Costs, Expenses and Other Income

Gross Margin

Gross margins by revenue classification were as follows:

		Year Ended December 31,
		2009				2008		2007
Sales			33.9	%		33.7	%	35.9	%
Service, outsourcing and rentals			42.6	%		41.9	%	42.7	%
Finance income			62.0	%		61.8	%	61.6	%
Total Gross margin			39.7	%		38.9	%	40.3	%

Gross Margin 2009

Total gross margin increased 0.8-percentage points compared to 2008, primarily driven by cost improvements enabled by restructuring and our cost actions, which were partially offset by the 0.5-percentage point unfavorable impact of transaction currency, primarily the Yen, and price declines of 1.0-percentage points.

• Sales gross margin increased 0.2-percentage points, primarily due to the cost improvements and the positive mix of revenues partially offset by the adverse impact of transaction currency on our inventory purchases of 1.0-percentage point and price declines of 1.2-percentage points.
• Service, outsourcing and rentals margin increased 0.7-percentage points, primarily due to the positive impact from the reduction in costs driven by our restructuring and cost actions of 1.5-percentage points. These cost improvements more than offset the approximate 0.9-percentage points impact of pricing.
• Financing income margin of 62% remained comparable to 2008.

Gross Margin 2008

2008 Total gross margin decreased 1.4-percentage points compared to 2007, as price declines and mix of approximately 2.0-percentage points were only partially offset by cost productivity improvements. Cost improvements were limited by an unfavorable impact on product costs of approximately 0.5-percentage points from the significant strengthening of the Yen versus the U.S. Dollar and Euro. The negative impact of 0.3-percentage points from an Office product line equipment write-off was offset by positive adjustments related to the capitalized costs for equipment on operating leases and European product disposal costs.

• Sales gross margin decreased 2.2-percentage points primarily due to the approximately 2.5-percentage point impact of price declines, as well as channel and product mix. Cost improvements, which historically tend to offset price declines, were limited in 2008 by the adverse impact of the strengthening Yen on our inventory purchases.
• Service, outsourcing and rentals margin decreased 0.8-percentage points, primarily due to mix, as price declines of 1.3-percentage points were offset by cost improvements. Mix reflects margin pressure from document management services.
• Financing income margin of approximately 62% remained comparable to 2007.
• Since a large portion of our inventory procurement is from Japan, the strengthening of the Yen versus the U.S. Dollar and Euro in 2008 significantly impacted our product cost. The Yen strengthened approximately 14% against the U.S. Dollar and 6% against the Euro in 2008 as compared to 2007. A significant portion of that strengthening occurred in the fourth quarter 2008 when the Yen strengthened 17% against the U.S. Dollar and 29% against the Euro as compared to prior year.

Research, Development and Engineering Expenses (“RD&E”)

We invest in technological development, particularly in color, and believe our RD&E spending is sufficient to remain technologically competitive. Our R&D is strategically coordinated with that of Fuji Xerox.

		Year Ended December 31,									Change
(in millions)		2009				2008		2007			2009			2008
RD&E % Revenue			5.5	%		5.0	%	5.3	%		0.5 pts			(0.3) pts
R&D			$713			$750		$764			$ (37	)		$ (14	)
Sustaining engineering			127			134		148			(7	)		(14	)
Total RD&E Expenses			$840			$884		$912			$ (44	)		$ (28	)
R&D Investment by Fuji Xerox(1)			$796			$788		$672			$8			$116

RD&E 2009

The decrease in RD&E spending for 2009 reflects our restructuring and cost actions which consolidated the Production and Office development and engineering infrastructures.

RD&E 2008

The decrease in R&D spending for 2008 reflects the capture of efficiencies following a significant number of new product launches over the previous two years, as well as leveraging our current RD&E investments to support our GIS operations. Sustaining engineering costs declined in 2008 due primarily to lower spending related to environmental compliance activities and maturing product platforms in the Production segment.

