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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2002

OR

For the transition period from            to            

Commission file number 1-7348

DYNAMICS RESEARCH CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s telephone number, including area code: (978) 475-9090

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

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

COMMON STOCK, $.10 Par Value

(Title of Class)

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  x  No  ¨

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.  x

Indicate by check mark whether the registrant is an accelerated filer as defined in the Exchange Act Rule

2b-2.  Yes  x  No  ¨

As of June 30, 2002, the aggregate market value of Common Stock held by nonaffiliates of the Registrant was $195,491,657 and the number of shares of Common Stock, $.10 par value, of the Registrant outstanding was 8,084,808.

Documents Incorporated By Reference

Portions of the Registrant’s Proxy Statement for the 2003 Annual Meeting of Shareholders are incorporated by reference in Part III.

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DYNAMICS RESEARCH CORPORATION

FORM 10-K         FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002

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PART I

ITEM 1. BUSINESS

OVERVIEW

Dynamics Research Corporation (“DRC” or the “company”) provides information technology, engineering, logistics and other consulting services to federal defense, civil and state agency customers. Founded in 1955 and headquartered in Andover, Massachusetts, DRC has 1,858 employees, including 93 employees associated with discontinued operations, in 45 offices in 20 states in 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 program administrative support services, simulation, modeling, training systems and services, and custom built electronic test equipment and services.

DRC applies these proven processes and technologies to enhance the performance and cost effectiveness of a variety of mission-critical customer systems. DRC believes that one of its competitive advantages 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.

DRC has a balanced organic and acquisition growth strategy. The company’s strategy is to supplement organic growth through the acquisition of firms with similar capabilities. Consistent with this strategy, the company acquired two companies in 2002, HJ Ford and ANDRULIS.

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, which manufactures optical encoders that convert analog motion and position information into digital signals, as a discontinued operation on a restated basis. 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 electronic parts that 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, and in Note 12, Business Segments of the company’s financial statements, Part II, Item 8.

DRC maintains an Internet website at http://www.drc.com. The company’s Annual Report on Form 10-K, its quarterly reports on Form 10-Q and its 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.

MARKETS

DRC’s systems and services business, which accounted for 96% of revenue in 2002, 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.

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According to the Office of Management and Budget, federal spending on technical services and information technology is projected to be $54 billion for the fiscal year ended September 30, 2003. In addition, a 9% increase has been proposed in the President’s budget submission to Congress for fiscal year 2004.

Several factors are driving growth in the defense sector of this market. First, increased spending on the war on terrorism, sustaining military readiness, homeland security and efforts to transform the United States military forces will focus on technology-based solutions. Second, there is an increased reliance on contractors to supply mission critical services due to government workforce ceilings.

Factors driving growth in the federal civilian agency sector include homeland security needs, an on-going need for systems modernization, and as in the defense sector, government workforce ceilings. Proposed information technology spending for the recently created Department of Homeland Defense is approximately $4 billion for the government’s fiscal 2004. These factors have 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 $40 billion on information technology products and services in 2003 and $42 billion in 2004. DRC has considerable experience in providing information technology expertise in the health and human services areas. 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. They 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 such agencies are antiquated and have limited data interfacing and reporting capabilities. The need to address severe budget deficits is expected to continue in the states during 2003, forcing spending cuts and reassessment of technology priorities, which could have an adverse impact on the company’s business.

DRC’s Precision Manufacturing business represented 4% of total company revenue in 2002, not including 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 2002, 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 2002 revenue, broken down by market sector, was derived 80% from the defense sector, 9% from federal civilian agencies, 7% from state and local governments, and 4% from commercial OEMs. Federal civilian agency revenue, which grew by more than 50% in 2002 from 2001, was the fastest growing sector for DRC in 2002.

Defense Sector

United States Air Force customers constituted the largest component of DRC’s defense revenue in 2002, representing 49% of total revenue, while Navy revenue represented 20%, Army revenue represented 7% and other agencies represented 4%. Key capabilities that DRC offers defense customers include 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 and operates a supercomputing facility for semiconductor modeling for defense applications. Descriptions of the work DRC performs for the company’s major customers in this sector follow.

Air Force Electronic Systems Center

The mission of the 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 providing advisory, engineering, logistics and program management services. Under this program, DRC will also support 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, Warner Robins and Hill Air Force Bases. 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 in Ogden, Utah. The company also provides support to Air Force reengineering and business process improvement initiatives at these Air Logistics Centers.

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 services, 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 on-going program management activities related to the migration of the previously unarmed Unmanned Aerial Vehicles to an expanded role as a weapons platform.

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

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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 at the United States Army Aviation Center, Tank-automotive and Armaments Command and Communications-Electronics Command.

In 2001, DRC received a contract from the United States Army Aviation and Missile Command located at Redstone Arsenal in Huntsville, Alabama to provide helicopter vibration analysis. The Vibration Management Enhancement Program (“VMEP”) is designed to improve the operational effectiveness of the Army’s helicopters through use of advanced identification, monitoring, and analysis techniques to control adverse vibrations in dynamic components. In 2002, DRC received a $3.3 million extension to its initial contract for the VMEP initiative.

