Costs, Expenses and Other Income

Gross margins by revenue classification were as follows:

	Year Ended December 31,			Change		Pro-forma(1) Change
	2010	2009	2008	2010	2009	2010
Sales	34.5%	33.9%	33.7%	0.6 pts	0.2 pts	1.1 pts
Service, outsourcing and rentals	33.1%	42.6%	41.9%	(9.5) pts	0.7 pts	(0.7) pts
Finance income	62.7%	62.0%	61.8%	0.7 pts	0.2 pts	0.7 pts
Total Gross Margin	34.4%	39.7%	38.9%	(5.3) pts	0.8 pts	(0.2) pts

Gross Margin 2010

The 2010 total gross margin decreased 5.3-percentage points, and service, outsourcing and rentals gross margin decreased 9.5-percentage points, on an actual basis primarily due to the ACS acquisition. ACS, as a services-based company, had a lower gross margin as compared to a technology-based company, which typified Xerox before the acquisition. Since actual comparisons are not meaningful, gross margins for these two categories are primarily discussed below on a pro-forma basis with ACS’s 2009 estimated results from February 6 through December 31 included in our historical 2009 results (see “Non-GAAP Financial Measures” section for a further discussion of this non-GAAP measure).

• Total gross margin decreased 5.3-percentage points or 0.2-percentage points on a pro-forma(1) basis, as compared to 2009. The decline was primarily due to the unfavorable impact of year-over-year transaction currency.
• Sales gross margin increased 0.6-percentage points or 1.1-percentage points on a pro-forma(1) basis, as compared to 2009. Cost improvements and positive mix more than offset a 0.5-percentage point adverse impact from transaction currency and price declines of about 1-percentage point.
• Service, outsourcing and rentals gross margin decreased 9.5-percentage points or 0.7-percentage points on a pro-forma(1) basis, as compared to 2009, as price declines and the higher rate of growth in lower-margin BPO revenue were only partially offset by cost improvements.
• Financing income gross margin of 62.7% remained comparable to 2009.

Since a large portion of our inventory is procured from Japan, the strengthening of the Yen versus the U.S. Dollar and Euro in 2010 and 2009 has significantly impacted our product costs. In 2010, the Yen strengthened approximately 6% against the U.S. Dollar and 10% against the Euro as compared to 2009. In 2009, the Yen strengthened approximately 10% against the U.S. Dollar and 15% against the Euro as compared to 2008. We expect product costs and gross margins to continue to be negatively impacted in 2011, particularly in the first half, if Yen exchange rates remain at January 2011 levels.

⁽¹⁾ Refer to the “Non-GAAP Financial Measures” section for an explanation of the Pro-forma non-GAAP financial measure.

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 point.
• 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 point impact of pricing.
• Financing income margin of 62% remained comparable to 2008.

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

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

	Year Ended December 31,			Change		Pro-forma(1) Change
(in millions)	2010	2009	2008	2010	2009	2010
R&D	$653	$713	$750	$(60)	$(37)	$(60)
Sustaining Engineering	128	127	134	1	(7)	1
Total RD&E Expenses	$781	$840	$884	$(59)	$(44)	$(59)
RD&E% Revenue	3.6%	5.5%	5.0%	(1.9) pts	0.5 pts	(0.4) pts
R&D Investment by Fuji Xerox(2)	$821	$796	$788	$25	$8	n/a

RD&E 2010

The decrease in RD&E spending for 2010 primarily reflects the savings from restructuring and productivity improvements.

