,       
|                     |                                  |                               
|                     |                                  | 2003                           |         | 2002    |       | 2001
|                     |                                  |                                |         |         |       |     
|Revenues             |                                  |                                |         |         |       |      |         |         |       |   |         |        
|                     | Systems and Services             |                                | $       | 237,876 |       |      | $       | 184,994 |       |   | $       | 179,350 |      
|                     | Metrigraphics                    |                                |         | 6,932   |       |      |         | 7,616   |       |   |         | 10,914  |      
|                     |                                  |                                |         |         |       |      |         |         |       |   |         |        
|                     |                                  | $                              | 244,808 |         |       | $    | 192,610 |         |       | $ | 190,264 |        
|                     |                                  |                                |         |         |       |      |         |         |       |   |         |        
|Operating income     |                                  |                                |         |         |       |      |         |         |       |   |         |        
|                     | Systems and Services             |                                | $       | 14,749  |       |      | $       | 11,513  |       |   | $       | 9,477   |      
|                     | Metrigraphics                    |                                |         | 640     |       |      |         | 1,134   |       |   |         | 3,533   |      
|                     |                                  |                                |         |         |       |      |         |         |       |   |         |        
|                     |                                  | $                              | 15,389  |         |       | $    | 12,647  |         |       | $ | 13,010  |        
|                     |                                  |                                |         |         |       |      |         |         |       |   |         |        
|Depreciation         |                                  |                                |         |         |       |      |         |         |       |   |         |        
|                     | Systems and Services             |                                | $       | 2,126   |       |      | $       | 1,997   |       |   | $       | 1,889   |      
|                     | Metrigraphics                    |                                |         | 546     |       |      |         | 602     |       |   |         | 574     |      
|                     |                                  |                                |         |         |       |      |         |         |       |   |         |        
|                     |                                  | Depreciation of segment assets |         |         | 2,672 |      |         |         | 2,599 |   |         |         | 2,463 | 
|                     | Depreciation of corporate assets |                                |         | 335     |       |      |         | 593     |       |   |         | 526     |      
|                     |                                  |                                |         |         |       |      |         |         |       |   |         |        
|                     |                                  | $                              | 3,007   |         |       | $    | 3,192   |         |       | $ | 2,989   |        
|                     |                                  |                                |         |         |       |      |         |         |       |   |         |        
|Capital expenditures |                                  |                                |         |         |       |      |         |         |       |   |         |        
|                     | Systems and Services             |                                | $       | 1,246   |       |      | $       | 2,174   |       |   | $       | 2,162   |      
|                     | Metrigraphics                    |                                |         | 6       |       |      |         | 329     |       |   |         | 692     |      
|                     |                                  |                                |         |         |       |      |         |         |       |   |         |        
|                     |                                  | Segment capital expenditures   |         |         | 1,252 |      |         |         | 2,503 |   |         |         | 2,854 | 
|                     | Corporate capital expenditures   |                                |         | 6,911   |       |      |         | 844     |       |   |         | 741     |      
|                     |                                  |                                |         |         |       |      |         |         |       |   |         |        
|                     |                                  | $                              | 8,163   |         |       | $    | 3,347   |         |       | $ | 3,595   |        
|                     |                                  |                                |         |         |       |      |         |         |       |   |         |        

Asset information for the companys business
segments and a reconciliation of segment assets to the
corresponding consolidated amounts as of December 31, 2003
and 2002 is as follows (in thousands):

|                        |                      |                      |         |        |         |   |         |        |        | 
|----------------------- | -------------------- | -------------------- | ------- | ------ | ------- | - | ------- | ------ | ------ | 
|                        |                      |                     
|                        |                      | December 31,        
|                        |                      |                     
|                        |                      | 2003                 |         | 2002  
|                        |                      |                      |         |       
|Segment assets          |                      |                      |         |        |         |   |         |       
|                        | Systems and Services |                      | $       | 98,274 |         |   | $       | 93,463 |       
|                        | Metrigraphics        |                      |         | 2,004  |         |   |         | 2,639  |       
|                        |                      |                      |         |        |         |   |         |       
|                        |                      | Total segment assets |         |        | 100,278 |   |         |        | 96,102 | 
|Corporate assets        |                      |                      | 20,792  |        |         |   | 11,811  |       
|Discontinued operations |                      |                      |        |        |         |   | 3,763   |       
|                        |                      |                      |         |        |         |   |         |       
|                        |                      | $                    | 121,070 |        |         | $ | 111,676 |       
|                        |                      |                      |         |        |         |   |         |       

Revenue is attributed to geographic areas based
on the customers location. The company does not have
locations outside the United States; however, in rare instances,
it may have contracts with sales representatives located in
foreign

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

countries and provide services at customer
locations outside the United States. Domestic revenues comprised
approximately 98% of revenues in 2003, 2002 and 2001.

Revenues from Department of Defense
(DoD) customers accounted for approximately 78%, 80%
and 78% of total revenues in 2003, 2002 and 2001, respectively.
Revenues earned from one significant DoD contract in the Systems
and Services segment accounted for approximately 12%, 15% and
20% of the companys total revenues in 2003, 2002 and 2001,
respectively. This customer had no outstanding accounts
receivable balance at December 31, 2003. This
customers accounts receivable balance at December 31,
2002, was $3.4 million. A second significant contract in
the Systems and Services segment comprised 18%, 11% and 13% of
the companys total revenues in 2003, 2002 and 2001,
respectively. This customer had an accounts receivable balance
of $1.6 million at December 31, 2003 and
$4.8 million at December 31, 2002. The company had no
other customer in any of the three years ended December 31,
2003, that accounted for more than 10% of revenues.