Army Research

In 2001, DRC received a five-year contract from the United States Army Medical Research Acquisition Activity to expand its MedTeams^® program for improving teamwork and reducing medical error among emergency care hospital staff into other medical specialties. The contract provides for research to expand MedTeams into other specialties such as labor and delivery. It also includes provisions for establishing MedTeams Centers of Excellence and a cadre of trainers to deliver MedTeams training throughout the Defense Department.

Recognizing the need for better communication and teamwork among Army air crews, the United States Army Research Institute for the Behavioral and Social Sciences, the Army’s main research laboratory for personnel performance and training, turned to DRC behavioral scientists. Based on the success of a program originally created for the Army in 1993, DRC is developing a web-based, interactive training system that will be able to provide air crews anywhere in the world the knowledge and teamwork skills designed to result in improved mission effectiveness and lower accident rates.

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 new five-year contract with an approximate potential value of $25 million 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 improved value chain performance and weapon systems affordability.

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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.

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 wargames 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 wargames. 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.

Based on the work performed under the JTIMS program, in September 2002, DRC was awarded a $2 million contract with the United States Joint Forces Command to develop a software system for the worldwide coordinating and scheduling of deployable United States forces. Known as the Joint Event Scheduling System (“JESS”), the web-based program is intended to develop a worldwide collaborative system to provide visibility and coordination on United States military activities.

Also, DRC has developed an analytical tool for the Chief of Naval Education and Training 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 under an aggressive schedule 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. Civilian agencies must also prepare for potential changes in their workforces.

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Approximately half of all federal employees engaged in program management are estimated to become 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. A description of DRC’s major customer engagements in this sector follows.

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 from 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 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 is building 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 is 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 back the first responders by anticipating what’s needed next, such as alerting nearby hospitals or summoning firefighters from a neighboring county.

Bureau of Citizenship and Immigration Service

The Bureau of Citizenship and Immigration Service (“BCIS”) provides benefits processing and a wide range of other services to immigrants and applicants for naturalization. These services are provided at BCIS headquarters, district offices, sub-offices, satellite offices and 131 application service centers throughout the United States, and in Puerto Rico, the Virgin Islands and Guam.

Ensuring consistent and high quality processes and service is a primary concern. DRC assists the BCIS with the development and implementation of standard operating procedures for use at all of its facilities, and conducts quality assurance process reviews. DRC’s employees work in the field conducting quarterly or semi-annual reviews at BCIS offices to view processes, applicant files and other supporting documentation to verify that practices are consistent and compliant with agency policies and procedures.

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.

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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 (“IT”) services in this sector has been weak over the past year due to state budget deficits. As a result, during 2002, DRC’s revenue with the State of Ohio was reduced on an annualized basis by approximately $5 million from 2001 revenue of $7.4 million. 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.

Colorado Department of Human Services

Since 1997, DRC has worked with the State of Colorado to develop, deploy and maintain an integrated statewide system, known as Colorado Trails (“Trails”), that streamlines the workload for social workers, youth corrections officers and administrators. DRC has developed and maintains the software and has installed a network of 3,000 computers at 130 sites, providing users with new computers, networking equipment, e-mail and the Trails application. Trails includes tools for determining and managing such functions as client eligibility, court appearances, residential facilities, finance, automatic payment generation through the state’s financial processing system and administration. DRC also developed an award-winning online support tool with a computer-based training program for social workers that incorporates links to electronic policy and procedure manuals. To facilitate intra-agency coordination, Trails also interfaces with systems supporting criminal justice and childcare tracking functions. The network supported by DRC has been expanded to support the state’s benefits management system, which also is under the responsibility of the Department of Human Services.

State of Ohio, Department of Job and Family Services

Since 1997, DRC has provided information technology expertise and implementation to the State of Ohio’s Support Enhancement Tracking System and other programs. In February 2002, Ohio began curtailing existing IT maintenance contracts and making decisions to downsize or eliminate certain follow-on contracts expected later in the year. This cutback resulted in reductions in revenue in 2002 as the year progressed.

New Hampshire Department of Health and Human Services

DRC has developed and implemented the 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 subject matter expertise, which pertain to the knowledge domains relevant to the company’s core customers. These include design, development, operation and maintenance of information technology systems, acquisition and program support, engineering services, complex logistics planning systems and services, defense program administrative support services, modeling, simulation, training systems and services and custom built electronic test equipment and services. More specific descriptions of these capabilities follow.

Defense Program 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.

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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 Analysis and Delivery

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.

Precision Manufacturing

The 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 devices 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.

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 operating line organizations. The group also maintains a proposal development and publication capability.

The group operates with formal processes, which 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 base purchase agreements, indefinite delivery, 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 IT 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

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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 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, excluding discontinued operations, was $111.1 million at December 31, 2002, $90.4 million at December 31, 2001 and $88.0 million at December 31, 2000. The company expects that substantially all of its backlog at December 31, 2002 will be filled during the year ending December 31, 2003. The funded backlog generally is subject to possible termination at the convenience of the contracting counterparty. The company has a number of multi-year contracts with agencies of the United States and state governments on 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 IT service firms and with government IT 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 own 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 measurement discs, scales and reticles. The principal competitive factors affecting the precision components manufacturing businesses are price, product quality and custom engineering to meet customers’ system requirements.

