UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

Commission file number 000-02479

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:

None

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

Common Stock, $0.10 par value

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

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

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

          The aggregate market value of the registrant’s common stock, $0.10 par value, held by nonaffiliates of the registrant as of June 30, 2004, was $99,420,589.80 based on the reported last sale price per share of $17.98 on that date on the Nasdaq Stock Market. As of February 28, 2005, 8,831,922 shares of the registrant’s common stock, $0.10 par value, were outstanding.

      This Annual Report on Form 10-K for the year ended December 31, 2004 does not include the audit report or consent of Grant Thornton LLP, our current auditors, or KPMG LLP, our previous auditors, and portions of Item 9A of Part II for the reasons outlined in our filing on Form 12b-25 made with the Securities and Exchange Commission on March 16, 2004, and therefore, this Annual Report on Form 10-K is incomplete until the time as such audit reports and consents of Grant Thornton LLP and of KPMG LLP and Item 9A of Part II are included in an amendment to this Annual Report filed on Form 10-K/A.

DOCUMENTS INCORPORATED BY REFERENCE

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

DYNAMICS RESEARCH CORPORATION

ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2004

PART I

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 approximately 1,960 employees, located throughout the United States. The company operated through the parent corporation and its wholly owned subsidiaries, HJ Ford Associates, Inc. (“HJ Ford”), Andrulis Corporation (“ANDRULIS”) and Impact Innovations Group LLC (“Impact Innovations”) through December 31, 2004, at which time ANDRULIS and Impact Innovations merged with and into the company. Effective January 1, 2005, the company operates through the parent corporation and its wholly owned subsidiary, HJ Ford.

      DRC’s core capabilities are focused on information technology, engineering and technical subject matter expertise that pertain to the knowledge domains relevant to the company’s core customers. More specifically, these solutions, which are offered by the company’s Systems and Services business segment, include design, development, operation and maintenance of business intelligence systems, business transformation services, defense program acquisition management services, training and performance support systems and services, automated case management systems and information technology (“IT”) infrastructure services.

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

      The company’s business growth strategy is focused on three national priority markets: national defense, public safety and legislated citizen services. Within these markets there are six strategic business areas on which the company focuses its efforts: C4ISR (Command, control, communications, computing, intelligence, surveillance and reconnaissance), logistics, readiness, military space, public security and citizen services. Because these markets address the mission critical functions of government, we expect that they will be funded regardless of economic cycle. The strategy leverages six solution sets where DRC has strong competencies and a record of meeting its customers’ most difficult challenges. These repeatable, proven, cost effective solutions are acquisition management services, training and performance support, business transformation, business intelligence, IT infrastructure services and automated case management.

      DRC has an organic and acquisition growth strategy, supplementing organic growth with the acquisition of businesses with additional or complementary capabilities, providing access to new customers. Consistent with this strategy, the company has completed three business acquisitions since 2002.

      The company’s other business segment, the Metrigraphics Division, develops and produces components for original equipment manufacturers in the computer peripheral device, medical electronics, telecommunications and other industries. Manufacturing core capabilities are focused on the custom design and manufacture of miniature electronics parts that are designed to meet ultra-high precision requirements through the use of electroforming, thin film deposition and photolithography technologies.

      Financial data and other information about the company’s operating segments can be found in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part I, Item 7 of this Annual Report on Form 10-K, and in Note 9, “Business Segment, Geographic, Major Customer and Related Party Information”, of the company’s Notes to Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K.

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

      DRC maintains an Internet website at http://www.drc.com. The company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K and all amendments to these reports are available free of charge through the company’s website by clicking on the “Investor Relations” page and selecting “SEC Filings”. These filings are also accessible on the Securities and Exchange Commission’s website at http://www.sec.gov. The company does not intend

that the information contained on the company’s website be deemed a part of this report or to be deemed filed with the Securities and Exchange Commission.

MARKETS

      DRC’s systems and services business, which accounted for 97.4% of revenue in 2004, is focused on providing technical and information technology services to government customers. The government market is composed of three sectors: defense, federal civilian agencies, and state and local governments.

      According to a report published in 2003 by Input, Inc. (“Input”), a leading research firm specializing in the market for government contractors, the federal market demand for vendor-furnished information systems and services will increase from $58.6 billion in fiscal 2004 to $80.7 billion in fiscal 2009, a compound annual growth rate of 6.6%. The Fiscal Year 2005 Mid-Session Review of the Federal Budget, submitted to Congress by the U.S. Office of Management and Budget, shows increases in the fiscal 2005 discretionary budgets for national defense and citizen security of 7.1% and 9.7%, respectively.

      The company believes that several factors are driving growth in the defense sector of this market. First, the continued focus on the war in Iraq is beginning to shift from short-term fixes for physical security to programs with sustaining focus that will rely on the application of information technology for the improvement of processes and training. Second, the company believes that increased reliance on contracts to supply mission-critical services is increasing due to government workforce ceilings and the administration’s emphasis on outsourcing activities that are not unique to government.

      The company believes the factors driving growth in the federal civilian agency sector include homeland security needs, an ongoing need for systems modernization, and, as in the defense sector, government workforce ceilings. These factors have caused, and are expected to continue to cause, federal civilian agencies to turn to contractors on an increasing basis to fill their needs for information technology services. The recent elections in Iraq could also mark a shift of resources away from military operations and renew the emphasis on Department of Defense (“DoD”) transformation, new systems development and systems modernization, areas where DRC is focused.

      In the state and local government sector, state and local jurisdictions are expected to spend $44.7 billion on information technology products and services in 2005, according to the market research firm Gartner, Inc. Additionally, Input projects growth rates in state and local outsourcing to reach 56% over the next five years, with an aging workforce and outdated equipment as the primary drivers for this growth. There is also a need for states to continue to modernize child welfare systems and Medicare management systems, areas where DRC’s Automated Case Management solution fits well. DRC has considerable experience in providing information technology expertise in the health and human services areas. The company believes the primary driving factors driving growth in this sector are infrastructure modernization and expansion, the migration of information and training to web-based applications and cost-sharing incentives to facilitate data exchange with federal agencies, which generally have large and burdensome caseloads. These agencies must maintain extensive records, report program data, eliminate errors and work toward a more responsive management. Yet the information systems of many of these agencies are antiquated; in some cases more than twenty years old, and have limited data interfacing and reporting capabilities.

      DRC’s Metrigraphics Division represented 2.6% of the company’s revenue in 2004. The Division serves the commercial original equipment manufacturers (“OEM”) market. This market includes manufacturers of computer peripheral devices, telecommunications and medical technology equipment. The Division sells principally to commercial customers.

MAJOR CUSTOMERS

      The company’s 2004 contract revenue, which accounted for 97.4% of revenues, delineated by market sector, was derived 80.2% from the defense sector, 11.6% from federal civilian agencies, 7.6% from state and local governments, and 0.6% from other commercial customers.

Defense Sector

      United States Air Force customers constituted the largest component of DRC’s defense revenue in 2004, representing 49.0% of total revenue, while U.S. Navy revenue represented 15.9%, U.S. Army revenue represented 7.8% and revenue from other agencies represented 5.4% of total revenue. Key capabilities that DRC offers defense customers include business intelligence systems, business transformation services, acquisition management services, training and performance support

systems and services, and IT infrastructure services. In addition, DRC’s test equipment business develops, maintains and validates hardware and software for complex weapons systems. The work DRC performs for its major customers in this sector is described below.

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, testing, evaluation and initial acquisition of aeronautical systems and related equipment for the Air Force. Major active programs supported include: B-2 and B-1B bombers; C-17 airlifter; Joint Unmanned Combat Air systems (“J-UCAS”), Reconnaissance, Special Operations Forces, F/A-22 Raptor fighter-attack aircraft; F-117A stealth fighter, F-15 Eagle air-to-ground fighter aircraft; and F-16 Fighting Falcon fighter aircraft. 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 acquisition management tasks and objectives such as product support, information service, supply management, depot maintenance, science and technology, test and evaluation, information management, installations and support, and combat support.