As previously discussed, the company has a 40%
interest in HMR Tech, which it accounts for using the equity
method of accounting. This interest was acquired as a result of
the companys May 31, 2002 acquisition of HJ Ford.
Accordingly, HMR Tech is considered a related party for the
period subsequent to May 31, 2002. Revenues from HMR Tech
for the year ended December 31, 2003 and the period from
May 31, 2002 through December 31, 2002 were
approximately $473,000 and $211,000, respectively. The amount
due from HMR Tech included in accounts receivable at
December 31, 2003 and 2002 were approximately $501,000 and
$184,000, respectively. Related party transactions and amounts
included in Accounts receivable are on standard pricing and
contractual terms and manner of settlement for services of
similar types at comparable volumes.

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DYNAMICS RESEARCH CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

NOTE 14. QUARTERLY RESULTS
(UNAUDITED)(in thousands, except per
share data)

|     |                                                   |                                             |                               |         |       |         |   |         |       |      |   |        |       |      |   |        |       |      | 
|---- | ------------------------------------------------- | ------------------------------------------- | ----------------------------- | ------- | ----- | ------- | - | ------- | ----- | ---- | - | ------ | ----- | ---- | - | ------ | ----- | ---- | 
|     |                                                   | First                                       |                               | Second  |       | Third   |   | Fourth 
|     |                                                   | Quarter                                     |                               | Quarter |       | Quarter |   | Quarter
|     |                                                   |                                             |                               |         |       |         |   |        
|2003 |                                                   |                                             |                               |         |       |         |   |         |       |      |   |        |       |      |   |       
|     | Revenues                                          |                                             | $                             | 58,606  |       |         | $ | 62,138  |       |      | $ | 62,432 |       |      | $ | 61,632 |      
|     | Gross profit                                      |                                             | $                             | 9,201   |       |         | $ | 10,005  |       |      | $ | 9,704  |       |      | $ | 11,151 |      
|     | Operating income                                  |                                             | $                             | 2,965   |       |         | $ | 3,473   |       |      | $ | 4,263  |       |      | $ | 4,688  |      
|     | Income from continuing operations                 |                                             | $                             | 1,632   |       |         | $ | 1,958   |       |      | $ | 2,387  |       |      | $ | 2,678  |      
|     | Loss from discontinued operations                 |                                             |                               | (357    | )     |         |   | (856    | )     |      |   | (147   | )     |      |   | (275   | )    
|     | Loss on disposal of discontinued operations       |                                             |                               | (233    | )     |         |   |        |       |      |   |       |       |      |   | (115   | )    
|     |                                                   |                                             |                               |         |       |         |   |         |       |      |   |        |       |      |   |       
|     | Net income                                        |                                             | $                             | 1,042   |       |         | $ | 1,102   |       |      | $ | 2,240  |       |      | $ | 2,288  |      
|     |                                                   |                                             |                               |         |       |         |   |         |       |      |   |        |       |      |   |       
|     | Earnings (loss) per common share 
    diluted(1) |                                             |                               |         |       |         |   |         |       |      |   |        |       |      |   |        |      
|     |                                                   | Income from continuing operations           |                               | $       | 0.19  |         |   | $       | 0.23  |      |   | $      | 0.27  |      |   | $      | 0.30  |     
|     |                                                   | Loss from discontinued operations           |                               |         | (0.04 | )       |   |         | (0.10 | )    |   |        | (0.02 | )    |   |        | (0.03 | )   
|     |                                                   | Loss on disposal of discontinued operations |                               |         | (0.03 | )       |   |         |      |      |   |        |      |      |   |        | (0.01 | )   
|     |                                                   |                                             |                               |         |       |         |   |         |       |      |   |        |       |      |   |       
|     |                                                   |                                             | Net earnings per common share |         | $     | 0.12    |   |         | $     | 0.13 |   |        | $     | 0.25 |   |        | $     | 0.26 | 
|     |                                                   |                                             |                               |         |       |         |   |         |       |      |   |        |       |      |   |       
|2002 |                                                   |                                             |                               |         |       |         |   |         |       |      |   |        |       |      |   |       
|     | Revenues                                          |                                             | $                             | 47,059  |       |         | $ | 47,805  |       |      | $ | 47,154 |       |      | $ | 50,592 |      
|     | Gross profit                                      |                                             | $                             | 7,030   |       |         | $ | 7,686   |       |      | $ | 7,605  |       |      | $ | 8,610  |      
|     | Operating income                                  |                                             | $                             | 2,882   |       |         | $ | 3,417   |       |      | $ | 3,266  |       |      | $ | 3,082  |      
|     | Income from continuing operations                 |                                             | $                             | 1,686   |       |         | $ | 2,003   |       |      | $ | 1,984  |       |      | $ | 1,684  |      
|     | Loss from discontinued operations                 |                                             |                               | (200    | )     |         |   | (199    | )     |      |   | (191   | )     |      |   | (534   | )    
|     |                                                   |                                             |                               |         |       |         |   |         |       |      |   |        |       |      |   |       
|     |                                                   | Net income                                  |                               | $       | 1,486 |         |   | $       | 1,804 |      |   | $      | 1,793 |      |   | $      | 1,150 |     
|     |                                                   |                                             |                               |         |       |         |   |         |       |      |   |        |       |      |   |       
|     | Earnings (loss) per common share 
    diluted(1) |                                             |                               |         |       |         |   |         |       |      |   |        |       |      |   |        |      
|     |                                                   | Income from continuing operations           |                               | $       | 0.19  |         |   | $       | 0.22  |      |   | $      | 0.22  |      |   | $      | 0.20  |     
|     |                                                   | Loss from discontinued operations           |                               |         | (0.02 | )       |   |         | (0.02 | )    |   |        | (0.02 | )    |   |        | (0.07 | )   
|     |                                                   |                                             |                               |         |       |         |   |         |       |      |   |        |       |      |   |       
|     |                                                   |                                             | Net earnings per common share |         | $     | 0.17    |   |         | $     | 0.20 |   |        | $     | 0.20 |   |        | $     | 0.13 | 
|     |                                                   |                                             |                               |         |       |         |   |         |       |      |   |        |       |      |   |       



---



|    |                                                                                                                                                                                                             
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Income (loss) per share is computed independently
    for each of the quarters presented; therefore, the sum of the
    quarterly income (loss) per share may not equal the total
    computed for the year.