Selling, Administrative and General Expenses (“SAG”)

		Year Ended December 31,								Change
(in millions)		2009			2008		2007			2009			2008
Total SAG			$4,149		$ 4,534		$ 4,312			$ (385)			$ 222
SAG as a % of Revenue			27.3	%	25.7	%	25.0	%		1.6 pts			0.7 pts
Bad Debt Expense			$ 291		$ 188		$ 134			$ 103			$ 54
Bad Debt as a % of Revenue			1.9	%	1.1	%	0.8	%		0.8 pts			0.3 pts

SAG 2009

SAG of $4,149 million was $385 million lower than 2008, including a $126 million benefit from currency. The SAG decrease was the result of the following:

• $311 million decrease in selling expenses reflecting favorable currency, benefits from restructuring, an overall reduction in marketing spend and lower commissions.
• $177 million decrease in general and administrative (“G&A”) expenses reflecting favorable currency and benefits from restructuring and cost actions partially offset by higher compensation accruals.
• $103 million increase in bad debt expense reflecting increased write-offs in North America and Europe.

SAG 2008

SAG of $4,534 million was $222 million higher than 2007, including a $12 million unfavorable impact from currency. The SAG increase was the result of the following:

• $94 million increase in selling expenses, primarily reflecting the full-year inclusion of GIS, investments in selling resources and marketing communications, and unfavorable currency partially offset by lower compensation.
• $75 million increase in G&A expenses, primarily from the full-year inclusion of GIS and unfavorable currency.
• $54 million increase in bad debt expense, reflecting increased write-offs, particularly in the fourth quarter 2008, which included several high-value account bankruptcies in the U.S., U.K. and Germany.

Bad debt expense, which is included in SAG, increased $103 million in 2009 and reserves as a percentage of trade and finance receivables increased to 4.1% at December 31, 2009 as compared to 3.4% at December 31, 2008. These increases reflect the weak worldwide eco­nomic conditions and the increased level of customer bankruptcies in certain industry groups during the year. Bad debts provision and write-offs in the fourth quarter 2009 were flat as compared to the prior year.

Restructuring and Asset Impairment Charges

For the years ended December 31, 2009, 2008 and 2007, we recorded net restructuring and asset impairment (credits)/charges of $(8) million, $429 million and $(6) million, respectively.

• Restructuring activity was minimal in 2009, and the credit of $8 million primarily reflected changes in estimates for prior years’ initiatives.
• The 2008 net charge included $357 million related to head count reductions of approximately 4,900 employees, primarily in North America and Europe, and lease termination and asset impairment charges of $72 million, primarily reflecting the exit from certain leased and owned facilities resulting from a rationalization of our worldwide operating locations. These actions applied equally to both North America and Europe, with approximately half focused on SAG reductions, approximately a third on gross margin improvements and the remainder focused on the optimization of RD&E investments. Estimated savings from these initiatives were approximately $250 million in 2009.
• Restructuring activity was minimal in 2007 and the related credit of $6 million primarily reflected changes in estimates for prior year’s severance costs.

The restructuring reserve balance as of December 31, 2009 for all programs was $74 million, of which approximately $64 million is expected to be spent over the next 12 months. Refer to Note 9 – Restructuring and Asset Impairment Charges in the Consolidated Financial Statements for further information regarding our restructuring programs.

2010 Expected Actions

In connection with our continued objective to align our cost base to current revenues, we expect to record pre-tax restructuring charges of approximately $280 million in 2010, of which $250 million is expected to be recorded in the first quarter. These actions are expected to impact all geographies and segments, with approximately equal focus on SAG reductions, gross margin improvements and optimization of RD&E investments. The restructuring is also expected to involve the rationalization of some of our facilities.

Acquisition-Related Costs

Acquisition-related costs of $72 million were incurred and expensed during 2009 in connection with our acquisition of ACS. $58 million of the costs relate to the write-off of fees associated with the Bridge Loan Facility commitment which was terminated as a result of securing permanent financing to fund the acquisition. The remainder of the costs represents transaction costs such as banking, legal and accounting fees, as well as some pre-integration costs such as external consulting services. Consistent with the new accounting guidance with respect to business combinations, adopted in 2009, all acquisition-related costs must be expensed as incurred.