      The services provided under this contract are subject to re-competition in 2005. It is anticipated that the competition will limit prime contract awards to small businesses. The company expects to participate in the competition through its wholly owned subsidiary, HJ Ford, as a sub-contractor to a small business, which has qualified for this competition under the Small Business Administration mentor-protégé joint venture program.

Air Force Electronic Systems Center

      The mission of the Air Force Electronic Systems Center (“ESC”), headquartered at Hanscom Air Force Base, Bedford, Massachusetts, is to serve as the Center of Excellence for command and control and information systems to support the Air Force war fighter 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.

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

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

      The services provided under this contract are subject to re-competition in 2005. It is currently anticipated that the competition will limit prime contract awards to small businesses. DRC expects to participate in the competition as a sub-contractor to a qualified small business.

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 October 2004, DRC’s work on GUARDIAN was increased by more than $5 million a year in this third year of the company’s five-year, $36.6 million effort to support Air National Guard activities throughout the United States. 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 architecture for eventual migration to the Air Force Portal, which is intended to integrate more than 28,000 information systems into one point of easy access.

Office of the Undersecretary of Defense for Public Affairs

      DRC is subcontractor under a $37 million, five year contract, of which DRC’s contract value is equal to 93% of the total contract value. DRC provides systems engineering and IT support services to the Office of the Undersecretary of Defense for Public Affairs (“OASD(PA)”) Headquarters and its field activities, including the Defense Information School, the American Forces Information Service and the Defense Media Center. As part of this effort, DRC maintains the DefendAmerica web site, providing the public with timely, reliable news about the war on terrorism and daily updates on activities in Iraq.

Navy Trident Missile Program

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

Air Force Depot Operations

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

Army Aviation/ Missile Command

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

Army Training

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

Air Force Air Mobility Command

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

Office of Naval Research

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

Missile Defense Agency

      The Missile Defense Agency is chartered with developing the future space-based missile defense capabilities. DRC currently provides research on manufacturability and research services to this client, under multi-year contracts. In December 2004, DRC was awarded a cost plus fixed fee contract to engage a diverse set of Ballistic Missile Defense Systems (“BMDS”) customers to develop and utilize a unique transformation process to eliminate waste and facilitate enterprise-wide performance across the entities that make up the BMDS supply chain. The 42-month contract has a total ceiling amount of $25 million and is expected to be completed in January 2008.

Navy Central HIV Program

      DRC provides network and database administration, system security and other information technology services to support and maintain the Navy’s HIV Management System (“HMS”) under a $4.8 million contract. The HMS supports clinical and patient management at field, hospital and branch clinical locations worldwide and processes approximately 10,000 records each day.

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 Air Systems Command

      In 2000, DRC was awarded a five-year subcontract to provide engineering and information services to the United States Naval Air Systems Command, or 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.

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

Other Business Intelligence Programs

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

      The United States Joint Forces Command Joint Warfighting Center orchestrates military training exercises in various world theaters. These war games entail major geographic and functional commands, and thousands of troops, as well as the

supplies, vehicles and equipment to support them. Such exercises require top-level coordination to maximize effectiveness and avoid schedule and resource conflicts. DRC developed and is now enhancing the Joint Training Information Management System (“JTIMS”), a web-based application that lets authorized personnel collaboratively plan and execute war games. The system is designed to enable combatant commands, joint organizations and defense agencies to align training with assigned missions, and helps ensure missions are consistent with organizational priorities. In 2004, DRC was asked by the Department of Defense to continue to support JTIMS by providing joint training information across the entire DoD under contracts valued at $8.2 million in the aggregate.

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

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

Federal Civilian Agency Sector

      The company believes that the United States Government federal civilian agencies present an important growth market for DRC. Growth in spending in this sector is being driven by the threat of domestic terrorism, as well as a high need for modernization.

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

Internal Revenue Service

      The Internal Revenue Service (“IRS”) is DRC’s largest customer in the federal civilian agency sector. 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. Currently, DRC’s efforts focus on two major projects: the Compliance Research Information System (“CRIS”), a tool that helps IRS statisticians detect deviations 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. The services provided under this contract are subject to re-competition in 2005.

Federal Deposit Insurance Corporation

      DRC currently serves the Federal Deposit Insurance Corporation (“FDIC”) through three contracts; two as prime and one as a subcontractor. Under the Configuration and Quality Management Staff contract DRC delivers independent software testing, quality assurance analysis and configuration management expertise for comprehensive, complex systems in development, implementation, maintenance and platform migration. The contract, awarded in 2004, includes two base years with an additional three-year option worth up to $16.6 million. Under the Release Management contract, awarded in 2003, DRC supports the FDIC’s Release Management Team for all phases of software quality assurance and independent application compatibility testing before software is released into the FDIC’s production computing environment. This $8.3 million effort includes two base years and three one-year options. Under the FDIC Internet/ Intranet Support contract, DRC provides

maintenance support of the FDIC Internet (www.fdic.gov), FDIC Intranet (FDICnet) and FDICconnect (formerly FDIC BankNet) sites with the company’s prime-teaming partner. On a weekly basis, the team handles over 50 routine site content update and move requests.

United States Customs Service Air and Marine Interdiction Division

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

State and Local Government Sector

      DRC designs, develops, implements, maintains and supports automated case management systems, networks and systems for state health and human services agencies and local users of these statewide systems. As states began to experience economic improvement in 2004, DRC saw increased bidding opportunities related to its case management solutions as applied to child welfare services. Primarily as a result of a new contract with the State of Ohio, DRC’s revenue in this sector increased approximately $9 million in 2004 from the 2003 level. The company believes that additional opportunities related to DRC’s solutions in this area will bring growth to its business in this sector in 2005. A description of DRC’s major customer engagements in this sector follows.

State of Ohio

      In May 2004, DRC was awarded a $30 million contract by the State of Ohio to develop and implement a web-based statewide-automated child welfare information system. The contract has a three-and-a-half-year base period, plus a one-year option. The new statewide system will provide a centralized database for use by the state and county officials to track children in their care. With real time access to critical information, county children’s service agencies can make informed decisions that will help protect children and provide needed services to their families.

      The Ohio system will utilize a three-tier, web-based, model-driven architecture that uses the Java 2 Enterprise Editor architectural specification. This represents the state-of-the-art in case management solutions and can be easily extended to support a state’s juvenile justice system.

      DRC, with Compuware Corporation (“Compuware”) as a major subcontractor, will provide a wide array of services, including analysis, design, development and implementation support. Compuware will fulfill the software development and data conversion aspects of the program.

State of Colorado

      DRC has worked with and for the State of Colorado since 1997. DRC’s original Colorado effort was to develop an integrated statewide child welfare and youth corrections system, known as the Colorado Trails application. DRC continues to support this application with database and host server maintenance and support.

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

      DRC also is performing as a key subcontracting team member to Electronic Data Systems Corporation for the State of Colorado on the Colorado Benefits Management System project to deploy an integrated, statewide eligibility system that replaces six existing legacy systems.

DRC’s SOLUTIONS

Systems and Services

      DRC’s systems and services business provides solutions to its customers that include the design, development, operation and maintenance of business intelligence systems, business transformation services, defense program acquisition management services, training and performance support systems and services, automated case management systems and IT infrastructure services.

Business Intelligence

      DRC provides business intelligence systems and solutions that help end users make sense of the intelligence buried in their data systems, giving them the actionable information needed to make critical decisions and continuously improve organizational performance. The company’s Capability Maturity Model (“CMM”) Level 3 and Capability Maturity Model Integration (“CMMI”) Level 2 ratings reflect our dedication to continuous improvement. Developed by the Software Engineering Institute, CMM and CMMI are internationally recognized measures to determine the level of maturity of software development processes in an organization.

Business Transformation

      DRC provides its customers with a comprehensive set of services and tools to support rapidly transforming organizations and to significantly improve their organizational performance.