RD&E 2009

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

Selling, Administrative and General Expenses (“SAG”)

	Year Ended December 31,			Change		Pro-forma(1) Change
(in millions)	2010	2009	2008	2010	2009	2010
Total SAG	$4,594	$4,149	$4,534	$445	$(385)	$(57)
SAG as a% of revenue	21.2%	27.3%	25.7%	(6.1) pts	1.6 pts	(0.9) pts
Bad Debt Expense	$188	$291	$188	$(103)	$103	$(108)
Bad Debt as a% of revenue	0.9%	1.9%	1.1%	(1.0) pts	0.8 pts	(0.5) pts

SAG 2010

SAG as a percent of revenue decreased 6.1-percentage points on an actual basis, primarily due to the ACS acquisition. ACS, as a typical services-based company, had lower SAG as a percent of revenue as compared to a technology-based company, which typified Xerox before the acquisition. Since actual comparisons are not meaningful, SAG is primarily discussed on a pro-forma basis, with ACS’s 2009 estimated results from February 6 through December 31 included in our historical 2009 results (see “Non-GAAP Financial Measures” section for additional discussion of this non-GAAP measure).

SAG of $4,594 million was $445 million higher than 2009, or $57 million lower on a pro-forma(1) basis, including a negligible impact from currency. The pro-forma(1) SAG decrease reflects the following:

• $137 million increase in selling expenses, reflecting increased demand generation and brand advertising and higher commissions, partially offset by restructuring savings and productivity improvements
• $86 million decrease in general and administrative expenses, reflecting benefits from restructuring and operational improvements
• $108 million decrease in bad debt expense, reflecting an improving write-off trend

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 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

Summary Costs and Expenses

The following is a summary of key metrics used to assess our performance:

	Year Ended December 31,			Change		Pro-forma(1) Change
(in millions)	2010	2009	2008	2010	2009	2010
Total Gross Margin	34.4%	39.7%	38.9%	(5.3) pts	0.8 pts	(0.2) pts
RD&E% of revenue	3.6%	5.5%	5.0%	(1.9) pts	0.5 pts	(0.4) pts
SAG% of revenue	21.2%	27.3%	25.7%	(6.1) pts	1.6 pts	(0.9) pts
Operating Margin(1)	9.6%	6.8%	8.4%	2.8 pts	(1.6) pts	1.0 pts
Pre-tax income (loss) margin	3.8%	4.1%	(0.4)%	(0.3) pts	4.5 pts	(2.2) pts

As previously noted, the acquisition of ACS increased the proportion of revenues from Services. Consistent with services companies, this portion of our operations has a lower gross margin than our Technology segment, but also has both lower SAG and R&D as a percent of revenue. Accordingly, in 2010 we began to assess our performance using an operating margin metric, which neutralizes this mix differential. Operating margin is an internal measurement metric and represents gross margin minus RD&E percentage of revenue and SAG percentage of revenue. (Refer to the “Non-GAAP Financial Measures” section for further information and the reconciliation of operating margin to pre-tax income (loss) margin.)

During 2010, operating margin increased 2.8-percentage points or 1.0-percentage-point on a pro-forma(1) basis, as compared to 2009. The improvement reflects strong revenue growth and continued disciplined cost and expense management. During 2009, operating margin decreased 1.6-percentage points largely due to lower revenue as a result of the worldwide recession, as well as the negative effects of currency on our product costs, which were only partially offset by savings from prior-year restructuring actions.

Restructuring and Asset Impairment Charges

2010 Activity

During 2010 we recorded $483 million of net restructuring and asset impairment charges which included the following:

• $470 million of severance costs related to headcount reductions of approximately 9,000 employees. The costs associated with these actions applied about equally to North America and Europe, with approximately 20% related to our developing market countries. Approximately 50% of the costs were focused on gross margin improvements, 40% on SAG and 10% on the optimization of RD&E investments, and impacted the following functional areas:
  • – Services
  • – Supply chain and manufacturing
  • – Back-office administration
  • – Development and engineering
• $28 million for lease termination costs, primarily reflecting the continued rationalization and optimization of our worldwide operating locations, including consolidations with ACS.
• $19 million loss associated with the sale of our Venezuelan subsidiary. The loss primarily reflects the write-off our Venezuelan net assets including working capital and long-lived assets. We will continue to sell equipment, parts and supplies to the acquiring company through a distribution arrangement but will no longer have any direct or local operations in Venezuela. The sale of our operations and change in business model follows a decision by management in the fourth quarter 2010 to reduce the Company’s future exposure and risk associated with operating in this unpredictable economy.

