In April 2001, Contractor made a decision to pursue the development of a new widget product line, which was a scaled down version of two earlier versions of the widget. Contractor was going to utilize the experience under these two earlier product lines by modifying the software, adapting certain hardware features and modifying other features. Five configurations (C-1, C-2, C-3, C-4 and C-5) were planned. The differences primarily involve the type components used.

However, little or no work was expended on the new widget line until Contractor began discussions in February 2002 with Customer to build the version C-3. Contractor anticipated that the total cost for development would be approximately $4M dollars. Customer, however, advised that they did not have sufficient funding available to pay for the entire development. Therefore, in order to proceed Contractor agreed to absorb approximately 50% of the estimated development costs which amounted to approximately $2M dollars. The development work which would be paid for by Contractor would benefit the entire new widget product line, not just the version C-3. Customer stated it was willing to pay approximately $2M in nonrecurring engineering costs in order to underwrite part of the development costs. In March, 2002, Contractor established specific job numbers to account for those costs which were specifically related to the development of the C-3 unit and work order numbers that would be applicable to the entire widget product line. In May 2002 Contractor received a letter contract to proceed. Notwithstanding the fact that separate job orders were established at the outset a portion of costs that were initially charged to IR&D were transferred to the contract job order.

In July 2002, Customer issued a purchase order for five C-3 widgets. The units were delivered in 2003. In August, 2003, Customer placed an order for another two units and in February 2004 ordered eight additional units.

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