<PAGE>   1


                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549


                                    FORM 10-Q


(Mark One)
[X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934
     For the fiscal period ended: SEPTEMBER 30, 1999

                                       OR

[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934
     For the transition period from              to
                                    ------------    ------------

                         Commission file number: 0-20679



                            MECHANICAL DYNAMICS, INC.
             (Exact name of registrant as specified in its charter)


            MICHIGAN                              38-2163045
    (State of incorporation)          (I.R.S. Employer Identification No.)



                             2301 COMMONWEALTH BLVD.
                            ANN ARBOR, MICHIGAN 48105
                                 (734) 994-3800
             (Address of principal executive offices, including zip
                code, and telephone number, including area code)


     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
                          [X] Yes          [ ] No



     The number of outstanding shares of the Registrant's common stock, as of
November 8, 1999, was 6,275,363.




<PAGE>   2



                            MECHANICAL DYNAMICS, INC.

                                    FORM 10-Q
                                TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                                                             PAGE
                                                                                                             ----
<S>        <C>                                                                                               <C>
PART I  -  FINANCIAL INFORMATION

  Item 1.  Financial Statements

           Condensed Consolidated Balance Sheets
           September 30, 1999 and December 31, 1998.................................................            3

           Condensed Consolidated Statements of Income
           Three and Nine Months Ended September 30, 1999 and 1998..................................            4

           Condensed Consolidated Statements of Cash Flows
           Nine Months Ended September 30, 1999 and 1998............................................            5

           Notes to Condensed Consolidated Financial Statements.....................................            7

  Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations....            8

  Item 3.  Quantitative and Qualitative Disclosures about Market Risk...............................           15

PART II -  OTHER INFORMATION

  Item 6.  Exhibits and Reports on Form 8-K.........................................................           16

SIGNATURES.                                                                                                    17

INDEX TO EXHIBITS....................................................................................          18
</TABLE>




                                       2
<PAGE>   3
                         PART I - FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS


                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
                      CONDENSED CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                        SEPTEMBER 30,    DECEMBER 31,
   in thousands                                                             1999             1998
----------------------------------------------------------------------------------------------------
<S>                                                                        <C>               <C>
   ASSETS:                                                               (UNAUDITED)
   Current assets:
     Cash and cash equivalents                                             $17,122           $16,843
     Accounts receivable, net                                                9,111             9,893
     Prepaid and deferred expenses                                           2,449             1,873
----------------------------------------------------------------------------------------------------
       Total current assets                                                 28,682            28,609
----------------------------------------------------------------------------------------------------
   Property and equipment, net                                               3,495             3,674
   Goodwill, net                                                             3,527             3,820
   Other assets                                                                482               144
----------------------------------------------------------------------------------------------------
   Total assets                                                            $36,186           $36,247
====================================================================================================

   LIABILITIES AND SHAREHOLDERS' EQUITY:
   Current liabilities:
     Borrowings under lines of credit                                      $    74           $   105
     Accounts payable                                                          991             1,781
     Accrued expenses                                                        2,917             3,544
     Deferred revenue                                                        5,160             4,745
----------------------------------------------------------------------------------------------------
       Total current liabilities                                             9,142            10,175
----------------------------------------------------------------------------------------------------
   Minority interest                                                           470               472
   Shareholders' equity:
     Common stock                                                           22,535            22,332
     Preferred stock                                                             0                 0
     Retained earnings                                                       3,684             3,073
     Cumulative translation adjustment                                         355               195
----------------------------------------------------------------------------------------------------
       Total shareholders' equity                                           26,574            25,600
----------------------------------------------------------------------------------------------------
   Total liabilities and shareholders' equity                              $36,186           $36,247
====================================================================================================
</TABLE>


         The accompanying notes are an integral part of these condensed
                       consolidated financial statements.