The above charges were partially offset by $41 million of net reversals for changes in estimated reserves from prior-period initiatives.

We expect 2011 pre-tax savings of approximately $270 million from our 2010 restructuring actions and approximately $475 million of annualized savings once all actions are fully implemented.

2009 Activity

Restructuring activity was minimal in 2009, and the related charges primarily reflected changes in estimates in severance costs from previously recorded actions.

2008 Activity

During 2008, we recorded $357 million of net restructuring charges predominantly consisting of severance and costs related to the elimination of approximately 4,900 positions primarily in North America and Europe. Focus areas for these actions include the following:

• Improving efficiency and effectiveness of infrastructure including: marketing, finance, human resources and training
• Capturing efficiencies in technical services, managed services, and supply chain and manufacturing infrastructure
• Optimizing product development and engineering resources

In addition, related to these activities, we also recorded lease cancellation and other costs of $19 million and asset impairment charges of $53 million. The lease termination and asset impairment charges primarily related to: (i) the relocation of certain manufacturing operations including the closing of our toner plant in Oklahoma City and the consolidation of our manufacturing operations in Ireland; and (ii) the exit from certain leased and owned facilities as a result of the actions noted above.

Restructuring Summary

The restructuring reserve balance as of December 31, 2010 for all programs was $323 million, of which approximately $309 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 additional information regarding our restructuring programs.

Acquisition-Related Costs

Costs of $77 million were incurred during 2010 in connection with our acquisition of ACS. These costs include $53 million of transaction costs, which represent external costs directly related to completing the acquisition of ACS and primarily include expenditures for investment banking, legal, accounting and other similar services. Legal costs include costs associated with the ACS shareholders litigation which was settled in 2010. The remainder of the acquisition-related costs represents external incremental costs directly related to the integration of ACS and Xerox. These costs include expenditures for consulting, systems integration, corporate communication services and the consolidation of facilities, as well as the expense associated with the performance shares that were granted to ACS management in connection with existing change-in-control agreements.

Costs of $72 million were incurred 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.

Amortization of Intangible Assets

During 2010, we recorded $312 million for the amortization of intangibles assets, which was $252 million higher than 2009. The increase primarily reflects the amortization of intangibles associated with our acquisition of ACS. Refer to Note 3 – Acquisitions in the Consolidated Financial Statements for additional information regarding the ACS acquisition.

Amortization of intangibles was $60 million in 2009 which was an increase of $6 million over 2008, primarily as a result of the full-year amortization of the assets acquired as part of our acquisitions in 2008.

Worldwide Employment

Worldwide employment of 136,500 as of December 31, 2010 increased approximately 83,000 from December 31, 2009, primarily due to the additional headcount related to the ACS acquisition partially offset by restructuring reductions. Worldwide employment was approximately 53,600 and 57,100 at December 31, 2009 and 2008, respectively.

Other Expenses, Net

Other expenses, net for the three years ended December 31, 2010 were as follows:

(in millions)	2010	2009	2008
Non-financing interest expense	$346	$256	$262
Interest income	(19)	(21)	(35)
Gain on sales of businesses and assets	(18)	(16)	(21)
Currency losses, net	11	26	34
ACS shareholders litigation settlement	36	—	—
Litigation matters	(4)	9	781
Loss on early extinguishment of debt	15	—	—
All Other expenses, net	22	31	12
Total Other Expenses, Net	$389	$285	$1,033

Non-financing interest expense: 2010 non-financing interest expense of $346 million increased $90 million from 2009 due to higher average debt balances, primarily resulting from the funding of the ACS acquisition, partially offset by the early extinguishment of certain debt instruments as well as the scheduled repayments of other debt.

In 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.

Interest income: Interest income is derived primarily from our invested cash and cash equivalent balances. The decline in interest income in 2010 and 2009 was primarily due to lower average cash balances and rates of return.