In the fourth quarter of 2002, the company
determined that the service method of revenue recognition was
the appropriate method for a small number of the companys
contracts performed during the periods presented in these
financial statements. As a result, the company recorded a
reduction in revenue of $0.1 million in that quarter to
adjust for the cumulative effect of the change in revenue
recognition. In the same quarter, the company adjusted for the
cumulative effect of lease costs related to operating leases
with rent escalations. The combined effect of these two
adjustments reduced income from continuing operations by
$0.3 million in the fourth quarter of 2002.

In the fourth quarter of 2002, the company
incurred fees in connection with the re-audit of the years ended
December 31, 2001 and 2000, necessitated by the decision to
divest the discontinued Encoder Division. The re-audit fees of
$0.4 million are included in the loss from discontinued
operations for that quarter.

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DYNAMICS RESEARCH CORPORATION

SCHEDULE II  VALUATION AND
QUALIFYING ACCOUNTS AND RESERVES

|                                                  |                         |                           |  |            |       |             |  |            |     |            |  |   |      |   |  |   |      |   |  |   |       | 
|------------------------------------------------- | ----------------------- | ------------------------- |  | ---------- | ----- | ----------- |  | ---------- | --- | ---------- |  | - | ---- | - |  | - | ---- | - |  | - | ----- | 
|                                                  |                         |                           |  |            |       |             |  |           
|                                                  |                         |                           |  | Additions  |       |             |  |           
|                                                  |                         |                           |  |            |       |             |  |           
|                                                  |                         | Balance at                |  | Charged to |       | Charged to  |  | Deductions |     | Balance at
|                                                  |                         | Beginning                 |  | Costs and  |       | Other       |  | and        |     | End       
|                                                  |                         | of Period                 |  | Expenses   |       | Accounts(A) |  | Write-offs |     | of Period 
|                                                  |                         |                           |  |            |       |             |  |            |     |           
|                                                  |                         |                          
|                                                  |                         | (in thousands of dollars)
|Allowance for doubtful accounts and sales returns |                         |                           |  |            |       |             |  |            |     |            |  |   |      |   |  |   |      |   |  |  
|                                                  | Year ended December 31, |                           |  |            |       |             |  |            |     |            |  |   |      |   |  |   |      |   |  |   |      
|                                                  |                         | 2003                      |  | $          | 373   |             |  | $          | 9   |            |  | $ | (30  | ) |  | $ | (31  | ) |  | $ | 321   | 
|                                                  |                         | 2002                      |  | $          | 1,271 |             |  | $          | 10  |            |  | $ | (402 | ) |  | $ | (506 | ) |  | $ | 373   | 
|                                                  |                         | 2001                      |  | $          | 1,028 |             |  | $          | 448 |            |  | $ |     |   |  | $ | (205 | ) |  | $ | 1,271 | 
|Restructuring reserve                             |                         |                           |  |            |       |             |  |            |     |            |  |   |      |   |  |   |      |   |  |  
|                                                  | Year ended December 31, |                           |  |            |       |             |  |            |     |            |  |   |      |   |  |   |      |   |  |   |      
|                                                  |                         | 2003                      |  | $          | 168   |             |  | $          |    |            |  | $ |     |   |  | $ | (168 | ) |  | $ |      | 
|                                                  |                         | 2002                      |  | $          |      |             |  | $          | 759 |            |  | $ |     |   |  | $ | (591 | ) |  | $ | 168   | 
|                                                  |                         | 2001                      |  | $          | 152   |             |  | $          |    |            |  | $ |     |   |  | $ | (152 | ) |  | $ |      | 



---



|    |                                        
|--- | ---------------------------------------
|(A) | Recovery of previously reserved amounts

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|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
    ON ACCOUNTING AND FINANCIAL DISCLOSURE

On November 13, 2003, the Audit Committee of
the Board of Directors dismissed KPMG LLP (KPMG) as
the independent accountants for the company, and on
December 23, 2003, engaged Grant Thornton LLP (Grant
Thornton) as its new independent accountants.

The audit report of KPMG on the companys
consolidated financial statements as of and for the years ended
December 31, 2002 and 2001 did not contain an adverse
opinion or disclaimer of opinion, nor was such report qualified
or modified as to uncertainty, audit scope or accounting
principles.

In connection with the audits of the
companys consolidated financial statements as of and for
the years ended December 31, 2002 and 2001 and the
subsequent interim period through November 13, 2003, there
were no disagreements with KPMG on any matter of accounting
principles or practices, financial statement disclosure, or
auditing scope or procedure, which disagreements, if not
resolved to the satisfaction of KPMG, would have caused KPMG to
make reference to the subject matter of the disagreement in
connection with their audit report. In addition, in connection
with the audits of the companys financial statements as of
and for the years ended December 31, 2002, there were no
reportable events as defined in Item 302(a)(1)(v) of
Regulation S-K, except that KPMG, in its Management Letter
to the company following the completion of the audits, noted the
following conditions which it considered to be reportable
conditions as defined under standards established by the
American Institute of Certified Public Accountants:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | KPMG noted deficiencies in the processes used by
    management to review and document new customer contracts and
    modifications to existing customer contracts for purposes of
    determining the proper revenue recognition model.                                                                                                                                                                                                                                                                                                                           
|
| |  | KPMG noted deficiencies in the systems and
    processes used in the preparation of the financial statements
    and the lack of proper management review and account
    reconciliation and analysis.                                                                                                                                                                                                                                                                                                                                                             
|
| |  | It was noted that personnel responsible for
    accounting and financial reporting did not have sufficient
    background or were overloaded with normal day-to-day activities.
    It was also noted that they lacked the Securities and Exchange
    Commission (SEC) and Generally Accepted Accounting
    Principles (GAAP) experience necessary to ensure
    compliance with financial reporting and disclosure requirements.
    Among other things, it was recommended that the company
    strengthen its level of SEC and GAAP accounting experience.