RESEARCH AND DEVELOPMENT

Excluding discontinued operations and including overhead and other indirect costs, the company expended approximately $0.2 million on web-based capabilities during the year ended December 31, 2002, compared with expenditures of $0.4 million in 2001 and no expenditures in 2000. The expenditures in 2001 were attributable mainly to the development of MedTeams training products.

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RAW MATERIALS

Raw materials and components are purchased from a large number of independent sources and are generally available in sufficient quantities to meet current requirements.

ENVIRONMENTAL MATTERS

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.

EMPLOYEES

At December 31, 2002, the company had 1,858 employees, including 93 employees associated with discontinued operations. 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.

IMPORTANT INFORMATION REGARDING FORWARD-LOOKING STATEMENTS

Safe harbor statements under the Private Securities Litigation Reform Act of 1995: Some statements contained or implied in this annual report, which are not historical fact such as financial forecasts, contain forward-looking information. These statements may be identified by forward-looking words such as “expect,” “look,” “believe,” “anticipate,” “may,” “will” and other forward-looking terminology. Such statements are subject to risks and uncertainties that could cause actual results to differ materially from these forward-looking statements, including uncertainties regarding contractual requirements, actions by customers and actual costs to complete; federal budget matters; government contracting risks and competitive market conditions; customer requirements, schedules and related funding; technological change; uncertainty of future financing; overall economic factors; and the ability to successfully complete and integrate acquisitions and other matters. These factors are discussed in more detail below. The company assumes no obligation to update any forward-looking information.

Our Revenue is Highly Dependent on the Department of Defense and Other Federal Agencies and Any Decreases in Their Budgets Could Affect Our Results

In 2002, approximately 89% of our revenue was derived from United States Government agencies, primarily the Department of Defense. In the past, our defense business has been 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.

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 rebid, as well as significant competitive pressure to lower prices, which may reduce profitability in this area of our business. Any reduction in the level or profitability of our defense business, if not offset by new commercial business or other business, will adversely affect our business, financial condition and results of operations.

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

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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. For long-term 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 and results of operations.

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:

The potential for cost overruns may be heightened if we act as a subcontractor on a fixed-price project, because we have a limited ability to control project variables and to negotiate directly with the ultimate client. 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 and results of operations.

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 2002, the company derived $17.1 million in revenue from a small business set aside contract held by its HJ Ford subsidiary and due for recompetition in 2005. The company does not know what effects these events, including HJ Ford’s loss of small business status now that it is part of DRC, will have on future financial results.

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 and results of operations.

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 and results of operations.

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

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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.

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 Inspector 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 in the United States District Court of Massachusetts 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.

Loss of Key Personnel or Increased Government Regulation of Immigration 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 lose 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 and results of operations.

In addition, we recruit technical professionals globally and, as a result, we must comply with the immigration laws in the countries in which we operate, particularly the United States. As of December 31, 2002, less than 1% of our workforce was working under H-1B temporary work permits in the United States. Government regulation limits the number of new H-1B permits that may be approved in a fiscal year. If the limit is reached in any year, we may not be able to recruit enough technical professionals to meet our personnel requirements. This could materially affect our business. Congress and administrative agencies with jurisdiction over immigration matters have periodically expressed concern over the level of legal and illegal immigration into the United States, which may reduce the number of work permits that may be issued. Recently there have been substantial delays in approval of petitions filed by employers with the Bureau of Citizenship and Immigration Services (the successor agency to the INS). These delays, coupled with the uncertain and lengthy visa issuance process at United States consulates abroad, may create delays in foreign national personnel being available to work in the United States. Any change making it more difficult for us to hire foreign nationals, or limiting our ability to retain foreign employees, could require us to incur additional unexpected labor costs and other expenses.

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 price performance, technical competence and reliability.

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 price, product quality and the ability to specialize our engineering in order to meet our customers’ specific system requirements. Our precision products business has a number of competitors, many of which have significantly greater financial, technical and

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marketing resources than we do. Competitive pressures in our government and commercial businesses could have a material adverse effect on our business, financial condition and results of operations.

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 80% of our total revenue during 2002. Within the Department of Defense, individual services and program offices account for a significant portion of our United States Government business. We cannot be assured that any of these customers 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 profitability, and the loss of any large customer could have a material adverse effect on our business, financial condition and results of operations.

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 be assured 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 conditions or results of operations.

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 divisions. Significantly lower production volumes resulting in under-utilization of our manufacturing would adversely affect our business, financial condition and results of operations.

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 be assured 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 be assured 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.

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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 be assured 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 and results of operations.

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:

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, including Andrulis Corporation. 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:

We cannot be assured 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 and results of operations and could cause substantial fluctuations in our quarterly and yearly operating results.

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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:

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

ITEM 2. PROPERTIES

The company leases approximately 319,000 square feet of office and manufacturing space. This space is used for its federal and state government services, manufacturing and warehousing 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 Wilmington leases expire in 2005, with options to renew the leases to the year 2010. The remaining leased facilities consist of offices in 32 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’s total rental cost for 2002 was $4.2 million.

The company believes its 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, the Inspector 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.