Acquisition Management

      DRC offers a complete set of business, financial, engineering and logistic services to support the acquisition and management of complex systems throughout their life cycle.

Training and Performance Support

      DRC works with its customers to develop flexible, interactive training and support products to enhance performance on mission-essential operations.

Automated Case Management

      DRC’s automated case management solutions combine technology, training and performance support and business transformation tools to increase organizational efficiency and provide better services to our customers and their clients.

IT Infrastructure Services

      DRC provides a full range of services to support the design, development, installation, operation and management of large complex networks and other critical IT infrastructures.

Precision Manufacturing

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

BUSINESS DEVELOPMENT

      The company believes it has a well-established record of winning contract renewals and re-competitions based on the company’s line management knowledge of customer needs and DRC’s incumbent expertise.

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

GOVERNMENT CONTRACTS

      The federal procurement process has changed significantly in recent years. 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 information technology and technical services. These vehicles have enabled contracting officers to accelerate the pace of awards.

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

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

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

BACKLOG

      The company’s funded backlog was $165.0 million at December 31, 2004, $123.9 million at December 31, 2003 and $111.1 million at December 31, 2002. The company expects that substantially all of its backlog at December 31, 2004 will generate revenue during the year ending December 31, 2005. The funded backlog generally is subject to possible termination at the convenience of the contracting party. The company has a number of multi-year contracts with agencies of the United States and state governments for which actual funding generally occurs on an annual basis. A portion of its funded backlog is based on annual purchase contracts and subject to annual governmental approval or appropriations legislation, and the amount of funded backlog as of any date can be affected by the timing of order receipts and deliveries.

COMPETITION

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

      The company also competes with the government services divisions of large commercial information technology service firms and with government information technology service divisions of large defense weapons systems producers. The competition varies depending on the customer, geographic market and required capabilities. The United States Government’s in-house capabilities are also, in effect, competitors, because various agencies are able to perform services, which might

otherwise be performed by the company. The principal competitive factors affecting the systems and services business are past performance, technical competence and price.

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

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.

GOVERNMENT REGULATION

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

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

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

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

EMPLOYEES

      At December 31, 2004, the company had 1,960 employees. The company considers its relationship with its employees to be satisfactory.

PROPRIETARY INFORMATION

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

      The company leases approximately 293,000 square feet of office and manufacturing space. This space is used for its federal and state government services and manufacturing operations as well as its marketing and engineering offices. The company has approximately 113,000 square feet of manufacturing and office space in three Wilmington, Massachusetts facilities. The company’s Metrigraphics segment utilizes a portion of this space for its activities. The Wilmington leases expire in 2005, with options to renew the leases to the year 2010. The remaining leased facilities consist of offices in 24 locations across the United States. The company owns a 135,000 square foot facility in Andover, Massachusetts, which serves as its corporate headquarters. The company has a mortgage, collateralized by this facility, with an outstanding balance of $7.8 million at December 31, 2004. The remaining facilities, as well as a portion of the corporate headquarters building, are used by the company’s Systems and Services segment. With the exception of approximately 50,000 square feet of

leased manufacturing space previously occupied by the divested Encoder Division, the company’s leased space is fully utilized in all material respects. The company believes that its owned and leased properties are adequate for its present needs.

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

      On October 9, 2003, the United States Attorney filed a civil complaint against the company in the United States District Court for the District of Massachusetts based in substantial part upon the actions and omissions of two former employees which gave rise to criminal cases against them. The United States Attorney seeks to recover up to three times its actual damages and penalties under the False Claims Act and double damages and penalties under the Anti-Kickback Act and to recover costs and interest. The company disputes the claims, believes it has substantive defenses, and intends to vigorously defend itself. However, the outcome of such litigation, if unfavorable, could have a material adverse effect on the company’s business, financial position, results of operations and cash flows. The company and the United States Attorney have agreed to non-binding mediation of this matter.

      In 2002, a dispute arose between Genesis Tactical Group LLC (“Genesis”), Lockheed Martin Corporation (“Lockheed”) and DRC related to a contract for services to Lockheed which DRC sold to Genesis in 2001. In the first quarter of 2005, Genesis, Lockheed and the company settled the outstanding issues related to this dispute. The settlement did not have a material effect on the company’s business, financial position, results of operations or cash flows.

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

      During the quarter ended December 31, 2004, no matters were submitted to a vote of security holders through the solicitation of proxies or otherwise.

Executive Officers of the Registrant

      The following is a list of the names and ages of the executive officers of the company, all positions and offices held by each person and each person’s principal occupations or employment during the past five years. The officers were elected by the Board of Directors and will hold office until the next annual election of officers and their successors are elected and

qualified, or until their earlier resignation or removal by the Board of Directors. There are no family relationships between any executive officers and directors.

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

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

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

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

      Mr. Wentzell joined the company as Senior Vice President and General Manager, Human Resources, in October 2004. Prior to joining DRC, Mr. Wentzell was Senior Vice President of Human Resources for Brooks Automation, Inc., from 2002 to 2004, following its acquisition of PRI Automation, Inc., where Mr. Wentzell served as Corporate Vice President for Human Resources from 1997 through the acquisition. Prior to that, Mr. Wentzell served as the Corporate Vice President of Human Resources for Dialogic Corporation from 1993 through 1997.

PART II

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

Number of Holders

      As of January 7, 2005, there were 635 holders of record of the company’s common stock.

Dividend Policy

      In September 1984, the company’s Board of Directors voted not to declare cash dividends to preserve cash for the future growth and development of the company. The company did not declare any cash dividends between 1984 and 2004 and does not intend to in the near future. In addition, the company’s financing arrangements restrict the company’s ability to pay dividends, as described in Liquidity and Capital Resources in Part II, Item 7 of this Annual Report on Form 10-K and in Note 11, “Financing Arrangements”, of the company’s Notes to Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K.

      The selected condensed consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included as Part II, Item 7 of this Annual Report

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

FORWARD-LOOKING STATEMENTS

      Certain statements in this Annual Report on Form 10-K constitute “forward-looking statements” which involve known risks, uncertainties and other factors which may cause the actual results, performance or achievements of Dynamics Research Corporation (“DRC” or the “company”) to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include the “Factors That May Affect Future Results” set forth in this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Precautionary statements made herein should be read as being applicable to all related forward-looking statements whenever they appear in this report.

OVERVIEW

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

      The company’s strategy is comprised of four key objectives: (a) to increase shareholder value; (b) to grow revenues in selected markets; (c) to achieve operational excellence; and (d) to be an employer of choice. Operating margin and cash generation improvement initiatives support the company’s shareholder value objective. DRC has a balanced growth strategy aimed at organic growth in its existing markets and penetrating new market segments through acquisition. The company has made three business acquisitions since 2002. The company’s initiatives related to its employer of choice objective include professional development programs, performance-based compensation programs and competitive benefit programs.

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

      The company’s business growth strategy is focused on three national priority markets: national defense, public safety and legislated citizen services. Within these markets there are six strategic business areas on which the company focuses its efforts: C4ISR (Command, control, communications, computing, intelligence, surveillance and reconnaissance), logistics, readiness, military space, public security and citizen services. Because these markets address the mission critical functions of government, the company expects that they will be funded regardless of economic cycle. The strategy leverages six solution sets where DRC has strong competencies and a record of meeting its customers’ most difficult challenges. These repeatable, proven, cost-effective solutions are acquisition management services, training and performance support, business transformation, business intelligence, IT infrastructure services and automated case management.

      On July 1, 2004, the company announced that it had sharpened its government focus by consolidating and realigning its operations to better facilitate the execution of its recently developed business growth strategy, better address the needs of its customers and further strengthen the delivery of its solutions-based services. Accordingly, effective July 1, 2004, the company consolidated its five Systems and Services segment operating groups into two organizations. The two new organizations encompass all of the capabilities of the five former groups. This realignment did not impact the company’s business segments, as the new groups both provide solutions-based services and are subject to similar regulations.

