PRODUCT DEVELOPMENT

During fiscal 2002, 2003, and 2004, research and development expense was $6.30 billion, $6.60 billion, and $7.78 billion respectively. Those amounts represented 22.2%, 20.5%, and 21.1%, respectively, of revenue in each of those years. Fiscal 2002 and 2003 have been restated to reflect the retroactive adoption of SFAS 123, Accounting for Stock-Based Compensation. We plan to continue significant investment on a broad range of research and product development.

Most of our software products are developed internally. We also purchase technology, license intellectual property rights, and oversee third-party development and localization of certain products. We believe we are not materially dependent upon licenses and other agreements with third parties relating to the development of our products. Internal development allows us to maintain closer technical control over our products. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. Product documentation generally is also created internally. We strive to obtain information at the earliest possible time about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing.

Business and Product Development Strategy.    The key to Microsoft's growth is innovation. In fiscal 2004, we filed for more than 2,000 patents for new technologies, and we expect that number to increase. We expect these innovations to lead to revenue growth from market expansion, share growth, new scenarios and market opportunities, and value-added through services.

Key areas of focus include:

• PC Market Growth:    It took more than 20 years to grow the worldwide base of PC users to 600+ million. By 2010, we expect this base to grow to 1 billion, due to opportunities in emerging markets and new scenarios and form factors expected to stimulate demand. Our continued success will depend on delivering secure, groundbreaking software and compelling scenarios that capture the imagination of end users. We are working on new PC and Windows designs to make PCs affordable to millions of additional people around the world.
• New Information Worker Scenarios:    We believe one of our biggest growth opportunities is with our existing base of Office users. We plan to pursue this market by delivering new information worker scenarios such as collaboration, authoring, communications, planning and analysis, and expanding the toolset with new technologies such as SharePoint, Live Meeting, OneNote and InfoPath.
• Enhanced Server Position:    We believe Windows Server 2003 and our other server offerings provide customers with significant advantages in many areas, including innovation, performance, productivity, applications development tools and environment, security and manageability. In addition, we offer an integrated platform that includes our server and Information Worker applications as well as partner ISV workloads and applications.
• Reducing Complexity and Cost for IT Professionals and Developers:    We believe that building applications, integration, and managing information technology are still too hard for customers. We are working on new ways to further lower costs and speed time to deploy technology for IT professionals and developers. We believe we are already helping reduce costs and increase business value with products such as Windows Server 2003, Visual Studio .NET, SMS 2003, the Dynamic Systems Initiative, and Microsoft Operations Manager 2005.
• IT Services for Smaller Business and Consumers:    The MSN, Windows, and Office teams are working together on a set of integrated IT services for smaller businesses and consumers designed to enhance security, lower costs, and improve the end-user experience in areas such as communication, collaboration, and desktop management.
• Business Solutions:    Microsoft Business Solutions continues to expand its small and mid-market offerings with key investments in technologies for CRM, online services, retail management, and small business. We believe we have a significant opportunity to help this underserved market, while creating great opportunities for ISVs and partners.
• Non-PC Consumer Electronics:    We believe that our work to integrate the richness and intelligence of the PC world with everyday devices such as mobile phones, handheld devices, home entertainment and TV provides a broad new market opportunity. At the center of our efforts are products such as Pocket PC and Smartphone, Portable Media Center, MSTV, MSN TV, Windows Automotive, the Windows Media Center Extender, and other electronic devices built on Windows CE and Windows XP Embedded.
• Entertainment:    Likewise, we believe there is significant opportunity in delivering compelling entertainment experiences in key scenarios such as music, TV, movies, photos and games. Our vision centers on creating new and exciting ways for people to have fun with friends and family with Media Center PCs, devices like Xbox and Portable Media Center, and many of the other applications and services that Microsoft and our partners deliver.
• Advertising/Information:    The value that MSN and our platform bring to advertisers is already significant, as evidenced by the fact that our MSN advertising business today is a $1 billion-plus business. We believe the potential to expand advertising in all our online offerings is significant. In fiscal 2005, we will invest in and deliver improvements in search, music and other information services that should continue to provide good growth opportunities. We believe our industry has only scratched the surface in search. We are making significant investments to improve the user experience and deliver the information people want more efficiently and effectively.
• Communications:    Broadband and wireless technology is increasing the amount of time people spend online. Younger and savvier Internet users want communications experiences to build their social network on any device. We believe professionals and information workers want integrated, secure functionality that help them manage their personal and professional lives: personalized email, instant messaging, contact management, shared calendars, and relationship management. We are pursuing these opportunities by developing communications offerings designed to provide the greatest benefit to consumers and device manufacturers. For example, our Windows Mobile software is the basis for new mobile smartphones and for Portable Media Center devices from leading consumer electronics companies.