As previously disclosed, on October 26, 2000, two former company employees were indicted for conspiracy to defraud the United States Air Force and pled guilty. The United States Attorney’s office continues to discuss the possibility of civil liability on the part of the company arising from the former employees’ conspiracy to defraud the United States Air Force of a claimed $10 million dollars, a substantial portion of which has been recovered. If a suit is brought the company will vigorously defend itself. The company does not have a sufficient basis to determine whether this matter will have a material adverse effect on the company’s financial position or results of operations.

On September 5, 2002, Genesis Tactical Group LLC (“Genesis”) asserted a cross-claim against Lockheed Martin Corporation (“Lockheed”) seeking $50 million in damages and against the company seeking $35 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 which 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 is limited to $300,000, other than for intentional misrepresentation, willful breach or fraud. Lockheed has asserted breach of contract and is seeking damages from and performance of the contract by Genesis and unspecified compensatory damages from the company. Genesis’ cross-claims relate to alleged breaches of the contract by Lockheed and for alleged breaches of the asset purchase agreement by the company. The company has asserted claims against Lockheed and Genesis and believes that the Lockheed and Genesis claims against the company are without merit. The parties have exchanged settlement offers while litigation has been postponed. If

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the company’s settlement offer is accepted, the company would not be obligated to make any payments. While the company believes that the possibility of a material adverse effect on the company’s financial position or results of operations is remote, there can be no assurance as to the outcome.

The company is continuing to provide 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 and results of operations.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of 2002.

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.

Messrs. Ju and Wilkinson have served in their respective positions for more than five years.

Mr. Regan joined the company in 1999 as President, Chief Executive Officer and Director. 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. 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.

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.

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PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND  RELATED STOCKHOLDER MATTERS

The common stock of the company is traded on the NASDAQ National Market under the symbol DRCO.

The high and low prices for the quarters in 2002 and 2001 as reported on the NASDAQ National Market are listed below. These market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.

As of December 31, 2002 there were 716 holders of record of the company’s common stock.

In September 1984, the 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 2002 and does not intend to in the near future. In addition, the company’s financing arrangements restrict the company’s ability to pay dividends.

The Annual Meeting of the stockholders of Dynamics Research Corporation will be held at 2:00 p.m. on Wednesday, May 14, 2003 at the Colonnade Hotel, 120 Huntington Avenue, Boston, Massachusetts.

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ITEM 6. SELECTED FINANCIAL DATA

The selected consolidated condensed financial data set forth below is derived from the audited consolidated financial statements of the company for the years ended December 31, 2002, 2001 and 2000 and as of December 31, 2002 and 2001, and the unaudited restated consolidated financial statements of the company for the years ended December 31, 1999 and 1998 and as of December 31, 2000, 1999 and 1998. On May 31, 2002, the company acquired HJ Ford and on December 20, 2002, the company acquired ANDRULIS (see Note 11 of Notes to the Consolidated Financial Statements). 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 operations 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 in Item 7 and the consolidated financial statements of the company and the notes thereto included in Item 7 of this Form 10-K. The historical results provided here are not necessarily indicative of future results.

FIVE-YEAR SUMMARY OF SELECTED FINANCIAL INFORMATION

        See Management’s Discussion and Analysis of Financial Condition and Results of Operations for discussion of unusual items.

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION  AND RESULTS OF OPERATIONS

RESULTS OF OPERATIONS

(2001 and 2000 restated to exclude discontinued operations)

The company has two reportable business segments: Systems and Services and Metrigraphics. The Systems and Services Segment is the aggregation of five operating groups that provide similar services to government customers. The Metrigraphics Segment manufactures a variety of products that are used for precision measurement. Additional information about the company’s business segments is disclosed in Note 12, Business Segments, of Notes to the Consolidated Financial Statements and is further discussed below.

Revenue from the Systems and Services Segment and the Metrigraphics Segment is reported in the Consolidated Statement of Operations as contract and product sales, respectively.

OVERVIEW

In 2002 Dynamics Research Corporation (“DRC”) was strengthened by strategic accomplishments and tested by business environment challenges. We ended the year a stronger company in every important dimension – customers, human resources, capabilities and finances.

Many of our long-term defense contracts were up for re-competition in 2002. We emerged from these re-competitions with a more growth-oriented, more profitable mix of customers and contracts. We also successfully completed two strategic acquisitions in 2002, adding key customers in growth markets and increasing our revenue base by $65 million annualized, or more than 30%.

The prolonged slowdown in high-technology original equipment manufacturer markets led to our decision in October 2002 to divest the company’s Encoder Division (previously reported as a segment). Our state government information technology business was also impacted by budget reductions. While profit declines in these businesses offset most of the company’s 2002 gains in federal sector profits, action has been taken to mitigate these effects going forward.

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Operating profit margin for the Systems and Services Segment continued to improve for the third consecutive year increasing to 6.2% from 5.3% in 2001. However, lower profits from the Metrigraphics Segment more than offset this improvement, resulting in an overall operating margin of 6.6%, which was a decrease of 0.2% from 2001.

REVENUE

Total revenue from continuing operations was $192.6 million, $190.3 million, and $182.5 million for 2002, 2001 and 2000, respectively, representing an increase of 1.2% in 2002 and 4.2% in 2001.

Contract Revenue

Contract revenue in the Systems and Services Segment was $185.0 million in 2002, $179.4 million in 2001 and $172.8 million in 2000, representing increases of 3.1% and 3.8% in 2002 and 2001, respectively.

