An important part of ADTRAN’s strategy is to reduce the product cost of each succeeding product generation and then to lower the product’s price based on the cost savings achieved. This strategy, as described above, sometimes results in variations in ADTRAN’s gross profit margin due to timing differences between the recognition of cost reductions and the lowering of product selling prices. In view of the rapid pace of new product introductions by ADTRAN, this strategy may result in variations in gross profit margins that, for any particular financial period, can be difficult to predict. 

## Selling, General, and Administrative Expenses 

Selling, general, and administrative expenses decreased 15.5% from $95,954,000 in 2001 to $81,116,000 in 2002. This decrease is a result of a reduction in force, mandatory salary reductions, and other cost reductions implemented in the second half of 2001. In the second half of 2002, ADTRAN’s operating margins returned to normal levels, allowing the rescission of the mandatory salary reductions, effective September 1, 2002. Selling, general, and administrative expenses as a percentage of sales decreased from 24.8% in 2001 to 23.5% in 2002. ADTRAN historically has experienced very little bad debt expense; however, due to the recent financial difficulties in the telecommunications industry, bad debt expense was $2,013,000 and $3,297,000 in 2002 and 2001, respectively. Selling, general, and administrative expenses as a percent of sales will generally fluctuate whenever there is significant fluctuation in revenues during the periods being compared. 

## Research and Development Expenses 

Research and development expenses decreased 4.5% from $58,935,000 in 2001 to $56,295,000 in 2002. As a percentage of sales, research and development expenses increased from 15.2% in 2001 to 16.2% in 2002. ADTRAN continually evaluates new product opportunities and engages in intensive research and product development efforts. To date, ADTRAN has expensed all product research and development costs as incurred. Additionally, ADTRAN frequently invests heavily in up-front new product development efforts prior to the actual commencement of sales of a major new product. As a result, ADTRAN may incur significant research and development expenses prior to the receipt of revenues from a major new product group. ADTRAN is presently incurring research and development expenses in connection with its new products and its expansion into international markets. In today’s challenging industry environ- ment, ADTRAN has maintained its level of investment in research and development. This has provided for continued new product development, the enhancement of current products, and product cost reductions. Research and develop- ment expenses as a percentage of sales will fluctuate whenever there is a significant fluctuation in revenues during the periods being compared. 

## Interest Expense 

Interest expense increased 24.3% from $2,069,000 in 2001 to $2,572,000 in 2002. This increase is primarily related to an increase in the interest rate on our $50,000,000 revenue bond. 

## Other Income, Net (Primarily Interest) 

Other income increased 12.8% from $8,077,000 in 2001 to $9,113,000 in 2002. This increase is primarily related to an increase in fixed income investments and related investment income and an increase in the interest rate earned on the collateral deposit associated with our $50,000,000 revenue bond. 

## Net Realized Investment Losses 

Net realized investment losses increased from a net loss of $674,000 in 2001 to a net loss of $12,022,000 in 2002. This increase is primarily related to an impairment charge for other-than-temporary declines in the market value of invest- ments. We recorded an impairment charge of $11,627,000 during 2002 related to 21 equity security investments. The remaining $395,000 of net realized investment loss was realized transactional gains and losses in 2002. 

## Income Taxes 

Our effective tax rate decreased from 27% in 2001 to 23% in 2002. Pre-tax income for financial reporting purposes was substantially lower through 2002 due to the other-than-temporary declines in the market value of certain investments. 

The higher mix of non-taxable income and higher research and development tax credits and economic incentive credits as a percent of taxable income resulted in a substantially lower effective tax rate. 

