PRODUCT DEVELOPMENT

During fiscal years 2006, 2005, and 2004, research and development expense was $6.58 billion, $6.10 billion, and $7.74 billion, respectively. Those amounts represented 14.9%, 15.3%, and 21.0%, 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. Generally, we also create product documentation 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.     Innovation is a key factor affecting Microsoft’s growth. In fiscal year 2006, we received our 5,000th patent. We continue our long-term commitment to research and development, including advanced work aimed at innovations in a wide spectrum of technologies: tools and platforms; 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:

• Strengthening core businesses.   The Client, Server & Tools, and Information Worker segments remain our largest businesses and continue to grow as a result of growth in personal computer and server shipments, software upgrades and growth in the market for business software and services. We believe the growth in our core businesses will be driven by our forthcoming innovations, including the Windows Vista operating system, the 2007 Microsoft Office system, and Exchange Server 2007. We also expect these businesses to be impacted by expected growth in the world’s developing countries, as their economies develop and they adopt global standards for intellectual property protection. In fiscal year 2006, nearly 60 million PCs were sold with pirated versions of Windows. Our Windows Genuine Advantage program and agreements with PC manufacturers in China are just two examples of our commitment to protect our intellectual property. Meanwhile, new payment options like FlexGo, which enables people to finance their computer use on a pay-as-you-go basis, will help us reach new consumers in emerging markets.
• Succeeding in adjacent businesses.    In fiscal year 2007, we will deliver new products, services, and technologies that we believe will position us to take advantage of new opportunities. One example is unified communications, which brings together telephony, email, instant messaging, mobile devices, and Web conferencing, in order to streamline the way workers communicate. We believe new enterprise information management tools will help knowledge workers create, find, use, and share business information more quickly and more effectively. In addition, we’ll offer new security capabilities, improved management products, and new development tools. We recently entered the high-performance computing business and we have new offerings and initiatives in industries such as life sciences and manufacturing.
• Entering new markets.    We believe new markets, such as online gaming and entertainment services, including IPTV, our digital television technology, provide a number of new opportunities for us.

Leading the Software Services Transformation.    Internet-based services are transforming the way people create, deploy, manage and use technology. We are committed to playing a leadership role in the software services transformation through our efforts to create our services platform for the next generation of applications, communications, and commerce. Across the company, software services are at the core of our development efforts.

In fiscal year 2006, we introduced Windows Live and Office Live, which provides small businesses with affordable Internet-based business services hosted by Microsoft. We rolled out new search services, including beta releases of Windows Live Search and Windows Live Academic Search. We introduced new and enhanced services for computer safety and computer maintenance (Windows Live SafetyCenter and Windows Live OneCare), communications (Windows Live Mail and Windows Live Messenger), and entertainment (Xbox Live). We also created Live Labs, an applied research program that targets Internet products and services.

Because software services offer strong opportunities for growth, we will continue to refine and improve adCenter, our advertising engine for Windows Live, MSN and other online offerings. We will deploy new service-based solutions, including Dynamics CRM Live, which we announced in July 2006. We will also continue to build out our services infrastructure, providing new tools to help partners and businesses create and host services, and adding new data centers to meet growing consumer demand for services.