The company has taken a number of measures in
2003 intended to effectively address these reportable conditions.

KPMG noted that none of these reportable
conditions was believed to be a material weakness, and it issued
an unqualified audit opinion on the financial statements as of
and for the years ended December 31, 2002 and 2001. All
reportable conditions were discussed with the companys
Audit Committee, and the company authorized KPMG to respond
fully to the inquiries, if any, of its new accountant concerning
these reportable conditions.

During the fiscal years ended December 31,
2002 and 2001 and through the appointment of Grant Thornton, the
company has not consulted with Grant Thornton regarding any of
the following:



| |   |                                                                                                                                                                                                                                                                                                 
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the application of accounting principles to a
    specified transaction, either completed or proposed;                                                                                                                                                                                          
|
| |  | the type of audit opinion that might be rendered
    on the companys financial statements; or                                                                                                                                                                                                  
|
| |  | any matter that was either the subject of a
    disagreement, as that term is defined in Item 304(a)(1)(iv)
    of Regulation S-K and the related instructions to
    Item 304 of Regulation S-K, or a reportable event, as
    that term is defined in Item 304(a)(1)(v) of
    Regulation S-K.




Item 9A. CONTROLS AND
PROCEDURES

We strive to maintain disclosure controls and
procedures that are designed to ensure that information required
to be disclosed in our Exchange Act reports is recorded,
processed, summarized and reported within the time periods
specified in the Securities and Exchange Commissions rules
and forms, and that such information is accumulated and
communicated to our management, including our chief executive
officer and chief financial officer, as appropriate, to allow
timely decisions regarding required disclosure. In designing and
evaluating the disclosure controls and procedures, management
recognizes that any controls and procedures, no matter how well
designed and operated, can provide only reasonable assurance of
achieving

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##### Table of Contents



the desired control objectives, and management
necessarily is required to apply its judgment in evaluating the
cost-benefit relationship of possible controls and procedures.


Our company carried out an evaluation, under the
supervision and with the participation of its chief executive
officer and chief financial officer, pursuant to
Rule 13a-15 promulgated under the Securities Exchange Act
of 1934, as amended, of the effectiveness of the design and
operation of its disclosure controls and procedures as of
December 31, 2003. While we have identified internal
control weaknesses, which are discussed below, our evaluation
indicated that these weaknesses did not impair the effectiveness
of our overall disclosure controls and procedures and we have
concluded that the companys disclosure controls and
procedures are effective to ensure that information required to
be disclosed in the reports that the company files or submits
under the Securities Exchange Act of 1934 is recorded,
processed, summarized and reported as specified in the
Securities and Exchange Commissions rules and forms.

2003 Assessment

In evaluating our internal controls we sought to
determine whether there were any significant deficiencies under
standards established by the American Institute of Certified
Public Accountants (AICPA). In 2004, our management
and Audit Committee were notified by our engaged accountants,
Grant Thornton LLP (Grant Thornton), of the
existence of two significant deficiencies.

The first significant deficiency relates to the
companys accounting policy regarding the recognition of
liabilities for subcontractor work performed but not invoiced.
Under the companys accounting policy, at the end of each
reporting period, the companys recognition of liabilities
for un-invoiced subcontractor work performed was deferred until
the following accounting period, which is not consistent with
Generally Accepted Accounting Principles (GAAP).

Grant Thornton recommended that the company
develop policies and procedures to estimate and capture this
data and record the amounts in the proper period. This condition
also suggests the need for the company to review its GAAP
training procedures and strengthen its accounting resources.

This deficiency relates to recognition of
liabilities and assets for subcontractor work performed in the
last month of a reporting period. The companys policy was
to recognize the liabilities and the related assets in the month
following the end of the reporting period, coincident with the
recognition of related costs and revenues, when known and
determinable, and generally when invoices were received. The
company concurred with Grant Thorntons finding, recorded
liabilities and related assets of $2.4 million at
December 31, 2003, and has revised its policy to record the
liabilities and related assets in the period in which the
services are performed. The company continues to recognize costs
and revenues consistent with its policy. In addition, the
company continues to assess opportunities to strengthen its
accounting capabilities beyond the progress made in 2003.

The second deficiency relates to the
companys manually intensive financial reporting process,
which can limit the time for internal review. Although Grant
Thornton did not note any material adjustments as a result of
this condition, the potential for errors exists. Both the
company and Grant Thornton expect the implementation of the
companys new enterprise business system to assist in
resolving this deficiency.

Grant Thornton recommends that the company
consider updating its current accounting and reporting system to
a more automated system so that management will have adequate
time to analyze, record and review account balances for
accuracy, and that senior management reevaluate the current
organizational structure to determine if additional resources
are necessary. The company placed its PeopleSoft-based
enterprise business system into service effective
January 1, 2004, and is undergoing full implementation in
the first half of 2004. The company anticipates implementation
of this system will substantially mitigate this weakness.

The company plans to assess regularly the
quantity and effectiveness of its resources and to continue to
invest in its employees to improve the effectiveness of both the
individual employees and the overall organization.