Gain on sales of businesses and assets: Gains 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 2010 net currency losses were primarily due to the currency devaluation in Venezuela. In January 2010, Venezuela announced a devaluation of the Bolivar to an official rate of 4.30 Bolivars to the U.S. Dollar for a majority of our products. As a result of this devaluation, we recorded a currency loss of $21 million in the first quarter of 2010 for the re-measurement of our net Bolivar-denominated monetary assets. This loss was partially offset by a cumulative translation gain of $6 million that was recognized upon the repatriation of cash and liquidation of a foreign subsidiary.

The 2009 net 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.

ACS Shareholders’ Litigation Settlement: Represents litigation expense of $36 million for the settlement of claims by ACS shareholders arising from our acquisition of ACS. The total settlement for all defendants was approximately $69 million, with Xerox paying approximately $36 million net of insurance proceeds.

Litigation matters: The 2010 and 2009 amounts for litigation matters primarily relate to changes in estimated probable losses for various legal 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 and other pending securities-related cases, net of insurance recoveries.
• $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 17 – Contingencies in the Consolidated Financial Statements for additional information regarding litigation against the Company.

All other expenses, net: All Other expenses in 2010 decreased primarily due to lower interest expense on the Brazil tax and labor contingencies.

All Other expenses, net in 2009 were $19 million higher than 2008, 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,
	2010			2009			2008
(in millions)	Pre- Tax Income	Income Tax Expense	Effective Tax Rate	Pre- Tax Income	Income Tax Expense	Effective Tax Rate	Pre- Tax Income	Income Tax Expense	Effective Tax Rate
Reported	$815	$256	31.4%	$627	$152	24.2%	$(79)	$(231)	292.4%
Adjustments:
Xerox restructuring charge(1)	483	166		(8)	(3)		426	134
Acquisition-related costs	77	19		72	23		–	–
Amortization of intangible assets	312	118		60	22		54	19
Venezuela devaluation costs	21	–		–	–		–	–
Medicare subsidy tax law change	–	(16)		–	–		–	–
Equipment write-off	–	–		–	–		39	15
Provision for securities litigation	–	–		–	–		774	283
ACS Shareholders’ litigation settlement	36	–		–	–		–	–
Loss on early extinguishment of debt	15	5		–	–		–	41
Adjusted(2)	$1,759	$548	31.2%	$751	$194	25.8%	$1,214	$261	21.5%

The 2010 effective tax rate was 31.4%, or 31.2%⁽²⁾ on an adjusted basis, which was lower than the U.S. statutory rate primarily due to the geographical mix of income before taxes and the related effective tax rates in those jurisdictions as well as the U.S. tax impacts on certain foreign income and tax law changes.

The 2009 effective tax rate was 24.2%, or 25.8%⁽²⁾ on an adjusted basis, which 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 was 292.4%, or 21.5%⁽²⁾ on an adjusted basis, which 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.

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 the U.S. tax impacts on certain foreign income. In addition, our effective tax rate will change based on discrete or other nonrecurring events (such as audit settlements) that may not be predictable. We anticipate that our effective tax rate for 2011 will be approximately 31%, excluding the effects of any discrete events.

Refer to Note 16 – Income and Other Taxes in the Consolidated Financial Statements for additional information.

⁽¹⁾ Income tax benefit from restructuring in 2010 includes a $19 million benefit from the sale of our Venezuelan operations.

⁽²⁾ See the “Non-GAAP Measures” section for additional information.

Equity in Net Income of Unconsolidated Affiliates

	Year Ended December 31,
(in millions)	2010	2009	2008
Total equity in net income of unconsolidated affiliates	$78	$41	$113
Fuji Xerox after-tax restructuring costs(1)	38	46	16

Equity in net income of unconsolidated affiliates primarily reflects our 25% share in Fuji Xerox.

The 2010 increase of $37 million from 2009 was primarily due to an increase in Fuji Xerox’s net income, which was primarily driven by higher revenue and cost improvements, as well as lower restructuring costs.

The 2009 decrease of $72 million from 2008 was primarily due to Fuji Xerox’s lower net income, which was negatively impacted by the weakness in the worldwide economy, as well as $46 million related to our share of Fuji Xerox after-tax restructuring costs.

Recent Accounting Pronouncements

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