ACQUISITIONS

      The company has completed three business acquisitions since 2002: Impact Innovations LLC (“Impact Innovations”) on September 1, 2004, Andrulis Corporation (“ANDRULIS”) on December 20, 2002, and HJ Ford Associates, Inc. (“HJ

Ford”) on May 31, 2002. The results of these acquired entities are included in the company’s Consolidated Statements of Operations, Consolidated Statements of Changes in Stockholders Equity and Comprehensive Income (Loss) and Consolidated Statements of Cash Flows for the periods subsequent to their respective acquisitions.

DISCONTINUED OPERATIONS

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

CRITICAL ACCOUNTING POLICIES

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

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

Revenue Recognition

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

      For time and materials contracts, revenue reflects the number of direct labor hours expended in the performance of a contract multiplied by the contract billing rate, as well as reimbursement of other billable direct costs. The risk inherent in time and materials contracts is that actual costs may 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 primarily under the percentage of completion method or, for certain short-term contracts, by the completed contract method, in accordance with American Institute of Certified Public Accountants Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (“SOP 81-1”).

      Revenue from service-type fixed-price contracts is recognized ratably over the contract period or by other appropriate output methods to measure service provided, and contract costs are expensed as incurred. The risk to the company related to a fixed price contract is that if estimates to complete the contract change from one period to the next, profit levels will vary from period to period.

      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. Generally, 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, or delayed for other reasons. Costs related to United States Government contracts, including applicable indirect costs, are subject to audit by the government. Revenue from such contracts has been

recorded at amounts the company expects to realize upon final settlement. Unbilled expenditures and fees also include subcontractor costs for which invoices have not been received and for which revenues have not been recognized.

Valuation Allowances

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

Intangible and Other Long-lived Assets

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

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

Goodwill

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

Business Combinations

      Since 2002, the company has completed three business acquisitions. The company determines and records the fair values of assets acquired and liabilities assumed as of the dates of acquisition. The company utilizes an independent valuation specialist to determine the fair values of identifiable intangible assets acquired in order to allocate a portion of the purchase price to these assets.

Deferred Taxes

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

Pensions

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

RESULTS OF OPERATIONS

      Operating results expressed as a percentage of total revenues for the years ended December 31, 2004, 2003 and 2002 are as follows:

Revenue

      The company reported revenues of $275.7 million, $244.8 million and $192.6 million in 2004, 2003 and 2002, respectively. These revenues represent an increase from the respective prior year of 12.6% in 2004 and 27.1% in 2003.

Contract revenues

      Contract revenues in the company’s Systems and Services segment were $268.6 million in 2004, $237.9 million in 2003 and $185.0 million in 2002. The increase in the current year was attributable to organic growth of 6.2% and $16.1 million of revenues added through acquisition. In 2004, organic growth was reduced by the completion in 2003 of the company’s quality assurance work at the Homeland Security Bureau of Citizenship and Immigration Services, which had contributed $8.1 million to revenues during 2003. The increase in revenues in 2003 compared to 2002 was primarily attributable to the addition of approximately $54 million in revenues through acquisitions. In 2003, revenues grew on an organic basis by approximately 2.1%. Reductions in subcontractor pass-through revenue with the Air Force Electronic Systems Center and in Navy Strategic Systems guidance work reduced 2003 revenues in the aggregate by an estimated $9 million, or 3.8%.

      Revenues from defense and intelligence agencies in 2004, 2003 and 2002 were $215.4 million, $191.7 million and $154.2 million, respectively. The increase in 2004 from 2003 was primarily attributable to internally generated growth, primarily in the C4ISR (Command, control, communications, computing, intelligence, surveillance and reconnaissance), readiness and logistics markets. The increase in 2003 from 2002 was primarily attributable to the company’s acquisitions, coupled with organic growth of the company’s core business. The 2003 increase was net of the $9 million reduction in subcontractor pass-through revenues and Navy Strategic Systems guidance work discussed above.

      Revenues from federal civilian agencies were $31.3 million, $35.2 million and $17.8 million in 2004, 2003 and 2002, respectively. The decrease in 2004 compared to 2003 was primarily due to the completion late in 2003 of the company’s quality assurance work at the Homeland Security Bureau of Citizenship and Immigration Services, which accounted for $8.1 million of revenue in 2003, partially offset by $16.1 million of revenues added through acquisition. Revenues for this sector virtually doubled in 2003, compared to the prior year, primarily as a result of the acquisitions discussed above.

      Revenues from state and local government agencies were $20.3 million in 2004, $11.0 million in 2003 and $12.9 million in 2002. In May 2004, the company announced that it had signed a fixed price contract with the state of Ohio for $30 million to design, develop and install an automated child welfare case management system. Revenues for 2004 under this three and one-half year contract were approximately $8 million. This new contract, coupled with higher revenues in 2004 from training and network management services with health and human services customers, accounted for the increase in state and local government revenues in 2004. The reduction in state and local revenues in 2003 from the prior year was primarily the result of significant state spending cutbacks in response to state budget deficits during 2003.

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

      The company’s contracts with the Internal Revenue Service, the Air Force Electronic Systems Center and the Aeronautical Systems Center, which provided approximately $12 million, $31 million and $47 million, respectively, of revenues in 2004, are subject to re-competition in 2005. The company has submitted a proposal for a prime contract with the Internal Revenue Service. It is currently anticipated that the 2005 competitions with the Air Force Electronic Systems Center and the Aeronautical Systems Center will restrict prime contract awards to small businesses. DRC expects to participate in the competitions as a sub-contractor to qualified small businesses.

Product sales

      Product sales for the Metrigraphics segment were $7.1 million, $6.9 million and $7.6 million the years ended December 31, 2004, 2003 and 2002, respectively. The slight increase in 2004 from 2003, compared to the decrease in 2003 from 2002, is due in part to an overall improvement in order levels and a strengthening in the segment’s market in the recent periods.

Funded backlog

      The company’s funded backlog was $165.0 million at December 31, 2004, $123.9 million at December 31, 2003 and $111.1 million at December 31, 2002. Included in the company’s funded backlog at December 31, 2004, was $30.9 million of funded backlog attributable to Impact Innovations. The company expects that substantially all of its backlog at December 31, 2004, will generate revenue during the year ended December 31, 2005. In 2003, ANDRULIS and HJ Ford contributed significantly to the increase in backlog, coupled with organic growth of the company’s core business. The funded backlog generally is subject to possible termination at the convenience of the contracting counter party. A portion of the company’s backlog is based on annual purchase contracts and subject to annual governmental approvals or appropriations legislation. The amount of backlog as of any date may be affected by the timing of order receipts and associated deliveries.

Gross profit and margin

      Total gross margin was 15.6%, 16.4% and 16.1% for 2004, 2003 and 2002, respectively. Gross margin on contract revenues was 15.3%, 16.1% and 15.4% for 2003, 2003 and 2002, respectively. In 2004, the portion of the company’s revenues derived from prime contracts increased by five percentage points. Related to this shift, the portion of revenues generated through sub-contractors and other direct costs, which contribute lower margins than DRC’s labor-generated revenues, increased by two percentage points. Amortization and maintenance expense related to the implementation of the company’s new PeopleSoft-based enterprise business system, which was placed into service on January 1, 2004, was also a factor in this segment’s lower gross margin in 2004. These factors were partially offset by efficiencies realized from the

integration of the company’s earlier acquisitions into the company’s operations, primarily through facility consolidation and lower overhead as a percentage of revenues.

      The improved performance in 2003 was attributable to efficiencies realized from the integration of the recent acquisitions into the company’s operations, contract mix and lower overhead costs as a percentage of revenues.

      The company’s product sales gross margin was virtually flat in 2004 compared to 2003, and is indicative of the improvement in the sector in which the company’s Metrigraphics segment operates, as also evidenced in the slight increase in product sales in 2004, discussed above and compared to 2003 decline from 2002. This decline was attributable to decreased product sales in 2003 compared to the prior year, a result of continued weak economic conditions and customer product life cycle shifts, partially offset by cost reductions.

