The following discussion should be read in conjunction with the Financial Statements and Notes contained herein and with those in our Form 10-KSB for the year ended December 31, 2007.

Except for the historical information contained herein, the matters discussed in this Quarterly Report on Form 10-Q include certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, which are intended to be covered by the safe harbors created thereby. Those statements include, but may not be limited to, all statements regarding our intent, belief, and expectations, such as statements concerning our future profitability and operating and growth strategy. Words such as "believe," "anticipate," "expect," "will," "may," "should," "intend," "plan," "estimate," "predict," "potential," "continue," "likely" and similar expressions are intended to identify forward-looking statements. Investors are cautioned that all forward-looking statements contained in this Quarterly Report on Form 10-Q and in other statements we make involve risks and uncertainties including, without limitation, the factors set forth under the caption "Risk Factors" included in our Annual Report on Form 10-KSB for the year ended December 31, 2007, and other factors detailed from time to time in our other filings with the Securities and Exchange Commission. One or more of these factors have affected, and in the future could affect our business and financial condition and could cause actual results to differ materially from plans and projections. Although we believe the assumptions underlying the forward-looking statements contained herein are reasonable, there can be no assurance that any of the forward-looking statements included in this Quarterly Report on Form 10-Q will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved.

Any forward-looking statement speaks only as of the date on which such statement is made, and we undertake no obligation to update any forward-looking statement or statements to reflect events or circumstances after the date on which such statements are made or reflect the occurrence of unanticipated events, unless necessary to prevent such statements from becoming misleading. New factors emerge from time to time and it is not possible for us to predict all factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

Overview

SCI Engineered Materials, Inc. ("SCI" or the "Company"), formerly Superconductive Components, Inc., an Ohio corporation, was incorporated in 1987. We manufacture ceramic and metal sputtering targets for a variety of industrial applications including: Photonics, Semiconductor, Thin Film Battery and, to a lesser extent HTS materials. Photonics (which includes solar) currently represents the largest market for our targets. Thin Film Battery is a developing market where manufacturers of batteries use our targets to produce very small power supplies with small quantities of stored energy. Semiconductor is a developing market. We hired additional marketing staff during late 2006 to develop opportunities in this market, and we added to our sales staff in late 2007 for the purpose of focusing on opportunities for our products in the Solar industry. We also added staff to our Technology group during the second half of 2007 for the development of innovative products. During the third quarter of 2008 we entered into an exclusive agreement with a manufacturer's representative headquartered in Ede, The Netherlands. This firm will market and sell our sputtering targets for Thin Film Solar applications in 26 European countries plus Russia and Turkey.

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued)

Executive Summary

For the nine months ended September 30, 2008, we had revenues of $7,240,088. This was a decrease of $1,207,601, or 14.3%, compared to the nine months ended September 30, 2007. The decrease in revenues was attributed to a reduction in the cost of a high value raw material. We anticipate that the cost of this high value raw material will continue to be lower for the remainder of 2008 compared to 2007. Revenues for the third quarter of 2008 were a record $4,008,635, which was the first time we have had quarterly revenues in excess of $4 million. The increase in revenues was mostly attributable to one of our largest customers who increased orders on certain targets that shipped during the third quarter and also by increased revenues for other products. We do not expect the orders for this customer to remain at this level in the fourth quarter of 2008. The order backlog at September 30, 2008 was $2.7 million, which was essentially the same as June 30, 2008.

Reflecting positive benefits from product mix, gross profit increased 12.0% to $1,636,438 for the first nine months of 2008 from $1,461,381 for the same period in 2007. Gross margin increased to 22.6% of total revenues for the first nine months of 2008 from 17.3% for the same period in 2007. For the third quarter of 2008 gross profit was $769,566 compared to $489,633 for the third quarter of 2007, an increase of $279,933, or 57.2%. Gross margin increased to 19.2% for the third quarter of 2008 from 18.9% for the third quarter of 2007.

For the nine months ended September 30, 2008, we had net income applicable to common shares of $11,390 compared to $186,706 for the same period in 2007. This decrease can be largely attributed to additional operating expenses of approximately $294,000 along with an increase in depreciation expense. For the three months ended September 30, 2008, we had net income applicable to common shares of $198,635 compared to $30,011 for the same period in 2007. We continued to invest in R&D, marketing, and sales to take advantage of current and future market opportunities. During the past 24 months we have been actively marketing to additional customers in select markets. This has resulted in trial and qualification orders that were shipped to customers in the semiconductor and solar industries during the first nine months of 2008 that totaled approximately 14% of our revenues. We have received additional trial orders that should ship during the fourth quarter of 2008.

We received notification during the third quarter of 2008 from the Department of Energy of a Notice of Financial Assistance Award in the amount of $125,000. This award provides support for Phase II of an SBIR award entitled "Flux Pinning Additions to Increase Jc Performance in BSCCO-2212 Round Wire for Very High Field Magnets." The final amount of the award is still in negotiations and is expected to total approximately $750,000. The work on the contract began during the third quarter of 2008 and is expected to continue through August 2010.

