has continued toward a higher percentage

of organization licensing versus packaged products.

OEM channel revenue was $2.50 billion in 1996, $3.48 billion in 1997, and $4.72

billion in 1998.  The primary source of OEM revenue is the licensing of desktop

operating systems, and OEM revenue is highly dependent on PC shipment volume.

U.S. and Canadian channel revenue was $2.68 billion, $3.41 billion, and $4.36

billion in 1996, 1997, and 1998.  Revenue in Europe was $2.02 billion, $2.54

billion, and $3.15 billion in 1996, 1997, and 1998.  Growth rates have been

lower in Europe than in other geographic areas due to higher existing market

shares and a more dramatic shift to licensing programs.  Other International

channel revenue was $1.47 billion in 1996, $1.93 billion in 1997, and $2.26

billion in 1998.  Growth rates were higher in the Other International channel in

1996 and 1997 due to customers accepting newly localized products, particularly

in Japan, and penetration in emerging markets.  However, revenue was relatively

flat in Japan and Southeast Asia in 1998 due to economic issues and weak

currencies.

The Company's operating results are affected by foreign exchange rates.

Approximately 34%, 32%, and 34% of the Company's revenue was collected in

foreign currencies during 1996, 1997, and 1998.  Since a portion 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

COST OF REVENUE. As a percentage of revenue, cost of revenue was 13.7% in 1996,

9.6% in 1997, and 8.3% in 1998.  The decrease was due to the shifts in mix to

CD-ROMs (which carry lower cost of goods than disks), licenses to OEMs and

organizations, and higher-margin Windows NT Server, other servers, and client

access licenses in the BackOffice product family.  In 1998, the decrease was

offset somewhat by costs of WebTV.



RESEARCH AND DEVELOPMENT. Microsoft continued to invest heavily in the future by

funding research and development (R&D).  Expense increases of 67% in 1996, 34%

in 1997, and 30% in 1998 resulted primarily from development staff headcount

growth and higher levels of third-party development costs in many areas,

particularly Windows-based platforms, including desktop operating systems,

server systems, and consumer appliances, along with Internet and intranet technologies. R&D costs

also increased for desktop and server applications, development tools, and

interactive media initiatives such as MSN and other online services.

In August 1997, 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