2002 Assessment

In 2003, our management and Audit Committee were
notified by our then engaged accountants, KPMG LLP, of the
existence of three significant deficiencies relating to our
operations for the year ended December 31, 2002. These
significant deficiencies were not believed to be material
weaknesses, either individually or in the aggregate.

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The first significant deficiency related to
contract initiation and set-up for certain fixed price
contracts. During its audit of the year ended December 31,
2002, KPMG noted that the company had seven fixed-price
contracts that qualified as service-type contracts which should
have been accounted for on a proportional performance basis
using an output method, rather than under the
percentage-of-completion method provided for by AICPA Statement
of Position 81-1, Accounting for Construction-Type
Contracts. Accordingly, the company instituted additional
controls intended to ensure that new contracts are reviewed at
inception and that the appropriate method of revenue recognition
is applied.

The second significant deficiency related to our
quarterly and year-end closing procedures and consolidation.
KPMG noted findings related to financial systems and processes,
as well as account reconciliation review. The company took
several measures that improved its closing and account
reconciliation processes including, among other things, monthly
operational review of results by the chief operating officer; a
pre-closing review of critical items with the auditors; the
establishment of daily close meetings with all general
accounting personnel and business controllers; the assignment of
standard journal numbers for all standard journal entries; the
consolidation and reduction in the number of bank accounts; the
review and sign-off of all material account reconciliations by
the responsible supervisor or controller; and the
implementation, effective January 1, 2004, of the
companys new PeopleSoft-based enterprise business system
for contract and financial management.

The third significant deficiency related to the
level of SEC and generally accepted accounting principles, or
GAAP, experience of our personnel responsible for accounting and
financial reporting. In 2003, the company added staff intended
to strengthen its skills and experience in this area, including
an External Reporting Manager, a new General Accounting Manager,
an addition to the tax accounting staff, several additions to
the general accounting staff and an addition to the internal
audit staff of an internal controls oversight position.

While we have taken or begun to take the
foregoing steps in order to address the efficacy of our
disclosure controls and procedures, the adequacy of the steps we
have taken to date and the steps we are still in the process of
completing is subject to continued management review supported
by confirmation and testing by our internal and external
auditors.

Other than the foregoing matters, since the date
of the evaluation, supervised by our management, there have been
no changes to our internal controls over financial reporting
that have materially affected, or are reasonably likely to
materially affect, our internal controls over financial
reporting.




PART III






|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | DIRECTORS AND EXECUTIVE OFFICERS OF THE
    REGISTRANT

Information with respect to Directors of the
company required by this item is hereby incorporated by
reference to the companys definitive proxy statement to be
filed by the company within 120 days after the close of its
fiscal year. Information with respect to the Executive Officers
of the company is included in Part I Item 4 of this
Annual Report on Form 10-K.

A copy of the companys code of ethics,
which applies to its principal executive officer, principal
financial officer, principal accounting officer and controller,
may be obtained free of charge through the companys
internet website at http://www.drc.com.






|         |                       
|-------- | ----------------------
|Item 11. | EXECUTIVE COMPENSATION

The information required by this Item 11 is
hereby incorporated by reference to the companys
definitive proxy statement to be filed by the company within
120 days after the close of its fiscal year.






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
    OWNERS AND MANAGEMENT

Other than as set forth below, the information
required by this Item 12 is hereby incorporated by
reference to the companys definitive proxy statement to be
filed by the company within 120 days after the close of its
fiscal year.

73



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##### Table of Contents



The following table presents information about
shares reserved for issuance for outstanding options, warrants,
and appreciation rights granted under the companys equity
compensation plans as of December 31, 2003.

Equity Compensation Plan Information

|                                                                |     |                      |           |                      |           |                           |      |       |      |  |           |   |           | 
|--------------------------------------------------------------- | --- | -------------------- | --------- | -------------------- | --------- | ------------------------- | ---- | ----- | ---- |  | --------- | - | --------- | 
|                                                                |     |                      |           |                      |           | Number of securities     
|                                                                |     | Number of securities |           |                      |           | remaining available for  
|                                                                |     | to be issued upon    |           | Weighted-average     |           | future issuance under    
|                                                                |     | exercise of          |           | exercise price of    |           | equity compensation plans
|                                                                |     | outstanding options, |           | outstanding options, |           | (excluding securities    
|                                                                |     | warrants and rights  |           | warrants and rights  |           | reflected in column (a)) 
|Plan category                                                   |     | (a)                  |           | (b)                  |           | (c)                      
|                                                                |     |                      |           |                      |           |                          
|Equity compensation plans approved by security
    holders (1)  |     |                      | 1,354,886 |                      |           | $                         | 9.07 |       |      |  | 1,075,543 |  
|                                                                |     |                      |           |                      |           |                           |      |       |      |  |           |  
|Equity compensation plans not approved by
    security holders: |     |                      |           |                      |           |                           |      |       |      |  |           |  
|                                                                | (2) |                      |           | 250,000              |           |                           | $    | 4.44  |      |  |           |  |          
|                                                                | (3) |                      |           | 100,000              |           |                           | $    | 12.14 |      |  |           |  |          
|                                                                |     |                      |           |                      |           |                           |      |       |      |  |           |  
|                                                                |     |                      | 350,000   |                      |           |                           |      |       |      |  |          |  
|                                                                |     |                      |           |                      |           |                           |      |       |      |  |           |  
|                                                                |     | Total                |           |                      | 1,704,886 |                           |      | $     | 8.57 |  |           |   | 1,075,543 | 
|                                                                |     |                      |           |                      |           |                           |      |       |      |  |           |  