Selling, general and administrative expenses

      Selling, general and administrative expenses were $23.2 million in 2004, $22.9 million in 2003 and $17.9 million in 2002. The increase in 2004 compared to 2003 was primarily attributable to higher personnel costs related to increased staffing levels. The overall increase in 2003 was in part attributable to the absorption of general and administrative expenses of the company’s acquisitions. Higher employee benefit costs also contributed to the increase in selling, general and administrative costs in 2003. Legal expenses related to the U.S. Attorney’s civil complaint and antitrust investigation totaled $0.8 million in 2004 and $0.7 million in both 2003 and 2002.

      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. The remaining accrual of $0.2 million at December 31, 2002 was paid in the first half of 2003.

Amortization of intangible assets

      Amortization expense of $2.3 million, $1.7 million and $0.4 million in 2004, 2003 and 2002, respectively, reflects the amortization of identifiable intangible assets associated with the company’s business acquisitions. As a result of the acquisition of Impact Innovations on September 1, 2004, the company anticipates amortization expense for intangible assets will approximate $3 million in 2005.

Operating income

      Operating income for the Systems and Services segment was $17.4 million in 2004, compared to $14.8 million in 2003, and $11.5 million in 2002. Operating income for the Metrigraphics segment was $0.1 million in 2004, compared to $0.6 million in 2003, and $1.1 million in 2002. Segment operating income for each segment includes amortization of intangible assets and selling, engineering and administrative expenses directly attributable to the segment. All corporate operating expenses are allocated between the segments based on segment revenues, including depreciation.

      The company’s operating income was $17.5 million, $15.4 million, and $12.6 million in 2004, 2003 and 2002, respectively. The increase in operating margin in the current year, compared to 2003, is primarily attributable to higher gross profit resulting from the company’s higher revenue in 2004. These amounts were partially offset by increased amortization of the company’s acquired intangible assets. The decrease in operating margin in 2003, compared to 2002, is primarily attributable to higher selling, general and administrative expenses, coupled with amortization expense for the company’s acquired intangible assets.

Interest income and expense

      The company incurred interest expense totaling $2.3 million in 2004, $0.9 million in 2003 and $0.6 million in 2002. The increase in interest expense in 2004 is primarily attributable to the acquisition loan used to fund the September 1, 2004 acquisition of Impact Innovations, coupled with interest on the outstanding balance of the company’s revolving credit facility and mortgage on its Andover, Massachusetts corporate headquarters facility. Interest expense in 2003 and 2002 relates primarily to the outstanding balances on the company’s revolving credit facility and the mortgage on the corporate headquarters facility. The company recorded $60,000, $27,000 and $0.2 million of interest income in 2004, 2003 and 2002, respectively. The interest rates on the company’s current financing vehicles are variable. These vehicles are described

in detail in the “Liquidity and Capital Resources” section below. The weighted average interest rates on the company’s outstanding borrowings were 5.36%, 3.16% and 3.96% at December 2004, 2003 and 2002, respectively. An increase of one percentage point in the company’s rates would result in approximately $0.7 million of additional interest expense on an annual basis.

Other income and expense

      The company reported $0.4 million and $0.5 million of net other income in 2004 and 2003, respectively, including $0.1 million and $0.2 million which is attributable to gains on the company’s deferred compensation plan investments. The company reported other income of $0.1 million in 2002.

Income taxes

      Income tax expense was recorded at rates of 40.1% in 2004, 42.3% in 2003, and 40.2% in 2002. The increase in 2003 was due to amortization of acquired intangible assets that is not deductible for income tax purposes. These rates reflect the statutory federal rate of 34%, combined with an average state income tax rate, net of federal income tax benefit.

Discontinued operations

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

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

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

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

Shares used in computing earnings (loss) per share

      Weighted average common shares outstanding and common equivalent shares totaled 9.1 million, 8.8 million and 8.9 million at December 31, 2004, 2003 and 2002, respectively. The increase in 2004 from 2003 is primarily attributable to 0.3 million additional shares issued and outstanding in 2004. The slight decrease in 2003 from 2002 is primarily attributable to a reduction in the 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.

LIQUIDITY AND CAPITAL RESOURCES

      At December 31, 2004 and 2003, the company had cash and cash equivalents aggregating $0.9 million and $2.7 million, respectively. The decrease in cash and cash equivalents is primarily the result of $60.7 million of cash used in

investing activities, including $54.0 million related to the acquisition of Impact Innovations. This amount was partially offset by $55.7 million of cash provided by financing activities, including $55.0 million of cash proceeds from borrowings used to fund the aforementioned acquisition of Impact Innovations, and $3.2 million of cash provided by operating activities, including $0.8 million used in discontinued operations.

Operating Activities

      Cash provided by operating activities was $3.2 million, and is primarily attributable to $9.4 million of income from continuing operations, depreciation and amortization expenses aggregating $5.9 million, and increases in accounts payable and deferred income taxes of $8.5 million and $7.7 million, respectively. These amounts were partially offset by increases of $7.6 million in accounts receivable, $17.1 million in unbilled expenditures and fees on contracts in process, and $3.3 million in prepaid expenses and other current assets. The company used $0.8 million of cash for discontinued operations, primarily for lease liabilities related to the divestiture of the Encoder business.

      Stock compensation expense increased to $0.5 million for 2004, from $0.2 million in 2003 and $0.1 million in 2002. The company has realigned its approach to equity compensation by increasing its use of restricted stock awards and reducing its use of stock option awards. As a result, higher non-cash expense was recorded in 2004 and will continue to be recorded in subsequent periods.

      Non-cash amortization expense of the company’s acquired intangible assets was $2.3 million in 2004, $1.7 million in 2003 and $0.4 million in 2002. As a result of the company’s recent business acquisition, the company anticipates non-cash expense for the amortization of intangible assets to increase to approximately $3 million in 2005.

      Increases in deferred income taxes were $7.7 million in 2004, $2.7 million in 2003 and $0.3 million in 2002. These increases relate primarily to higher unbilled receivables and the deferral of income taxes thereon. At the end of 2004, deferred taxes on unbilled receivables totaled $17.4 million. Concurrent with an ongoing audit of the company’s 2003 and 2002 federal income tax returns, the Internal Revenue Service (“IRS”) has challenged the deferral of income for tax purposes related to the company’s unbilled accounts receivable (which is reported under the caption “Unbilled expenditures and fees on contracts in process” in the company’s Consolidated Balance Sheets), including the applicability of a Letter Ruling issued by the IRS to the company in January 1976, which granted the company deferred tax treatment of its unbilled receivables. While the outcome of the audit is not known, it is possible that the company’s deferred tax liabilities would be reduced and income tax payments would be increased substantially in 2005 and beyond. The company anticipates that 2005 payments will be offset by $3.8 million of refundable income taxes which are included in Prepaid expenses and other current assets at December 31, 2004, and are the primary source of cash from prepaid expenses in 2004.

      Total accounts receivable, billed and unbilled, were $96.3 million and $62.5 million at December 31, 2004 and 2003, respectively. Receivables days sales outstanding, or DSO, was 111 at December 31, 2004, compared to 89 at December 31, 2003. These amounts include amounts reported under the captions “Accounts receivable, net of allowances” and “Unbilled expenditures and fees on contracts in process.”

      In the fourth quarter of 2004, the company encountered collection delays with U.S. Defense Finance and Accounting Services and the General Services Administration totaling approximately $7 million, or 8 days sales outstanding. The company previously submitted invoices to these agencies, but due to technical problems at the agencies, the agencies requested that the company resubmit the invoices. A portion of these outstanding amounts has been collected, and the company is diligently supporting the customers’ requirements to ensure payment on the balances. Upon collection of the remainder of these amounts, the company expects that its days sales outstanding on its billed accounts receivable will decrease to the company’s historical range of 40 to 45 days. The company has no indication of concerns of collectibility of these or any of its other outstanding invoices.