Worldwide Employment

Worldwide employment of 53,600 as of December 31, 2009 decreased approximately 3,500 from December 31, 2008, primarily reflecting restructuring reductions, partially offset by additional headcount related to GIS acquisitions. Worldwide employment was approximately 57,100 and 57,400 at December 31, 2008 and 2007, respectively.

Other Expenses, Net

Other expenses, net for the years ended December 31, 2009, 2008 and 2007 consisted of the following:

		Year Ended December 31,
(in millions)		2009				2008				2007
Non-financing interest expense		$	256			$	262			$	263
Interest income			(21	)			(35	)			(55	)
Gain on sales of businesses and assets			(16	)			(21	)			(7	)
Currency losses, net			26				34				8
Amortization of intangible assets			60				54				42
Litigation matters			9				781				(6	)
All Other expenses, net			31				12				20
Total Other Expenses, Net		$	345			$	1,087			$	265

Non-financing interest expense: 2009 non-financing interest expense decreased compared to 2008, as interest expense associated with our $2.0 billion Senior Note offering for the funding of the ACS acquisition was more than offset by lower interest rates on the remaining debt.

In 2008, non-financing interest expense was flat compared to 2007, as the benefit of lower interest rates was offset by higher average non-financing debt balances.

Interest income: Interest income is derived primarily from our invested cash and cash equivalent balances. The decline in interest income in 2009 and 2008 was primarily due to lower average cash balances and rates of return.

Gain on sales of businesses and assets: 2009 and 2008 gain on sales of business and assets primarily consisted of the sales of certain surplus facilities in Latin America.

Currency losses, net: Currency losses primarily result from the re-measurement of foreign currency-denominated assets and liabilities, the cost of hedging foreign currency-denominated assets and liabilities, the mark-to-market of foreign exchange contracts utilized to hedge those foreign currency-denominated assets and liabilities and the mark-to-market impact of hedges of anticipated transactions, primarily future inventory purchases, for those that we do not apply cash flow hedge accounting treatment.

The 2009 currency losses were primarily due to the significant movement in exchange rates among the U.S. Dollar, Euro and Yen in the first quarter of 2009, as well as the increased cost of hedging, particularly in developing markets.

The 2008 currency losses were primarily due to net re-measurement losses associated with our Yen-denominated payables, foreign currency-denominated assets and liabilities in our developing markets and the cost of hedging. The currency losses on Yen-denominated payables were largely limited to the first quarter 2008 as a result of the significant and rapid weakening of the U.S. Dollar and Euro versus the Yen.

Amortization of intangible assets: The increase in 2009 and 2008 amortization as compared to prior years primarily reflects the full-year amortization of the assets acquired as part of our recent acquisitions.

Litigation matters: In 2008 legal matters consisted of the following:

• $721 million reflecting provisions for the $670 million court approved settlement of Carlson v. Xerox Corporation (“Carlson”) and other pending securities-related cases, net of expected insurance recoveries. On January 14, 2009, the United States Court for the District of Connecticut entered a Final Order and Judgment approving the settlement of the Carlson litigation.
• $36 million for probable losses on Brazilian labor-related contin­gencies. Following an assessment of the most recent trend in the outcomes of these matters, we reassessed the probable estimated loss and, as a result, recorded an additional reserve of $36 million in the fourth quarter of 2008.
• $24 million associated with probable losses from various other legal matters.

Refer to Note 16 – Contingencies in the Consolidated Financial Statements for additional information regarding litigation against the Company.

All other expenses, net: All Other expenses in 2009 were $19 million higher than the prior year, primarily due to fees associated with the sale of receivables, as well as an increase in interest expense related to Brazil tax and labor contingencies.

Income Taxes

		Year Ended December 31,
(in millions)		2009			2008			2007
Pre-tax income (loss)		$	627		$	(79	)	$	1,468
Income tax expense (benefit)			152			(231	)		400
Effective tax rate			24.2	%		292.4	%		27.2	%

The 2009 effective tax rate of 24.2% was lower than the U.S. statutory tax rate, primarily reflecting the benefit to taxes from the geographical mix of income before taxes and the related effective tax rates in those jurisdictions, and the settlement of certain previously unrecognized tax benefits partially offset by a reduction in the utilization of foreign tax credits.