---



| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Includes the number of shares subject to options
    issued under the following plans: 1993 Equity Incentive Plan,
    1995 Stock Option Plan for Non-Employee Directors, 2000
    Incentive Plan, 2000 Employee Stock Purchase Plan and 2003
    Incentive Plan.                                                                                                                                                                                                                                                                                                                     
|
| | (2) | In 1999, the company granted Mr. Regan
    250,000 non-qualified stock options to purchase shares of the
    companys common stock. The option price is $4.44, which
    was the fair market value of the common stock at the date of
    grant. Twenty percent of the options vested immediately. An
    additional 20% vest in each successive year from the date of
    grant. The options expire ten years from the date of grant.                                                                                                                                               
|
| | (3) | On February 19, 2003, the Board of Directors
    authorized the grant of 100,000 non-qualified stock options as
    an inducement for the hiring of a new executive officer. The
    grant was made on April 7, 2003, to William C. Hoover,
    President and Chief Operating Officer. The option price is
    $12.14, which was the fair market value of the common stock at
    the date of grant. The options will vest one-third on the first
    anniversary of employment and one third on each successive
    anniversary. The options expire ten years from the date of grant.






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | CERTAIN RELATIONSHIPS AND RELATED
    TRANSACTIONS

The information required by this Item 13 is
hereby incorporated by reference to the companys
definitive proxy statement to be filed by the company within
120 days after the close of its fiscal year.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | PRINCIPAL ACCOUNTANT FEES AND
    SERVICES

The information required by this Item 14 is
hereby incorporated by reference to the companys
definitive proxy statement to be filed by the company within
120 days after the close of its fiscal year.

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PART IV






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 15. | EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND
    REPORTS ON FORM 8-K

(a) (1) and (2) Financial Statements
and Financial Statement Schedule

The consolidated financial statements of the
company and Schedule II Valuation and Qualifying Accounts
and Reserves of the company are listed in the index under
Part II, Item 8, of this Annual Report on
Form 10-K.

Other financial statements schedules are omitted
because of the absence of conditions under which they are
required or because the required information is given in the
supplementary consolidated financial statements or notes thereto.

(3) Exhibits

The exhibits that are filed with this Annual
Report on Form 10-K, or that are incorporated herein by
reference, are set forth in the Exhibit Index hereto.

(b) Reports on Form 8-K

The following reports on Form 8-K were filed
during the quarterly period ended December 31, 2003:



| |                                                                                                                                                                                                                                                                                                        
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) Current Report on Form 8-K, dated
    November 13, 2003, filed on November 21, 2003, related
    to the companys dismissal of KPMG LLP as its independent
    accountants.                                                                                                                        
|
| | (2) Current Report on Form 8-K/A,
    Amendment No. 1 to Form 8-K, dated November 13,
    2003, filed on November 25, 2003, containing a letter from
    KPMG LLP to the U.S. Securities and Exchange Commission
    related to the companys dismissal of KPMG LLP as its
    independent accountants.
|
| | (3) Current Report on Form 8-K, dated
    December 23, 2003, filed on December 24, 2003, related
    to the companys engagement of Grant Thornton LLP as its
    independent accountants.                                                                                                             

The following reports on Form 8-K were
furnished during the quarterly period ended December 31,
2003:



| |                                                                                                                                                                                                                                                              
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (4) Current Report on Form 8-K, filed
    on October 8, 2003, relating to a press release announcing
    a conference call to discuss a potential filing of a civil
    complaint by the U.S. Attorneys Office in Boston,
    Massachusetts.                
|
| | (5) Current Report on Form 8-K, filed
    on October 10, 2003, containing a transcript of the
    conference call held on October 8, 2003, to discuss a
    potential filing of a civil complaint by the
    U.S. Attorneys Office in Boston, Massachusetts.
|
| | (6) Current Report on Form 8-K, filed
    on October 28, 2003, relating to a press release of the
    companys quarterly results for the period ended
    September 30, 2003, and announcing a conference call re.
    same.                                

75



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##### Table of Contents



SIGNATURES

Pursuant to the requirements of the Securities
Exchange Act of 1934, the registrant has duly caused this report
to be signed on its behalf by the undersigned thereunto duly
authorized.



| |                              
| | -----------------------------
| | DYNAMICS RESEARCH CORPORATION



| |  |                   
| |  | ------------------
| |  | /s/ JAMES P. REGAN

| |                                     
| | ------------------------------------
| |                                     
| | James P. Regan,                     
| | Chairman and Chief Executive Officer

Date: March 15, 2004

Pursuant to the requirements of the Securities
Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the
capacities and on the dates indicated.

|                                               |  |                                                                                      |  |  |                | 
|---------------------------------------------- |  | ------------------------------------------------------------------------------------ |  |  | -------------- | 
|                                              
|/s/ JAMES P. REGANJames P. Regan               |  | Chairman and Chief Executive Officer                                                 |  |  | March 15, 2004 | 
|                                              
|/s/ WILLIAM C. HOOVERWilliam C. Hoover         |  | President and Chief Operating Officer                                                |  |  | March 15, 2004 | 
|                                              
|/s/ DAVID KELEHERDavid Keleher                 |  | Vice President and Chief Financial Officer
    (Principal Financial Officer)         |  |  | March 15, 2004 | 
|                                              
|/s/ DONALD B. LEVISDonald B. Levis             |  | Corporate Controller and Chief Accounting Officer
    (Principal Accounting Officer) |  |  | March 15, 2004 | 
|                                              
|/s/ JOHN S. ANDEREGG, JR.John S. Anderegg, Jr. |  | Director                                                                             |  |  | March 15, 2004 | 
|                                              
|/s/ FRANCIS J. AGUILARFrancis J. Aguilar       |  | Director                                                                             |  |  | March 15, 2004 | 
|                                              
|/s/ KENNETH F. KAMESKenneth F. Kames           |  | Director                                                                             |  |  | March 15, 2004 | 
|                                              
|/s/ CHARLES P. MCCAUSLANDCharles P. McCausland |  | Director                                                                             |  |  | March 15, 2004 | 
|                                              
|/s/ JAMES P. MULLINSJames P. Mullins           |  | Director                                                                             |  |  | March 15, 2004 | 