Defense revenue for 2002, 2001 and 2000 was $154.2 million, $147.6 million and $150.0 million, respectively. Revenue for 2002 was up $6.6 million over 2001, reflecting the effects of additional acquisition related revenue of $18 million; a reduction in low margin subcontract revenue with the Electronic Systems Center Combat Air Force program of $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 with the United States Navy’s guidance system program for Strategic Systems, estimated at $5 million on an annualized basis. Absent these effects, organic defense related revenue increased approximately 4% for 2002, compared with 2001.

During 2001, the company changed its contractual relationship with two major customers, moving from a prime contractor position to one as a subcontractor. Further, work that was previously subcontracted through the company is now directed to other companies. As a result of these changes, $9.4 million of low margin work performed by subcontractors to the company in 2000 was no longer reported in the company’s operating results as revenue with offsetting cost of sales in 2001. The comparison of revenue on a year-over-year basis is also affected by a one-time $4.1 million purchase and resale of equipment to a major customer under a cost reimbursable contract in 2000. Excluding the effect of these non-recurring items, defense related revenue grew approximately 9% in 2001 compared with 2000, primarily due to increased business with the United States Navy and other Department of Defense agencies.

Revenue from federal civilian agencies was $17.8 million, $11.7 million and $7.4 million in 2002, 2001 and 2000, respectively. Revenue in this sector increased $6.1 million, or 51.9%, in 2002 when compared with 2001, primarily from services performed under a contract with the Internal Revenue Service. Because approximately one third of the revenue of Andrulis Corporation (“ANDRULIS”) has historically been derived from federal civilian agencies, it is expected that revenue from this sector will increase significantly in 2003. In 2001, revenue from federal civilian agencies increased $4.2 million, or approximately 56% when compared with 2000, again primarily from services performed under a contract with the Internal Revenue Service.

State and local government revenue was $12.9 million in 2002, $20.1 million in 2001 and $14.7 million in 2000. The decrease in revenue in this sector in 2002 when compared with 2001 resulted substantially from the expected transition of work for the State of Colorado (see Note 2) and cutbacks in infrastructure support staff for the State of Ohio in the first half of 2002. The increase in state and local revenue in 2001 when compared with 2000 was primarily due to additional work related to the company’s contracts with the State of Colorado.

Revenue by contract type, as a percentage of Systems and Services Segment revenue, was as follows:

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Product Sales

Product sales for the Metrigraphics Segment decreased $3.3 million to $7.6 million in 2002 compared with 2001, and increased $1.1 million to $10.9 million in 2001 compared with 2000. The decrease in 2002 was due to continued weak economic conditions and customer product life cycle shifts. Increased demand from medical electronics customers contributed to the growth in 2001. The company remains cautious that further economic weakness could adversely affect the Metrigraphics Segment.

Funded Backlog

The company’s funded backlog, excluding discontinued operations, was $111.1 million, $90.4 million and $88.0 million at December 31, 2002, 2001 and 2000, respectively. In 2002, the addition of HJ Ford and ANDRULIS fully accounted for the increase in backlog. The funded backlog generally is subject to possible termination at the convenience of the contracting counterparty. 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 revenue.

GROSS MARGIN

Total gross margin was $30.9 million, $29.1 million and $20.9 million for 2002, 2001 and 2000, respectively, representing 16.1%, 15.3% and 11.5% of total revenue for 2002, 2001 and 2000, respectively.

Gross margin on contract revenue was $28.6 million, $24.0 million and $16.4 million for 2002, 2001 and 2000, respectively, representing 15.4%, 13.4% and 9.5% of contract revenue for 2002, 2001 and 2000, respectively. The increase in contract revenue gross margin in 2002 was partly due to improved contract mix and included the effect of the completion of the Colorado contract. In 2001, the increase in gross margin when compared with 2000 was due to improved contract pricing, the impact of better control of overhead costs and $1.2 million of contract close out credits, partially offset by $0.8 million of pension plan curtailment loss discussed below.

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 and $2.7 million in 2000 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 will expire 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 2002, 2001 and 2000, gross margin on Metrigraphics Segment sales was $2.4 million, $5.1 million, $4.5 million, respectively, representing 31.2%, 46.7% and 45.8% of product sales in 2002, 2001 and 2000, respectively. The decline in product sales gross margin was due to decreased product sales resulting from continued weak economic conditions and customer product life cycle shifts, partially offset by cost reductions.

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.

OTHER OPERATING ITEMS

Selling, engineering and administrative costs increased to $17.9 million in 2002, compared with $16.0 million in 2001 and $14.3 million in 2000. In 2002, the increase was primarily the result of the absorption of general and administrative expenses as part of the integration of the two acquired companies, increased costs reflecting the completion of the company’s 2001 initiative to expand its marketing resources, and $0.7 million of higher legal expenses incurred in the fourth quarter of 2002, primarily related to the production of documents in response to the Department of Justice subpoena on October 15, 2002 (see Note 9 of Notes to the Consolidated Financial

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Statements and Item 3 Legal Proceedings). Costs associated with document production for this matter are expected to continue in 2003 at a lower level than incurred for the fourth quarter of 2002. The increase in 2001 reflects two factors, a planned increase in sales and marketing activities and planned expenses associated with employee-centered initiatives.