The 2008 effective tax rate of 292.4% reflected the tax benefits from certain discrete items including the net provision for litigation matters; the second, third and fourth quarter restructuring and asset impairment charges; the product line equipment write-off; and the settlement of certain previously unrecognized tax benefits. Excluding these items, the adjusted effective tax rate was 20.9%*. The adjusted 2008 effective tax rate was lower than the U.S. statutory tax rate, primarily reflecting the benefit to taxes from the geographical mix of income before taxes and the related effective tax rates in those jurisdictions, the utilization of foreign tax credits and tax law changes.

The 2007 effective tax rate of 27.2% was lower than the U.S. statutory rate, primarily reflecting tax benefits from the geographical mix of income before taxes and the related effective tax rates in those juris­dictions and the utilization of foreign tax credits, as well as the resolution of other tax matters. These benefits were partially offset by changes in tax law.

Our effective tax rate will change based on nonrecurring events, as well as recurring factors including the geographical mix of income before taxes and the related effective tax rates in those jurisdictions and available foreign tax credits. In addition, our effective tax rate will change based on discrete or other nonrecurring events (such as audit settlements) that may not be predictable. Including the results from ACS, we anticipate that our effective tax rate for 2010 will be approxi­mately 32%, excluding the effects of any discrete events.

Refer to Note 15 – Income and Other Taxes in the Consolidated Financial Statements for additional information.

Equity in Net Income of Unconsolidated Affiliates

2009 equity in net income of unconsolidated affiliates of $41 million is principally related to our 25% share of Fuji Xerox income. The $72 million decrease from 2008 is primarily due to Fuji Xerox’s lower net income, which has been impacted by the worldwide economic weakness, and includes $46 million related to our share of Fuji Xerox after-tax restructuring costs.

2008 equity in net income of unconsolidated affiliates of $113 million increased by $16 million from 2007, primarily due to a $14 million reduction in our share of Fuji Xerox restructuring charges.

Subsequent Events

We have operations in Venezuela where the U.S. Dollar is the functional currency. At December 31, 2009 our Venezuelan operations had approximately 90 million in net Bolivar-denominated monetary assets that were re-measured to U.S. Dollars at the official exchange rate of 2.15 Bolivars to the Dollar. In January 2010, Venezuela announced a devaluation of the Bolivar to an official rate of 4.30 Bolivars to the Dollar for our products. As a result of this devaluation, we expect to record a loss of approximately $21 million in the first quarter of 2010 for the re-measurement of our net Bolivar-denominated monetary assets. Other than the loss from re-measurement, we do not expect the devaluation to materially impact our results of operations or financial position in 2010, since we derive less than 0.5% of our total revenue from Venezuela and expect to take actions to lessen the effect of the devaluation.

On January 20, 2010 we acquired Irish Business Systems Limited (“IBS”) for approximately $31 million. This acquisition expands our reach into the small and mid-size business (SMB) market in Ireland. IBS, with eight offices located throughout Ireland, is a managed print services provider and the largest independent supplier of digital imaging and printing solutions in Ireland.

On February 5, 2010 we completed the acquisition of ACS. Refer to Note 3 – Acquisitions, Note 11 – Debt and Note 17 – Shareholders’ Equity for further information regarding the acquisition and associated funding for it.

Recent Accounting Pronouncements

On January 1, 2009 we adopted SFAS No. 160 “Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51” (Accounting Standards Codification™ Topic 810-10-65). This guidance requires that minority interests be renamed noncontrolling interests and be presented as a separate component of equity. In addition, the Company must report a consolidated net income (loss) measure that includes the amount attributable to such noncontrolling interests for all periods presented.

Refer to Note 1 – Summary of Significant Accounting Policies in the Consolidated Financial Statements for a description of all recent accounting pronouncements, including the respective dates of adoption and the effects on results of operations and financial condition.