of local currency revenue is hedged and much of the Company’s international manufacturing costs and operating expenses are also incurred in local currencies, the impact of exchange rates is partially mitigated.



Operating Expenses

Microsoft encourages broad-based employee ownership of Microsoft stock through an employee stock option (ESO) program in which most employees are eligible to participate.  Historically, exercise prices of grants of ESOs were struck at the lowest price in the 30 days following July 1 for annual grants and the 30 days after the start date for new employees.  In connection with this practice, which is no longer employed, a charge of $217 million was recorded in the fourth quarter for fiscal 1999 compensation expense, calculated under the provisions of Accounting Principles Board Opinion 25 (APB 25).  Charges related to ESO compensation were reflected in 1999 operating expenses as follows (in millions):



Cost of revenue

Cost of revenue as a percent of revenue was 18.2% in 1997, 16.1% in 1998, and 14.3% in 1999.  The percentage decreases resulted primarily from the trend in mix shift to OEM and organizational licenses.  The decrease was also due to the shifts in mix to CD-ROMs (which carry lower cost of goods than disks) and higher-margin Windows NT Server, other servers, and client access licenses in the BackOffice product family.  Additionally, cost of revenue in 1999 was positively impacted by a reduction in estimates of obsolete inventory and other manufacturing costs of $67 million.  As discussed above, the Company’s business model continues to evolve toward licensing from sales of packaged products through distribution channels.  Consequently, risks associated with manufacturing and holding physical product have declined.



Research and development

Microsoft continued to invest heavily in the future by funding research and development (R&D).  Expense increases in 1997, 1998, and 1999 resulted primarily from development staff headcount growth in many areas, particularly Windows platforms, including PC operating systems, servers, and Internet and intranet technologies.  R&D costs also increased for productivity applications, development tools, and online services. In 1998, the Company acquired WebTV Networks, Inc., an online service that enables consumers to experience the Internet through their televisions via set-top terminals.  Microsoft paid $425 million in stock and cash.  The accompanying income statement reflects a one-time write-off of in-process technologies under development by WebTV Networks of $296 million.



Sales and marketing

The increase in the absolute dollar amount of sales and marketing expenses in the three-year period was due primarily to expanded product-specific marketing programs, such as Office 97 in 1997, Windows 98 in 1998, and Office 2000 in 1999.  Sales and marketing costs as a percentage of revenue decreased primarily due to moderate headcount growth.  Microsoft brand advertising expenses rose slightly in 1998, but declined in 1999.



General and administrative

Increases in general and administrative expenses were attributable to higher legal fees, litigation costs, and