The company expended approximately $0.2 million, inclusive of overhead and other indirect costs, on web-based capabilities during the year ended December 31, 2002, compared with expenditures of $0.4 million in 2001 and no expenditures in 2000 excluding discontinued operations. The expenditures in 2001 were attributable mainly to the development of MedTeams training products.

Amortization expense of $0.4 million for 2002 reflects the amortization of intangible assets associated with the HJ Ford and ANDRULIS acquisitions (see Note 11 of Notes to the Consolidated Financial Statements).

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, engineering and administrative expenses. An accrual of $0.2 million remains at December 31, 2002 and is expected to be paid in the first half of 2003.

During 2000, the company paid approximately $0.9 million related to severance costs and outplacement services for 58 employees. During the fourth quarter of 2000, the company determined that $0.1 million of reserves related to a specific business unit were no longer necessary, and reversed those reserves against cost of contract revenue. The remaining restructuring reserve of $0.2 million at December 31, 2000 was paid during the first half of 2001.

Operating income for the Systems and Services Segment increased to $11.5 million, or 6.2% of contract revenue for 2002, compared with $9.5 million, or 5.3% of contract revenue for 2001 and $3.5 million, or 2.0% of contract revenue for 2000.

Operating income for the Metrigraphics Segment was $1.1 million, or 14.9% of product revenue for 2002, compared with operating income of $3.5 million, or 32.4% of product revenue for 2001 and $3.1 million, or 31.4% of product revenue for 2000.

Total operating income was $12.6 million, or 6.6% of revenue, $13.0 million, or 6.8% of revenue and $6.6 million, or 3.6% of revenue for 2002, 2001 and 2000, respectively. Margin improvement in the Systems and Services Segment was more than offset by the lower margin from the Metrigraphics Segment.

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 revenue of approximately $0.8 million and a loss of $0.5 million. The sale resulted in a net loss of $0.2 million, shown as Other expense on the Consolidated Statements of Operations in 2001. Proceeds from the transaction were $0.1 million in cash. In 2000, TCG recorded revenue of $2.3 million and an after tax-loss of $0.9 million, including a $0.4 million pre-tax impairment charge included in operating income.

Interest expense was $0.6 million, $1.0 million and $1.9 million in 2002, 2001 and 2000, respectively, offest by interest income of $0.2 million, $0.2 million and $0.1 million in 2002, 2001 and 2000, respectively. The decrease in net interest expense reflects lower average interest rates and debt levels over the last two years, and the net benefit of investment income on cash and cash equivalents.

Income tax expense has been recorded at a rate of 40.2%, 40.7% and 40.8% of income from continuing operations before taxes in 2002, 2001 and 2000, respectively. The 2002, 2001 and 2000 rates reflect the statutory federal rate of 34% combined with an average state income tax rate, net of federal income tax benefit.

Loss from discontinued operations for 2002 was $1.1 million, or $0.13 per diluted share, compared with a loss of $0.6 million, or $0.08 per diluted share for 2001 and income of $1.5 million, or $0.20 per share for 2000. Due to

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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 ended December 31, 2001 and 2000 it became necessary to engage KPMG LLP, the company’s new independent auditors, to re-audit results for those years in order to obtain a current independent auditor opinion for 2001 and 2000. The 2002 loss from discontinued operations includes $0.4 million in fees to re-audit 2000 and 2001 results.

As of December 31, 2002, and in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the company reviewed the possible impairment of assets associated with the Encoder Division and determined that an impairment charge was not required. However, there can be no assurance as to whether an impairment charge will be required in future periods, depending on then current events and circumstances.

Related to the gain on the disposal of discontinued operations, the company recognizes royalty income associated with the company’s 1999 sale of its discontinued Telecommunications Fraud Control business on a cash basis and reported $0.1 million and $0.2 million of royalty income, after tax, in 2001 and 2000, respectively. In the first quarter of 2003, the company received a final royalty payment associated with this transaction of $0.7 million, and will include $0.4 million, net of tax, in results from discontinued operations during 2003.

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 7.7 million at December 31, 2000 to 8.1 million at December 31, 2001 and 8.9 million at December 31, 2002.

LIQUIDITY AND CAPITAL RESOURCES

Cash provided by continuing operations was $9.9 million for 2002, principally from income from continuing operations and decreased accounts receivable and unbilled expenditures and fees on contracts in process, partially offset by decreases in accounts payable and accrued payroll and employee benefits. In 2001, cash provided by continuing operations was $23.6 million. This primarily resulted from income from continuing operations, refundable income taxes, and decreased accounts receivable and unbilled expenditures and fees on contracts in process. Successful cash collections on aged receivable balances contributed to the increased level of cash provided by continuing operations in 2001. Cash provided by income from continuing operations of $3.8 million in 2000 primarily resulted from income from continuing operations, a decrease in accounts receivable and an increase in the deferred tax provision partially offset by an increase in unbilled expenditures and fees on contracts in process and prepaid expenses. The increase in prepaid expenses in 2000 was primarily due to $2.6 million of refundable federal income taxes, most of which was received in the first quarter of 2001.

Net cash provided by discontinued operations was $0.4 million, $0.9 million and $1.4 million in 2002, 2001 and 2000, respectively.