We received notification during the second quarter of 2008 from the Department of Energy of a Notice of Financial Assistance Award in the amount of $99,961. This award provides support for Phase I of an SBIR award entitled "Homogenous BSCCO-2212 Round Wires for Very High Field Magnet Applications." The work on the contract began during the third quarter of 2008.

We received notification during the second quarter of 2007 from the Department of Energy of a Notice of Financial Assistance Award in the amount of $97,900. This award provides support for Phase I of a Small Business Innovative Research (SBIR) award entitled "Flux Pinning Additions to Increase Jc Performance in BSCCO-2212 Round Wire for Very High Field Magnets." The work on the contract was completed during the first quarter of 2008.

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued)

RESULTS OF OPERATIONS

Nine months ended September 30, 2008 (unaudited) compared to nine months ended September 30, 2007 (unaudited):

Revenues

Revenues for the nine months ended September 30, 2008 were $7,240,088 compared to $8,447,689, for the same period last year, a decrease of $1,207,601 or 14.3%. The revenue decline can be attributed to the ongoing purchase of raw materials whose prices have historically experienced periods of significant fluctuation. Cost changes for this high value raw material are fully reflected in the final selling price that insulates us from market risk associated with the raw material. We anticipate the cost of this high value raw material will continue to be lower for the remainder of 2008. This will result in lower total revenues. Revenues exclusive of this high value raw material increased approximately $500,000, or 19.0% over the first nine months of 2007.

Gross Profit

Gross profit for the nine months ended September 30, 2008 was $1,636,438 compared to $1,461,381 for the nine months ended September 30, 2007. Gross margin as a percentage of revenue was 22.6% for the nine months ended September 30, 2008 versus 17.3% for the nine months ended September 30, 2007. The increase in gross margin was primarily due to less cost related to the high value raw material that has low margins and product mix.

Marketing and Sales Expense

Marketing and Sales expense for the nine months ended September 30, 2008 increased 33.1% to $441,556 from $331,703 for the same period in 2007. The increase was due to the addition of staff and increased travel. We added a sales engineer late in 2007 to focus marketing efforts on applications in the rapidly expanding Thin Film Solar market.

General and Administrative Expense

General and administrative expense for the nine months ended September 30, 2008 increased to $751,562 from $669,423 for the nine months ended September 30, 2007, or 12.3%. The increase was due to an increase in staff and professional fees.

Research and Development Expense

Research and development expense for the first nine months of 2008 was $355,785 compared to $253,980 for the same period in 2007, an increase of 40.1%. The increase was due to additional staff and expenses associated within the continued development efforts in the Photonic, Solar, Thin Film Battery and Semiconductor markets as well as research related to the SBIRs.

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued)

Interest Income and Expense

Interest income was $19,744 and $48,721 for the nine months ended September 30, 2008 and 2007, respectively.

Interest expense was $79,487 and $56,433 for the nine months ended September 30, 2008 and 2007, respectively. The increase was due to additional capital lease obligations incurred for the purchase of production equipment for increased production capacity.

INCOME APPLICABLE TO COMMON SHARES

Income applicable to common shares was $11,390, or $0.00 per basic common share and $186,706, or $0.05 per basic common share for the nine months ended September 30, 2008 and 2007, respectively. Basic net income per common share before dividends on preferred stock was $0.01 and $0.06 for the nine months ended September 30, 2008 and 2007, respectively. The income applicable to common shares includes net income from operations and the accretion of Series B preferred stock dividends. Dividends on the Series B preferred stock accrue at 10% annually on the outstanding shares. Dividends accrued during the nine months ended September 30, 2008 and 2007, was $18,402 and $18,837, respectively.

Basic net income for the nine months ended September 30, 2008 was $0.00 per common share based on 3,520,490 weighted average shares outstanding compared to income of $0.05 per common share based on 3,457,005 weighted average shares outstanding for the nine months ended September 30, 2007.

Diluted net income per common share for the nine months ended September 30, 2008 was $0.00 based on 4,122,439 weighted average shares outstanding compared to income of $0.04 per share based on 4,224,899 weighted average shares outstanding for the nine months ended September 30, 2007.

The following schedule represents our outstanding common shares during the period of 2008 through 2018 assuming all outstanding stock options and stock warrants are exercised during the year of expiration. If each shareholder exercises his or her options or warrants, it could increase our common shares by 1,153,307 to 4,713,378 by December 31, 2018. Exercise prices for options and warrants range from $1.00 to $4.00 at September 30, 2008. Assuming all such options and warrants are exercised in the year of expiration, the effect on shares outstanding is illustrated as follows:

        Options and Warrants due to expire     Potential Shares Outstanding

2008                                      0                        3,560,071
2009                                160,418                        3,720,489
2010                                443,389                        4,163,878
2011                                 62,500                        4,226,378
2012                                170,000                        4,396,378
2013                                 30,500                        4,426,878
2014                                 90,000                        4,516,878
2015                                140,000                        4,656,878
2016                                 37,000                        4,693,878
2017                                      0                        4,693,878
2018                                 19,500                        4,713,378