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EXHIBIT INDEX

|            |       |             |  |                                                                                                                                                                                                                                                                                           |  |      
|----------- | ----- | ----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -----
|Exhibit No. |       | Description |  | Reference                                                                                                                                                                                                                                                                                
|            |       |             |  |                                                                                                                                                                                                                                                                                          
|            | 2.1   |             |  | Stock Purchase Agreement, dated December 12,
    2002, by and among Dynamics Research Corporation, Andrulis
    Corporation and the individuals listed on the signature page
    thereto.                                                                                                 |  | A**  
|            | 3.1   |             |  | Restated Articles of Organization of the company,
    dated May 22, 1987.                                                                                                                                                                                                                 |  | B**  
|            | 3.2   |             |  | By-Laws of the company, dated May 22, 1987.                                                                                                                                                                                                                                               |  | B**  
|            | 3.3   |             |  | Certificate of Vote of Directors Establishing
    Series A Preferred Stock, dated July 14, 1988.                                                                                                                                                                                          |  | C**  
|            | 3.4   |             |  | Certificate of Vote of Directors Establishing
    Series B Preferred Stock, dated February 17, 1998.                                                                                                                                                                                      |  | D**  
|            | 3.5   |             |  | Amendment, dated September 10, 1998, to the
    Certificate of Vote of Directors Establishing Series B
    Preferred Stock.                                                                                                                                                               |  | E**  
|            | 3.6   |             |  | Amendment, dated April 28, 1998, to the
    Articles of Organization of the company.                                                                                                                                                                                                      |  | C**  
|            | 3.7   |             |  | Amendment, dated April 25, 2000, to the
    Articles of Organization of the company.                                                                                                                                                                                                      |  | C**  
|            | 4.1   |             |  | Specimen certificate for shares of the
    companys common stock.                                                                                                                                                                                                                        |  | F**  
|            | 4.2   |             |  | Rights Agreement, dated February 17, 1998,
    between Dynamics Research Corporation and the American Stock
    Transfer & Trust Company, as Rights Agent.                                                                                                                                |  | D**  
|            | 10.1  |             |  | Form of indemnification agreement for directors
    of the company.                                                                                                                                                                                                                       |  | G**  
|            | 10.2  |             |  | Severance Agreement between John S.
    Anderegg, Jr. and the company.                                                                                                                                                                                                                    |  | G* **
|            | 10.3  |             |  | Deferred Compensation Plan for Non-Employee
    Directors of the company.                                                                                                                                                                                                                 |  | G* **
|            | 10.4  |             |  | Form of Consulting Agreement by and between the
    company and Albert Rand.                                                                                                                                                                                                              |  | H* **
|            | 10.5  |             |  | Form of Supplemental Retirement Pension Agreement
    by and between the company and Albert Rand.                                                                                                                                                                                         |  | H* **
|            | 10.6  |             |  | Amended 1993 Equity Incentive Plan.                                                                                                                                                                                                                                                       |  | I* **
|            | 10.7  |             |  | Amended 1995 Stock Option Plan for Non-Employee
    Directors.                                                                                                                                                                                                                            |  | H* **
|            | 10.8  |             |  | Mortgage Security Agreement and Assignment, dated
    February 10, 2000, by and among Dynamics Research
    Corporation and Brown Brothers Harriman & Co. and Family
    Bank, FSB.                                                                                                       |  | J**  
|            | 10.9  |             |  | Amendment, dated June 12, 2000, to Mortgage
    Security Agreement and Assignment, by and among Dynamics
    Research Corporation and First Massachusetts Bank, N.A., f/k/a
    Family Bank, FSB.                                                                                         |  | K**  
|            | 10.10 |             |  | Employment Agreement between the company and
    James P Regan.                                                                                                                                                                                                                           |  | L* **
|            | 10.11 |             |  | Change of Control Agreement between the company
    and James P. Regan.                                                                                                                                                                                                                   |  | L* **
|            | 10.12 |             |  | 2000 Incentive Plan.                                                                                                                                                                                                                                                                      |  | M* **
|            | 10.13 |             |  | Non-qualified Stock Option Agreement between the
    company and James P. Regan.                                                                                                                                                                                                          |  | N* **
|            | 10.14 |             |  | 2000 Employee Stock Purchase Plan.                                                                                                                                                                                                                                                        |  | F* **
|            | 10.15 |             |  | Special Severance Plan.                                                                                                                                                                                                                                                                   |  | O* **
|            | 10.16 |             |  | Senior Management Deferred Compensation Plan.                                                                                                                                                                                                                                             |  | P* **
|            | 10.17 |             |  | Amended and Restated Loan Agreement, dated
    June 28, 2002, by and among Dynamics Research Corporation,
    certain of its subsidiaries, and Brown Brothers Harriman &
    Co., Banknorth, N.A. and Key Corporation Capital Inc.                                                        |  | Q**  
|            | 10.18 |             |  | Amendment, dated December 16, 2002, to the
    Amended and Restated Loan Agreement, dated June 28, 2002,
    by and among Dynamics Research Corporation, certain of its
    subsidiaries, and Brown Brothers Harriman & Co., Banknorth,
    N.A. and Key Corporation Capital Inc.         |  | A**  
|            | 10.19 |             |  | Second Amendment, dated June 26, 2002, to
    the Mortgage Security Agreement and Assignment, by and between
    Dynamics Research Corporation and Banknorth N.A., f/k/a First
    Massachusetts Bank, N.A., f/k/a Family Bank, FSB.                                                      |  | C**  
|            | 10.20 |             |  | Amendment and Waiver, dated March 26, 2003,
    to the Amended and Restated Loan Agreement, dated June 28,
    2002, by and among Dynamics Research Corporation, certain of its
    subsidiaries, and Brown Brothers Harriman & Co., Banknorth,
    N.A. and Key Corporation Capital Inc. |  | C**  