      The December 31, 2004 unbilled receivables balance includes $8.2 million related to the company’s contract with the State of Ohio. Under the current terms of the contract, invoicing does not begin until 2005 in accordance with anticipated completion of contract milestones. This amount represents approximately 10 days sales outstanding of the company’s 111 days at December 31, 2004.

      Accounts payable increased by $8.5 million in 2004. Approximately $4 million of this increase relates to subcontractor costs for the Ohio contract which will be paid when the company receives payment from the State of Ohio.

Investing Activities

      The company used $60.7 million of cash in investing activities, principally comprised of $54.0 million related to the acquisition of Impact Innovations and $4.5 million for capital expenditures. The company used the proceeds from its acquisition loan, described below, to pay the consideration for Impact Innovations. The company believes that selective acquisitions are an important component of its 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 will continue to consider acquisition opportunities that align with its strategic objectives, along with the possibility of utilizing the credit facility as a source of financing.

      The company’s capital expenditures in 2004 were primarily comprised of $1.7 million related to the implementation of the company’s new PeopleSoft-based enterprise business system and $1.4 million for facility renovation costs for its corporate headquarters in Andover, Massachusetts. The company’s capital expenditures, excluding business acquisitions, are expected to approximate $5 to $6 million in 2005, primarily for facilities infrastructure consolidation and improvements.

Financing Activities

      Cash provided by financing activities was comprised of $55.0 million from the company’s new acquisition term loan, described below, $1.5 million of net borrowings under the company’s revolver and $2.6 million of cash proceeds from the exercise of stock options and issuance of shares under the employee stock purchase plan. As discussed above, the company entered into a new financing arrangement, of which $55.0 million was related to the acquisition of Impact Innovations. The company repaid $1.6 million of the principal borrowed immediately after the initial consideration paid for Impact Innovations was reduced to $53.4 million. The company’s proceeds from financing activities were partially offset by $2.9 million of acquisition term loan principal payments, including the $1.6 million of principal repaid immediately as discussed above and $0.5 million of principal payments under the company’s term loan.

      On September 1, 2004, the company entered into a new secured financing agreement (the “facility”) with a bank group to restructure and increase the company’s credit facilities to $100.0 million, including the current mortgage financing on the company’s Andover, Massachusetts corporate headquarters, which had a balance of $7.9 million at closing (the “term loan”). The facility provides for a $55.0 million, five-year term loan (the “acquisition term loan”) with a seven-year amortization schedule for the acquisition of Impact Innovations and a $37.0 million, five-year revolving credit agreement for working capital (the “revolver”). The bank group, led by Brown Brothers Harriman & Co. as a lender and as administrative agent (when acting such capacity, the “Administrative Agent”), also includes KeyBank National Association, Banknorth, NA and Fleet National Bank, a Bank of America company. The facility replaces the company’s previous $50.0 million revolving credit agreement, which was entered into on June 28, 2002.

      The company used $53.4 million of the $55.0 million of proceeds from the acquisition term loan to complete the acquisition of Impact Innovations. The company repaid $1.6 million of the $55.0 million financed on September 1, 2004. The facility requires quarterly principal payments of approximately $2 million on the acquisition term loan, with a final payment of approximately $16 million on September 1, 2009. At December 31, 2004, the outstanding principal balance on the acquisition term loan was $52.1 million.

      The company has a ten-year term loan as amended and restated on September 1, 2004, with an outstanding balance of $7.8 million, which is secured by a mortgage on the company’s headquarters in Andover, Massachusetts. The agreement requires quarterly principal payments of $125,000, with a final payment of $5.0 million due on May 1, 2010.

      The revolver has a five-year term and is available to the company for general corporate purposes, including strategic acquisitions. The fee on the unused portion of the revolver ranges from 0.25% to 0.50%, depending on the company’s leverage ratio, and is payable quarterly in arrears.

      All of the obligations of the company and its subsidiaries under the new facility are secured by a security interest in substantially all of the assets of the company and its subsidiaries granted to the Administrative Agent. The agreement requires financial covenant tests to be performed against the company’s annual results beginning with the results for the year ended December 31, 2005, that, if met, would result in the release of all collateral securing the facility except for the mortgage that secures the term loan. If the company’s results do not meet specific financial ratio requirements, the company and its subsidiaries will be required to perfect the security interest granted to the Administrative Agent in all of the government contracts of the company and its subsidiaries.

      On an ongoing basis, the facility requires the company to meet certain financial covenants, including maintaining a minimum net worth and certain cash flow and debt coverage ratios. The covenants also limit the company’s ability to incur additional debt, pay dividends, purchase capital assets, sell or dispose of assets, make additional acquisitions or investments, or enter into new leases, among other restrictions. In addition, the facility provides that the bank group may accelerate payment of all unpaid principal and all accrued and unpaid interest under the facility, upon the occurrence and continuance of certain events of default, including, among others, the following:

      In addition to the principal payments required on the acquisition term loan and the term loan, the company will also make annual payments by February 15 of each year, commending in 2006. The payment amount will be equal to 50.0% of the company’s excess cash flow, defined as EBITDA (earnings before interest, taxes, depreciation and amortization) plus net decreases in working capital or less net increases in working capital, minus interest expense and principal payments on the acquisition term loan and term loan, capital expenditures, and all cash taxes and cash dividends paid for the most recently completed fiscal year, commencing with the year ended December 31, 2005. Each payment will be applied: first, to the outstanding balance of the revolver, provided the outstanding balance on the last day of the fiscal year compared with the outstanding balance of the revolver on the last day of the previous fiscal year does not already reflect such a reduction; second, to the outstanding principal balance of the acquisition term loan; and lastly, to the outstanding principal balance of the term loan.

      The company’s results of operations, cash flows and financial condition are subject to certain trends, events and uncertainties, including demands for capital to support growth, economic conditions, government payment practices and contractual matters. The company’s need for, cost of and access to funds are dependent on future operating results, the company’s growth and acquisition activity, and conditions external to the company.

      Based upon its present business plan and operating performance, the company believes that cash provided by operating activities, combined with amounts available for borrowing under the revolver, will be adequate to fund the capital requirements of its existing operations during 2005 and for the foreseeable future. In the event that the company’s current capital resources are not sufficient to fund requirements, the company believes its access to additional capital resources would be sufficient to meet its needs. However, the development of adverse economic or business conditions could significantly affect the need for and availability of capital resources.

Commitments

      The company’s contractual obligations as of December 31, 2004 consist of the following (in thousands):

      The amounts above related to the revolver and long-term debt do not include interest payments on any outstanding principal balance, because the interest rates on the company’s financing arrangements are not fixed. Additionally, the amounts above exclude the effect on the schedule of payments of the application of any annual February 15 payments, as described above, to the outstanding principal balances of either the acquisition term loan or the term loan (reported under the caption “Long-term debt” in the table above), as these amounts are not fixed.

      The amounts above related to operating leases include payments on facilities that the company either no longer occupies or is in the process of abandoning, for which the company is contractually obligated.

      The company currently expects to contribute $4.4 million in 2005 to fund its pension plan. This amount is not included in the table above.

Contingencies

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

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

      On October 9, 2003, the United States Attorney filed a civil complaint against the company in the United States District Court for the District of Massachusetts based in substantial part upon the actions and omissions of two former employees which gave rise to criminal cases against them. The United States Attorney seeks to recover up to three times its actual damages and penalties under the False Claims Act and double damages and penalties under the Anti-Kickback Act and to recover costs and interest. The company disputes the claims, believes it has substantive defenses, and intends to vigorously defend itself. However, the outcome of such litigation, if unfavorable, could have a material adverse effect on the company’s business, financial position, results of operations and cash flows. The company and the United States Attorney have agreed to non-binding mediation of this matter.

      In 2002, a dispute arose between Genesis Tactical Group LLC (“Genesis”), Lockheed Martin Corporation (“Lockheed”) and DRC related to a contract for services to Lockheed which DRC sold to Genesis in 2001. In the first quarter of 2005, Genesis, Lockheed and the company settled the outstanding issues related to this dispute. The settlement did not have a material effect on the company’s business, financial position, results of operations or cash flows.