Accounts receivable of $29.8 million at December 31, 2002 included $5.8 million of receivables acquired with the purchase of ANDRULIS on December 20, 2002. Unbilled expenditures and fees on contracts of $26.6 million at December 31, 2002 included $2.4 million acquired with the purchase of ANDRULIS. Days sales outstanding (“DSO”) on total receivables, both billed and unbilled, was 88 days at the end of 2002 compared with 84 days at the end of 2001. Delay in payment of $2.8 million under a large contract, subsequently received on January 7, 2003 resulted in a five-day increase in days sales outstanding at December 31, 2002. The delay was related to slow payment from the federal government to the prime contractor. The company also is experiencing slow payments from one commercial customer having an account balance of $0.3 million at March 31, 2003. The company has received payments subsequent to December 31, 2002, has considered the account to be collectible and, accordingly, has not provided for a loss on the receivable. On March 31, 2003 the company became aware that on March 28, 2003 the customer’s parent company, located in the Netherlands announced that a bankruptcy filing in the United States was being considered. The company has insufficient information to evaluate the possible future events and financial effects related to this matter. Should the company determine that the account, or a portion thereof, is uncollectible a provision for the loss will be made in the period in which this

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determination is made. In addition, under U.S. Bankruptcy code, certain amounts collected by the company from the customer may be deemed preference payments, requiring the amounts to be forfeited by the company.

Cash used for investing activities for continuing operations was $28.1 million for 2002, including $24.3 million for the purchases of HJ Ford and ANDRULIS (see Note 11 of Notes to the Consolidated Financial Statements). In 2001 and 2000, cash used for investing activities for continuing operations was $3.9 million and $3.1 million, respectively. Capital spending for property, plant and equipment for continuing operations was $3.3 million, $3.6 million and $2.9 million in 2002, 2001 and 2000, respectively. The principal capital investment in 2002 related to implementation of an electronic time collection system. In 2001, capital investments were made primarily for enterprise information systems and equipment, and building improvements to the Andover corporate headquarters. The major capital project for the company in 2000 was the development of an enterprise human resource management system, which was put into service in January 2001. 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.

The company’s prospective 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 $7 million to $9 million in 2003, primarily for enterprise business systems and facilities infrastructure consolidation and improvements.

Total debt outstanding at December 31, 2002 of $23.4 million consisted of a mortgage loan 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.

Effective June 28, 2002, the company obtained a $50 million unsecured revolving credit agreement (the “Revolver”), replacing the previous revolver. 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 0.2% to 0.5% depending on the outstanding balance and is payable quarterly in arrears. The company has the option to elect on a fixed 30, 60 or 90-day term, an interest rate of LIBOR plus 2.0% 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, 2002, the outstanding balance under the Revolver was $2.2 million, which was the maximum outstanding balance during the year. The interest rate on the balance outstanding under the Revolver was 4.25% based on the prime rate at December 31, 2002. At December 31, 2001, there was no outstanding balance under the previous revolver.

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 $8.8 million at December 31, 2002. The agreement requires quarterly principal payments of $125,000, with a final payment of $5 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 on the Mortgage was reduced to LIBOR plus 2.0%. The interest rate on the Mortgage under the 90-day LIBOR option, elected at October 15, 2002, was 3.83%, which was effective at December 31, 2002. The average interest rate on the Mortgage was 3.97% and 6.89% during 2002 and 2001, respectively.

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 contains a subjective acceleration clause allowing the lender to seek payment upon the occurence of a material adverse change.

Except as noted herein, the company was in compliance with all loan covenants on December 31, 2002. As a result of an other comprehensive income charge in 2002 related to the decline in value of pension plan assets, the

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company was not in compliance with the tangible net worth covenant of the Revolver at December 31, 2002. On February 26, 2003, the company received a written notice from the bank group approving the waiver of this covenant and agreeing to amend the loan agreement so as to base the covenant on total net worth and to exclude other comprehensive income adjustments from the covenant calculation currently and in future periods. On March 26, 2003, the company entered into the amendment to the Revolver giving effect to this change.

In 2002, 2001 and 2000, the company realized $0.7 million, $0.8 million and $0.8 million, respectively, in proceeds from the exercise of stock options. In 2002 and 2001, the company realized $1.6 million and $0.5 million, respectively, in proceeds from the issuance of shares under the employee stock purchase plan.

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 million to $50 million to enable pursuit of the company’s acquisition strategy. In 2003, the company will continue to consider acquisition opportunities which align with its strategic objectives, along with the possibility of utilizing the revolving credit facility as a source of financing.

Commitments and Contingencies

At December 31, 2002, the company was guarantor on a $0.2 million line of credit for a small disadvantaged business in which the company owns a 40% interest and has continuing business relationships. There was $0.2 million drawn on the line of credit at December 31, 2002, which expires on March 31, 2003. At December 31,  2002, the company’s investment in this business was $0.2 million and was included in other noncurrent assets.

The company has change of control agreements with certain employees of the company providing them with benefits if their employment with the company is 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.

On December 26, 2002, the company entered into an installment payment agreement in connection with the acquisition of its enterprise business system software. The company made the first payment on January 26, 2003 and the second and last payment is 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. The obligation is reflected in the table below as a purchase commitment.