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##### Table of Contents



|            |       |             |  |                                                                                                                                                                                                                                                                                       |  |                
|----------- | ----- | ----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------
|Exhibit No. |       | Description |  | Reference                                                                                                                                                                                                                                                                            
|            |       |             |  |                                                                                                                                                                                                                                                                                      
|            | 10.21 |             |  | Dynamics Research Corporation Special Severance
    Plan, as amended on May 14, 2003.                                                                                                                                                                                                 |  | Filed herewith*
|            | 10.22 |             |  | 2003 Incentive Plan.                                                                                                                                                                                                                                                                  |  | Filed herewith*
|            | 10.23 |             |  | Third Amendment, dated December 23, 2003, to
    the Amended and Restated Loan Agreement, dated June 28,
    2002, by and among Dynamics Research Corporation, certain of its
    subsidiaries, and Brown Brothers Harriman & Co., Banknorth,
    N.A. and Key Corporate Capital Inc. |  | Filed herewith 
|            | 16.1  |             |  | Letter regarding change in certifying accountant.                                                                                                                                                                                                                                     |  | Filed herewith 
|            | 21.1  |             |  | Subsidiaries of the registrant.                                                                                                                                                                                                                                                       |  | Filed herewith 
|            | 23.1  |             |  | Consent of Independent Certified Public
    Accountants (Grant Thornton LLP)                                                                                                                                                                                                          |  | Filed herewith 
|            | 23.2  |             |  | Independent Auditors Consent (KPMG LLP)                                                                                                                                                                                                                                              |  | Filed herewith 
|            | 23.3  |             |  | Report of Independent Accountants on Financial
    Schedule (KPMG LLP)                                                                                                                                                                                                                |  | Filed herewith 
|            | 31.1  |             |  | Certification of the Chief Executive Officer
    pursuant to Rule 13a-14(a) under the Securities Exchange
    Act of 1934, as adopted pursuant to Section 302 of the
    Sarbanes-Oxley Act of 2002.                                                                                  |  | Filed herewith 
|            | 31.2  |             |  | Certification of the Chief Financial Officer
    pursuant to Rule 13a-14(a) under the Securities Exchange
    Act of 1934, as adopted pursuant to Section 302 of the
    Sarbanes-Oxley Act of 2002.                                                                                  |  | Filed herewith 
|            | 32.1  |             |  | Certification of the Chief Executive Officer
    pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                        |  | Filed herewith 
|            | 32.2  |             |  | Certification of the Chief Financial Officer
    pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                        |  | Filed herewith 



---



|   |                                                                                                                                                                                                                                                             
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A  | Incorporated by reference to the companys
    Current Report on Form 8-K filed on January 6, 2003.                                                                                                                                                         
|  
|B  | Incorporated by reference to the companys
    Quarterly Report on Form 10-Q for the quarterly period
    ended June 17, 1987.                                                                                                                              
|  
|C  | Incorporated by reference to the companys
    Annual Report on Form 10-K for the year ended
    December 31, 2002.                                                                                                                                         
|  
|D  | Incorporated by reference to the companys
    Form 8-A filed on June 25, 1998.                                                                                                                                                                             
|  
|E  | Incorporated by reference to the companys
    Form 8-A/A filed on September 30, 1998.                                                                                                                                                                      
|  
|F  | Incorporated by reference to the companys
    Registration Statement on Form S-8 (Registration
    No. 333-59706) filed on April 27, 2001.                                                                                                                 
|  
|G  | Incorporated by reference to the companys
    Annual Report on Form 10-K for the year ended
    December 31, 1991.                                                                                                                                         
|  
|H  | Incorporated by reference to the companys
    Quarterly Report on Form 10-Q for the quarterly period
    ended March 31, 1997.                                                                                                                             
|  
|I  | Incorporated by reference to the companys
    Annual Report on Form 10-K for the year ended
    December 31, 1998.                                                                                                                                         
|  
|J  | Incorporated by reference to the companys
    Current Report on Form 8-K filed on March 24, 2000.                                                                                                                                                          
|  
|K  | Incorporated by reference to the companys
    Current Report on Form 8-K filed on June 27, 2000.                                                                                                                                                           
|  
|L  | Incorporated by reference to the companys
    Annual Report on Form 10-K for the year ended
    December 31, 1999.                                                                                                                                         
|  
|M  | Incorporated by reference to the companys
    Schedule 14A filed on December 6, 1999.                                                                                                                                                                      
|  
|N  | Incorporated by reference to the companys
    Registration Statement on Form S-8 (Registration
    No. 333-47838) filed on October 12, 2000.                                                                                                               
|  
|O  | Incorporated by reference to the companys
    Annual Report on Form 10-K for the year ended
    December 31, 2001.                                                                                                                                         
|  
|P  | Incorporated by reference to the companys
    Quarterly Report on Form 10-Q for the quarterly period
    ended March 31, 2002.                                                                                                                             
|  
|Q  | Incorporated by reference to the companys
    Quarterly Report on Form 10-Q for the quarterly period
    ended June 30, 2002.                                                                                                                              
|  
|*  | Management contract or compensatory plan or
    arrangement.                                                                                                                                                                                                
|  
|** | In accordance with Rule 12b-32 under the
    Securities Exchange Act of 1934, as amended, reference is made
    to the documents previously filed with the Securities and
    Exchange Commission, which documents are hereby incorporated by
    reference.