PRODUCT DEVELOPMENT

During fiscal years 2003, 2004, and 2005, research and development expense was $6.60 billion, $7.78 billion, and $6.18 billion respectively. Those amounts represented 20.5%, 21.1%, and 15.5%, respectively, of revenue in each of those years. We plan to continue significant investment in 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.     A key factor affecting Microsoft’s growth is innovation. In fiscal year 2005, we filed for more than 3,000 U.S. patents for new technologies. We continue our long-term commitment to research and development, including advanced work aimed at important innovations in a wide spectrum of technologies: tools and platform; communication, collaboration and expression; information access and organization; entertainment; business and e-commerce; and devices. Through innovations in these areas, we expect to grow revenue via three principal strategies:

• Growing our anchor businesses.    The markets for our Client, Server & Tools, and Information Worker businesses are continuing to grow as a result of growth in hardware shipments and software upgrades. We believe the growth in our anchor businesses can be accelerated by our forthcoming innovations, including the Windows Vista operating system, the Office 12 upgrade of the Microsoft Office system, and new products from our Server & Tools business. In addition, we see opportunities to grow these businesses by making inroads against software piracy. As the world’s emerging economies develop and integrate more fully into the global economy, we expect that intellectual property will be more widely and effectively protected, and the current widespread use of unlicensed software will gradually diminish. At the same time, we are developing new products and services that are specifically designed to appeal to the unique requirements of emerging markets. Among them are products designed to be readily available and affordable for first-time PC users. We also expect our anchor businesses to grow through successfully competing against alternative solutions. In servers, for example, we expect to continue gaining customers as a result of migration from UNIX. We particularly see opportunities in the markets for Web servers, data centers, e-mail servers and in high-performance computing.
• Expanding our innovation portfolio.    Across each of our businesses, we see opportunities for growth through expansion of the technologies we offer. Within our anchor businesses, we are working to develop new technologies that offer greater value in meeting many targeted customer needs: workflow management, real-time communications, document management, collaboration, terminal services, search and portals, unified messaging, media technologies management, anti-spam and anti-malware protection, network edge security, desktop access to enterprise applications, business intelligence, rights management services, and storage. We expect to offer these technologies as new products and also as higher-value versions of existing products. In our emerging businesses, we are also moving forward with a broad portfolio of products, with a goal of providing best-in-class products in every major market where we compete, such as gaming, software for mobile devices, small business applications and interactive television.
• Delivering software services.    During the past several years, we have gained extensive experience in providing a variety of online consumer services, many of them supported by advertising or subscriptions. These services include the world’s largest email service, one of the world’s most popular online portals, MSN Search for the Web and the PC desktop, and Xbox Live, the world’s largest online gaming service. We also have begun to develop services for business, such as Outlook Live and Office Live Meeting, which enable workers to collaborate interactively without the cost and disruption of business travel. We expect to pursue opportunities to offer other new services both to consumers and businesses. Our announced plans to acquire FrontBridge Technologies, for example, will enable us to provide businesses with e-mail filtering and security to help protect the health of their networks and the security of their data. We expect that services will be an important component of our future growth.