Contractual obligations at December 31, 2002 were as follows:

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, the Inspector 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 results of operations, financial position and cash flows.

As previously disclosed, on October 26, 2000, two former company employees were indicted for conspiracy to defraud the United States Air Force and pled guilty. The United States Attorney’s office continues to discuss the possibility of civil liability on the part of the company arising from the former employees’ conspiracy to defraud the

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United States Air Force of a claimed $10 million dollars, a substantial portion of which has been recovered. If a suit is brought the company will vigorously defend itself. The company does not have a sufficient basis to determine whether this matter will have a material adverse effect on the company’s financial position or results of operations.

On September 5, 2002, Genesis Tactical Group LLC (“Genesis”) asserted a cross-claim against Lockheed Martin Corporation (“Lockheed”) seeking $50 million in damages and against the company seeking $35 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 which 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 is limited to $300,000, other than for intentional misrepresentation, willful breach or fraud. Lockheed has asserted breach of contract and is seeking damages from and performance of the contract by Genesis and unspecified compensatory damages from the company. Genesis’ cross-claims relate to alleged breaches of the contract by Lockheed and for alleged breaches of the asset purchase agreement by the company. The company has asserted claims against Lockheed and Genesis and believes that the Lockheed and Genesis claims against the company are without merit. The parties have exchanged settlement offers while litigation has been postponed. If the company’s settlement offer is accepted, the company would not be obligated to make any payments. While the company believes that the possibility of a material adverse effect on the company’s financial position or results of operations is remote, there can be no assurance as to the outcome.

The company is continuing to provide 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 and results of operations.

CRITICAL ACCOUNTING POLICIES

Use of Estimates

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. Management must make use of estimates in the areas discussed below.

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 services provided, and contract costs are expensed as incurred. The risk to the

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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 expected to be realized 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 amounts are based upon specific identification of potential uncollectible accounts. In addition, payment to the company for performance on United States Government contracts are subject to audit by the Defense Contract Audit Agency. 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. Due to the diversity of contracts with the United States Government, it is not probable that the company will incur a material loss.

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 per 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, HJ Ford and ANDRULIS. All assets and liabilities acquired have been recorded at their fair values at the date of the acquisition and the results of operations are included in the consolidated financial statements from the date of acquisition. The company has determined the fair value of all assets acquired and liabilities assumed. The company has utilized an independent valuation specialist to determine the fair value of intangible assets acquired in order to allocate a portion of the purchase price related to intangible assets.

Pensions

Accounting and reporting for the company’s pension plan requires the use of assumptions, including but not limited to, discount rate, rate of compensation increases and expected return on invested assets. If these assumptions materially differ from actual results, the company’s obligations under the pension plan could also materially differ, requiring the company to record an additional pension liability.

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New Accounting Pronouncements

In April 2002, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standard SFAS (“SFAS”) No. 145, Rescission of FASB Statements Nos. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections. It rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, SFAS No. 44, Accounting for Intangible Assets of Motor Carriers and SFAS No. 64, Extinguishment of Debt Made to Satisfy Sinking-Fund Requirements. SFAS No. 145 also amends SFAS No. 13, Accounting for Leases, to eliminate the inconsistency in the required accounting for sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings or describe their applicability under changed conditions. The new rule is effective for the company beginning January 1, 2003. The adoption of SFAS No.145 is not expected to have a material impact on the company’s financial position or results of operations.

In November 2002, the FASB issued FASB Interpretation No. (“FIN”) 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 No. 45 clarifies requirements relating to the guarantor’s accounting for, and disclosure of, the issuance of certain types of guarantees. FIN No. 45 requires that upon issuance of a guarantee, companies recognize a liability for the fair value of the obligation it assumes under that guarantee. The company adopted the annual disclosure provisions of FIN No. 45 in the year ended December 31, 2002. The company will adopt the provisions for initial recognition and measurement and the interim disclosures during the first quarter of 2003. The company does not expect the adoption of FIN No. 45 to have a material effect on the consolidated financial statements.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 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 new rule is effective for the company beginning January 1, 2003. The adoption of SFAS No. 146 is not expected to have a material impact on the company’s financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure – An Amendment of SFAS No. 123. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, 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 No. 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 No. 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. The company intends to continue to account for stock options under APB No. 25.

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 80% of revenue in 2002, are generally one year and include salary increase factors for future years, thus reducing the potential impact of inflation on the company.

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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 Consolidated Statements of Operations. A full percentage point increase in the interest rate on the balance of the Mortgage and Revolver at December 31, 2002, would result in a $0.1 million increase in interest expense per year. The company does not currently hedge these interest rate exposures.

The company presently has minimal exposure to market interest rates with regard to investments. The company’s cash investments, which consisted primarily of money market accounts, were liquidated during 2002 to finance two acquisitions.

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

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

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REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

The Board of Directors and Stockholders

Dynamics Research Corporation:

We have audited the accompanying Consolidated Balance Sheets of Dynamics Research Corporation and Subsidiaries (the “company”) as of December 31, 2002 and 2001, 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 three-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 2001 and the results of their operations and their cash flows for each of the years in the three-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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CONSOLIDATED BALANCE SHEETS

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

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CONSOLIDATED STATEMENTS OF OPERATIONS