increased in 2005 to 29.0% of net sales from 27.3% of net sales in 2004. The Company’s gross margin during 2005 increased due to more favorable pricing on certain commodity components including LCD flat-panel displays and DRAM memory; an increase in higher margin software sales; a favorable shift in direct sales related primarily to the Company’s retail and online stores; and higher overall revenue that provided for more leverage on fixed production costs. These increases to gross margin were partially offset by an increase in lower margin iPod sales. 

Operating Expenses 

See the “Explanatory Note” immediately preceding Part I, Item 1 and Note 2, “Restatement of Consolidated Financial Statements,” in Notes to Consolidated Financial Statements of this Form 10-K. 

Research and Development (R&D) 

Expenditures for R&D increased 33% or $177 million to $712 million in 2006 compared to $535 million in 2005. The increase was due primarily to an increase in R&D headcount in the current year to support expanded R&D activities, an increase of $46 million in stock-based compensation recognized as R&D expense resulting from the adoption of SFAS No. 123R, and higher overall expenses due to the 14th week added to the first fiscal quarter of 2006 to realign the Company’s fiscal quarters with calendar quarters . In addition, during 2005, the Company capitalized approximately $29.7 million of costs associated with the development of Mac OS X Tiger. No software development costs were capitalized during 2006. Further information related to the Company’s capitalization of software development costs may be found in Part II, Item 8 of this Form 10-K at Note 1 of Notes to Consolidated Financial Statements. Despite the increase in expenditures, R&D as a percentage of net sales remained relatively flat in 2006 as compared to 2005 due to the significant increase in revenue. The Company continues to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace and are directly related to timely development of new and enhanced products that are central to the Company’s core business strategy. As such, the Company expects to make further investments in R&D to remain competitive. 

Selling, General, and Administrative Expense (SG&A) 

Expenditures for SG&A increased $569 million or 31% during 2006 compared to 2005. These increases are due primarily to the Company’s continued expansion of its Retail segment in both domestic and international markets, an increase of $50 million in stock-based compensation expense recognized as SG&A expense resulting from the adoption of SFAS No. 123R, a current year increase in discretionary spending on marketing and advertising, higher direct and channel selling expenses resulting from the increase in net sales and employee salary merit increases, and the expenses associated with the 14th week added to the first fiscal quarter of 2006 . Despite the increase in expenditures, SG&A as a percentage of total net sales in 2006 remained flat as compared to 2005. 

Expenditures for SG&A increased $434 million or 30% during 2005 compared to 2004. These increases are due primarily to the