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued)

LIQUIDITY AND WORKING CAPITAL

At September 30, 2008, working capital was $1,742,911 compared to $1,475,136 at September 30, 2007. We used cash from operations of approximately $153,000 for the nine months ended September 30, 2008. We provided cash from operations of approximately $1,165,000 for the nine months ended September 30, 2007. Significant non-cash items including depreciation, accretion and amortization, stock based compensation expense, inventory reserve on excess and obsolete inventory, and provision for doubtful accounts were approximately $338,000 and $270,000, respectively, for the nine months ended September 30, 2008 and 2007. Accounts receivable, inventory, prepaid expenses and other assets increased approximately $1,328,000 for the nine months ended September 30, 2008. Accounts receivable, inventory, prepaid expenses and other assets decreased approximately $108,000 for the nine months ended September 30, 2007. Accounts payable, accrued expenses and customer deposits increased approximately $810,000 for the nine months ended September 30, 2008 and approximately $589,000 for the same period in 2007. Cash of approximately $92,000 and $193,000 was used for investing activities for the nine months ended September 30, 2008 and 2007, respectively. The amounts invested were used to purchase machinery and equipment for increased production capacity and new product lines.

Cash of approximately $31,000 was used for financing activities during the nine months ended September 30, 2008. Cash payments to third parties for capital lease obligations approximated $468,000. Proceeds received from the exercise of common stock warrants were approximately $68,000. Proceeds received from the exercise of common stock options were $10,250. Cash payments for services provided for the registration of common stock were approximately $17,000. A cash payment related to Series B preferred stock dividend was approximately $25,000. Proceeds received from The Ohio Department of Development were $400,000. We incurred new capital lease obligations of approximately $263,000 for new production equipment during the first nine months of 2008. We obtained additional lease commitments of approximately $544,000 in the third quarter for production equipment that should be placed in service during the first quarter of 2009.

Cash of approximately $103,000 was used for financing activities during the nine months ended September 30, 2007. Cash payments to third parties for capital lease obligations approximated $107,000. Proceeds received from the exercise of common stock options were $9,625. Proceeds received from the exercise of common stock warrants were approximately $27,000. Cash payments for services provided for the registration of common stock were approximately $32,000. We incurred new capital lease obligations of approximately $1,067,000 for new production equipment during the first nine months ended September 30, 2007.

RISK FACTORS

We desire to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. The following factors, as well as the factors listed under the caption "Risk Factors" in our Form 10-KSB filed with the Securities and Exchange Commission on March 9, 2008, have affected or could affect our actual results and could cause such results to differ materially from those expressed in any forward-looking statements made by us. Investors should consider carefully these risks and speculative factors inherent in and affecting our business and an investment in our common stock.

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued)

Historically we have experienced significant operating losses and may continue to do so in the future.

While we have had profitable operations in 2008, 2007 and 2006, profits have not been consistent. We have financed the losses prior to 2006 primarily from additional investments and loans by our major shareholders and private offerings of common stock and warrants to purchase common stock.

We cannot assure you that we will be able to raise additional capital in the future to fund our operations. While certain of our major shareholders have advanced funds in the form of secured debt, subordinated debt, accounts payable and guaranteeing bank debt in the past, there is no commitment by these individuals to continue funding us or guaranteeing bank debt in the future. We will continue to seek new financing or equity financing arrangements. However, we cannot be certain that it will be successful in efforts to raise additional funds.

Off Balance Sheet Arrangements

We have no off balance sheet arrangements including special purpose entities.

Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make judgments, assumptions and estimates that affect the amounts reported in the Financial Statements and accompanying notes. Note 2 to the Financial Statements in our Annual Report on Form 10-KSB for the year ended December 31, 2007 describes the significant accounting policies and methods used in the preparation of the Financial Statements. Estimates are used for, but not limited to, accounting for the allowance for doubtful accounts, inventory allowances, property and equipment depreciable lives, patents and licenses useful lives, and assessing changes in which impairment of certain long-lived assets may occur. Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the Financial Statements. The allowance for doubtful accounts is based on our assessment of the collectability of specific customer accounts and the aging of the accounts receivable. If there is a deterioration of a major customer's credit worthiness or actual defaults are higher than our historical experience, our estimates of the recoverability of amounts due us could be adversely affected. Inventory purchases and commitments are based upon future demand forecasts. If there is a sudden and significant decrease in demand for our products or there is a higher risk of inventory obsolescence because of rapidly changing technology and customer requirements, we may be required to increase our inventory allowances and our gross margin could be adversely affected. Depreciable and useful lives estimated for property and equipment, licenses and patents are based on initial expectations of the period of time these assets and intangibles will benefit us. Changes in circumstances related to a change in our business, change in technology or other factors could result in these assets becoming impaired, which could adversely affect the value of these assets.