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

NEW ACCOUNTING PRONOUNCEMENTS

      In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payments (“SFAS 123R”). SFAS 123R replaces SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), and supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”). Under SFAS 123R, companies will be required to recognize compensation costs related to share-based payment transactions to employees in their financial statements. The amount of compensation cost will be measured using the grant-date fair value of the equity or liability instruments issued. Additionally, liability awards will be re-measured each reporting period. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. The company is required to adopt the new standard in its third quarter of 2005. The company historically has disclosed the pro forma effect of expensing its stock options as prescribed by SFAS 123. The company is evaluating the different alternatives available for applying the provisions of SFAS 123R and is currently assessing their effects on its financial position and results of operations.

      In December 2004, the FASB issued FASB Staff Position (“FSP”) SFAS No. 109-1, Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (“FSP SFAS 109-1”). FAS SFAS 109-1 provides guidance on the application of SFAS No. 109, Accounting for Income Taxes (“SFAS 109”), to the provision within the American Jobs Creation Act of 2004 (the “Act”) that provides tax relief to U.S. domestic manufacturers. FSP SFAS 109-1 states that the manufacturer’s deduction provided for under the Act should be accounted for as a special deduction in accordance with SFAS 109 and not as a tax rate reduction. A special deduction is accounted for by recording the benefit of the deduction in the year in which it can be taken in the company’s tax return, and by not adjusting deferred tax assets and liabilities in the period of the Act’s enactment. FSP SFAS 109-1 was effective upon issuance. The adoption of FSP SFAS 109-1 did not have a material effect on the company’s financial position and results of operations. Further, the company does not believe the adoption of FSP SFAS 109-1 will have a material effect on its federal income tax returns.

      In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4 (“SFAS 151”). SFAS 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material by requiring that these items be recognized as current period charges regardless of whether they meet the “so abnormal” criterion outlined in ARB 43. The company is required to adopt the new standard in its third quarter of 2005. The company is currently assessing the impact of this new standard on its financial position and results of operations; however, the company does not believe the adoption of SFAS 151 will have a material effect on its financial position, results of operations or cash flows.

IMPACT OF INFLATION AND CHANGING PRICES

      Overall, inflation has not had a material impact on the company’s operations. Additionally, the terms of Department of Defense contracts, which accounted for approximately 78% of revenue in 2004, are generally one year contracts and include salary increase factors for future years, thus reducing the potential impact of inflation on the company.

FACTORS THAT MAY AFFECT FUTURE RESULTS

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

Our Revenue is Highly Concentrated on the Department of Defense and Other Federal Agencies, and A Significant Portion of Our Revenue is Derived From a Few Customers. Decreases in Their Budgets, Changes in Program Priorities or Military Base Closures Could Affect Our Results.

      In the years ended December 31, 2004 and 2003, approximately 89% and 93% of our revenue, respectively, was derived from United States government agencies. Within the Department of Defense, certain programs account for a significant portion of our United States Government business. Our revenue from contracts with the Department of Defense, either as a prime contractor or subcontractor, accounted for approximately 78% of our total revenue in both 2004 and 2003. We cannot provide any assurance that any of these programs will continue as such or will continue at current levels. Our revenue could be adversely affected by significant changes in defense spending during periods of declining United States

defense budgets. Among the effects of this general decline has been increased competition within a consolidating defense industry.

      Under procedures established by the Base Reduction and Closure Act, the Department of Defense has announced its intention to select in 2005 certain military bases for closure. In 2003, the Department of Defense published an initial list of bases from which it is expected the final selections will be made. Hanscom Air Force Base and other installations at which the company does business were included on the initial list for consideration. Should a base be selected for closure at which the company has significant business, the company’s business, financial condition, results of operations and cash flows could be adversely affected.

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

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

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

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

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

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

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

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

      Recent federal regulations and renewed congressional interest in small business set aside contracts is likely to influence decisions pertaining to contracting methods for many of the company’s customers. These regulations require more frequent review and certification of small business contractor status, so as the ensure that companies competing for contracts

intended for small business are qualified as such at the time of the competition. In the years ended December 31, 2004 and 2003, the company derived $43.6 million and $42.4 million, respectively, of revenue from a small business set aside contract held by its HJ Ford subsidiary and due for re-competition in 2005. The customer has currently indicated that the re-competition will continue to be set aside, or reserved, to include only prime contractors that qualify as small businesses under regulations established by the Small Business Administration. The company will strive to retain its current work by moving work to other contract vehicles to the extent possible and by partnering with firms that will qualify as small businesses. To the extent these efforts are not successful, the company’s business, financial condition, results of operations and cash flows could be adversely affected.

      The company’s contracts with the Internal Revenue Service, Air Force Electronic Systems Center and Aeronautical Systems Center are subject to re-competition in 2005.

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

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

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

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

Loss of Key Personnel Could Limit Our Growth.

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

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

      Some government contracts require us to maintain facility security clearances, and require some of our employees to maintain individual security clearances. If our employees lose or are unable to obtain security clearances on a timely basis, or we lose a facility clearance, the government client can terminate the contract or decide not to renew the contract upon its expiration. As a result, to the extent that we cannot obtain the required security clearances for our employees working on a

particular contract, or we fail to obtain them on a timely basis, we may not derive the revenue anticipated from the contract, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Security Breaches in Sensitive Government Systems Could Harm Our Business.

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

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

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

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

      On October 26, 2000, two former company employees were indicted and charged with conspiracy to defraud the United States, and wire fraud, among other charges, arising out of a scheme to defraud the United States out of approximately $10 million. Both men subsequently pled guilty to the principal charges against them. On October 9, 2003, the United States Attorney’s office filed a civil complaint in the District Court of Massachusetts against the company based in substantial part upon the actions and omissions of the former executives that gave rise to the criminal cases against them. In the civil action, the United States is asserting claims against the company based on the False Claims Act and the Anti-Kickback Act, in addition to certain common law and equitable claims. The United States seeks to recover up to three times its actual damages and penalties under the False Claims Act, and double damages and penalties under the Anti-Kickback Act. The United States also seeks to recover its costs and interest in this action. The company believes it has substantive defenses to these claims and intends to vigorously defend itself. However, the outcome of this litigation and other proceedings to which the company is a part, if unfavorable, could have a material adverse effect on the company’s business, financial position, results of operations and cash flows.

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

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

      In March 2004, our management and Audit Committee were notified by our independent accountants, Grant Thornton LLP, of two significant deficiencies in our internal controls and procedures regarding, first, the accrual of subcontractor work performed and, second, our manually intensive financial reporting process. In 2003, our management and Audit Committee were notified by our then engaged independent accountants, KPMG LLP, of three significant deficiencies relating to contract initiation and set-up for certain fixed price contracts, inefficiencies in our quarterly and year-end closing procedures and consolidation and the level of SEC and generally accepted accounting principles, or GAAP, experience of our personnel responsible for accounting and financial reporting. Although we are committed to addressing these deficiencies, we cannot assure you that we will be able to successfully implement the revised controls and procedures or that our revised controls

and procedures will be effective in remedying all of the identified significant deficiencies. Our inability to successfully eliminate these significant deficiencies could have a material adverse effect on our business, financial condition, results of operations and cash flows. Our auditors are completing their work relating to the preparation and delivery of their attestation report on our management’s assessment of our internal control over financial reporting. The outcome of that work could impact the matters reported in this Form 10-K and require amendment of this Form 10-K. Moreover, this Form 10-K is incomplete until the time the auditor reports and consents discussed on the cover page to this Form 10-K and amendments to Item 9A of Part II of this Form 10-K are included in an amendment filed on Form 10-K/ A. If this Annual Report on Form 10-K is not so amended or completed by March 31, 2005, we will not be current in our SEC filings.

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

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

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

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

We May Be Subject to Product Liability Claims.

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

Economic Events May Affect Our Business Segments.

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

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

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

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

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

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

      In 2004, we installed a new enterprise business system, and from time to time, we may be required to make changes to that system as we integrate businesses or upgrade to new technologies. Future accounting system conversions and upgrades could cause delays in billing and collection of accounts receivable under our contracts, which could adversely affect our business, financial condition, results of operations and cash flows.

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 2004, we acquired Impact Innovations Group LLC, and in 2002, we acquired HJ Ford Associates, Inc. and Andrulis Corporation. We may seek to continue to expand our operations through mergers, acquisitions or strategic alliances with businesses that will complement our existing business. However, we may not be able to find attractive candidates, or enter into acquisitions on terms that are favorable to us, or successfully integrate the operations of companies that we acquire. In addition, we may compete with other companies for these acquisition candidates, which could make an acquisition more expensive for us. If we are able to successfully identify and complete an acquisition or similar transaction, it could involve a number of risks, including, among others:

      We cannot assure you that any acquisition will be made, that we will be able to obtain financing needed to fund such acquisitions and, if any acquisitions are so made, that the acquired business will be successfully integrated into our operations or that the acquired business will perform as expected. In addition, if we were to proceed with one or more

significant strategic alliances, acquisitions or investments in which the consideration consists of cash, a substantial portion of our available cash could be used to consummate the strategic alliances, acquisitions or investments. The financial impact of acquisitions, investments and strategic alliances could have a material adverse effect on our business, financial condition, results of operations and cash flows and could cause substantial fluctuations in our quarterly and annual operating results.

The Market Price of Our Common Stock May Be Volatile.

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

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

      The company is subject to interest rate risk associated with our acquisition term loan, term loan and revolver, where interest payments are tied to either the LIBOR or prime rate. The interest rate on the acquisition term loan was 5.41% at December 31, 2004, under the 90 day LIBOR Rate option elected on November 1, 2004. The interest rate on the term loan was 5.16% at December 31, 2004, under the 90 day LIBOR Rate option elected on November 1, 2004. The interest rate on the revolver was 5.28% at December 31, 2004, under the 30 day LIBOR Rate option elected on December 1, 2004. At any time, a sharp rise in interest rates could have an adverse effect on net interest expense as reported in the company’s Consolidated Statements of Operations. An increase of one full percentage point in the interest rate on the company’s acquisition term loan, term loan and revolver would result in increases in annual interest expense aggregating $0.7 million.

      The company presently has no investments, and, accordingly, no exposure to market interest rates on investments.

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

PART II

DYNAMICS RESEARCH CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

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

DYNAMICS RESEARCH CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except share and per share data)

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

DYNAMICS RESEARCH CORPORATION

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

(in thousands)

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

DYNAMICS RESEARCH CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

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

DYNAMICS RESEARCH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(INFORMATION SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

      Dynamics Research Corporation (“DRC” or the “company”), headquartered in Andover, Massachusetts, 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 approximately 1,960 employees located throughout the United States. The company operated through the parent corporation and its wholly owned subsidiaries, HJ Ford Associates, Inc. (“HJ Ford”), Andrulis Corporation (“ANDRULIS”) and Impact Innovations Group LLC (“Impact Innovations”) through December 31, 2004, at which time ANDRULIS and Impact Innovations merged with and into the company. Effective January 1, 2005, the company operates through the parent corporation and its wholly owned subsidiary, HJ Ford.

      DRC’s core capabilities are focused on information technology, engineering and technical subject matter expertise that pertain to the knowledge domains relevant to the company’s core customers. These capabilities include design, development, operation and maintenance of information technology systems, engineering services, complex logistics planning systems and services, defense program administrative support services, simulation, modeling, training systems and services, and custom built electronic test equipment and services.

Principles of Consolidation and Basis of Presentation

      The consolidated financial statements include the accounts of the company and all wholly owned subsidiaries. All significant intercompany accounts and transactions are eliminated.

      On September 1, 2004, the company completed the acquisition of Impact Innovations from J3 Technology Services Corp. (“J3 Technology”), a Georgia corporation. Impact Innovations, based in the Washington, D.C. area, offers solutions in business intelligence, enterprise software, application development, information technology service management and other related areas. This transaction was recorded using the purchase method of accounting in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations (“SFAS 141”). Accordingly, the results of this acquired entity are included in the company’s Consolidated Statements of Operations and of Cash Flows for the period subsequent to its acquisition.

      On December 20, 2002, the company completed the acquisition of all of the outstanding shares of capital stock of ANDRULIS, and on May 31, 2002, the company completed the acquisition of all of the outstanding voting common stock of HJ Ford. These transactions were recorded in accordance with SFAS 141. Accordingly, the results of these acquired entities are included in the company’s Consolidated Statements of Operations and of Cash Flows for the periods subsequent to their respective acquisitions.

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

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

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

DYNAMICS RESEARCH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(INFORMATION SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

Risks, Uncertainties and Use of Estimates

      There are business risks specific to the industries in which the company operates. These risks include, but are not limited to, estimates of costs to complete contract obligations, changes in government policies and procedures, government contracting issues and risks associated with technological development. The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Estimates and assumptions also affect the amount of revenue and expenses during the reported period. Management believes the most sensitive estimates include the allowance for uncollectible accounts receivable, recoverability of unbilled expenditures and fees on contracts in process, valuation allowance of deferred tax assets, assumptions made in business combinations and in the impairment analysis of goodwill and intangible assets, assumptions to estimate pension obligations and cost, estimates to complete on percentage-of-completion revenue recognition, costs billed to the government subject to audit and adjustments, provision for contract losses, and amounts and disclosures of contingent liabilities. Actual results could differ from those estimates.

Revenue Recognition

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

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

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

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

      The company does not recognize revenue associated with amounts claimed under a contract that are not agreed to by the customer. For all types of contracts, the company recognizes anticipated contract losses as soon as they become known and estimable. Out-of-pocket expenses that are reimbursable by the customer are included in contract revenue and cost of contract revenue.

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

Income Taxes

      The company accounts for income taxes using the asset and liability method in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS 109”), pursuant to which deferred income taxes are recognized based on temporary differences between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the

DYNAMICS RESEARCH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(INFORMATION SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

current year. Valuation allowances are provided if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

Cash and Cash Equivalents

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

Unbilled Expenditures and Fees on Contracts in Process

      Unbilled expenditures and fees on contracts in process include work in process which will be billed in accordance with contract terms and delivery schedules, as well as amounts billable upon final execution of contracts, contract completion, milestones or completion of rate negotiations. Generally, unbilled expenditures and fees on contracts in process are expected to be collected within one year. At December 31, 2004, the company was carrying approximately $4 million of working capital related to its child welfare systems contract with the State of Ohio. Under the current contract, approximately $1 million of the working capital would not be realized in 2005. The State of Ohio and the company have agreed to renegotiate to accelerate the payment terms of the contract. As a result, the company anticipates it will receive these amounts in 2005. Payments to the company for performance on certain United States Government contracts are subject to audit by the Defense Contract Audit Agency. Revenue has been recorded at amounts the company expects to realize upon final settlement.

Concentration of Risk

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

Inventories

      Inventories are stated at the lower of cost (first-in, first-out) or market, and consist of materials, labor and overhead. There are no amounts in inventories relating to contracts having production cycles longer than one year. Work-in-process, raw materials and subassemblies aggregated approximately $64,000 and $40,000 at December 31, 2004 and 2003, respectively.

Property, Plant and Equipment

      Property, plant and equipment are stated at cost. Plant and equipment are depreciated principally on the straight-line basis over their estimated useful lives. Useful lives for equipment range from three to ten years. The corporate office building has a useful life of 31 years. Leasehold improvements are amortized over the shorter of the remaining term of the lease or

DYNAMICS RESEARCH CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(INFORMATION SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

the life of the related asset. The components of Property, plant and equipment, net, in the Consolidated Balance Sheets are as follows (in thousands):