                                        3
<PAGE>   4
                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
                   CONDENSED CONSOLIDATED STATEMENTS OF INCOME
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                                            THREE MONTHS ENDED          NINE MONTHS ENDED
                                                                                SEPTEMBER 30,              SEPTEMBER 30,
                                                                         ----------------------------------------------------
     in thousands except share and per share data                            1999         1998          1999          1998
-----------------------------------------------------------------------------------------------------------------------------
<S>                                                                      <C>          <C>            <C>           <C>
   Revenue:
     Software licenses                                                   $    4,572   $     4,093    $   13,868    $   13,530
     Services                                                                 5,157         4,087        15,385        12,290
-----------------------------------------------------------------------------------------------------------------------------
       Total revenue                                                          9,729         8,180        29,253        25,820
-----------------------------------------------------------------------------------------------------------------------------
   Cost of revenue:
     Software licenses                                                          871           689         2,520         1,489
     Services                                                                 2,797         2,414         8,354         6,900
-----------------------------------------------------------------------------------------------------------------------------
       Total cost of revenue                                                  3,668         3,103        10,874         8,389
-----------------------------------------------------------------------------------------------------------------------------
   Gross profit                                                               6,061         5,077        18,379        17,431
-----------------------------------------------------------------------------------------------------------------------------
   Operating expenses:
     Sales and marketing                                                      3,631         3,499        11,416        10,077
     Research and development                                                 1,362         1,358         4,118         3,870
     General and administrative                                                 886           881         2,770         2,570
     Goodwill amortization                                                      113            75           340           157
     Acquisition-related and non-recurring charges                                0           203             0         1,403
-----------------------------------------------------------------------------------------------------------------------------
       Total operating expenses                                               5,992         6,016        18,644        18,077
-----------------------------------------------------------------------------------------------------------------------------
   Operating income (loss)                                                       69          (939)         (265)         (646)
   Other income, net                                                            116           207           415           622
-----------------------------------------------------------------------------------------------------------------------------
   Income (loss) before income taxes and minority interest                      185          (732)          150           (24)
   Provision (credit) for income taxes                                         (449)         (160)         (459)          416
-----------------------------------------------------------------------------------------------------------------------------
   Net income (loss) before minority interest                                   634          (572)          609          (440)
   Minority interest in net income (loss) of subsidiary                          (6)           14            (2)           26
-----------------------------------------------------------------------------------------------------------------------------
   Net income (loss)                                                           $640         ($586)         $611         ($466)
-----------------------------------------------------------------------------------------------------------------------------

   Basic net income (loss) per common share                              $     0.10        ($0.09)   $     0.10        ($0.08)
-----------------------------------------------------------------------------------------------------------------------------
   Weighted average common shares                                         6,260,443     6,213,082     6,247,778     6,173,224
-----------------------------------------------------------------------------------------------------------------------------

   Diluted net income (loss) per common share                            $     0.10        ($0.09)        $0.10        ($0.08)
-----------------------------------------------------------------------------------------------------------------------------
   Weighted average common and common equivalent shares                   6,260,443     6,213,082     6,247,778     6,173,224
-----------------------------------------------------------------------------------------------------------------------------
</TABLE>

              The accompanying notes are an integral part of these
                  condensed consolidated financial statements.

                                        4
<PAGE>   5

                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
                 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                         NINE MONTHS ENDED
                                                                                            SEPTEMBER 30,
                                                                                -------------------------------
   in thousands                                                                         1999              1998
---------------------------------------------------------------------------------------------------------------
<S>                                                                                      <C>              <C>
   Cash flows from operating activities:
     Net income (loss)                                                                $   611             ($466)
     Adjustments to reconcile net income (loss) to net cash
      provided by (used in) operating activities:
       Acquisition-related and non-recurring charges                                        0             1,403
       Depreciation and amortization                                                    1,502             1,165
       Loss on disposal of assets, net                                                     63                39
       Minority interest in net income of subsidiary                                       (2)               26
       Changes in assets and liabilities:
         Accounts receivable                                                              552              (418)
         Prepaid and deferred expenses                                                   (603)             (264)
         Other assets                                                                    (359)              (50)
         Accounts payable                                                                (581)             (176)
         Accrued expenses                                                                (542)             (784)
         Deferred revenue                                                                 466              (636)
---------------------------------------------------------------------------------------------------------------
            Net cash provided by (used in) operating activities                         1,107              (161)
---------------------------------------------------------------------------------------------------------------
   Cash flows from investing activities:
     Proceeds from the sale of property and equipment                                       0                19
     Purchases of property and equipment                                               (1,046)           (1,507)
     Purchase of HGE, Inc., net of cash acquired                                            0            (2,040)
     Purchase of DTI Asia Pte. Ltd., net of cash acquired                                   0              (563)
---------------------------------------------------------------------------------------------------------------
            Net cash used in investing activities                                      (1,046)           (4,091)
---------------------------------------------------------------------------------------------------------------
   Cash flows from financing activities:
     Net borrowings under line of credit agreements                                       (31)               85
     Proceeds from the issuance of common stock                                           203               335
---------------------------------------------------------------------------------------------------------------
            Net cash provided by financing activities                                     172               420
---------------------------------------------------------------------------------------------------------------
   Effect of exchange rate changes on cash                                                 46                72
---------------------------------------------------------------------------------------------------------------
   Net decrease in cash and cash equivalents                                              279            (3,760)
   Cash and cash equivalents at beginning of period                                    16,843            20,261
---------------------------------------------------------------------------------------------------------------
   Cash and cash equivalents at end of period                                         $17,122           $16,501
---------------------------------------------------------------------------------------------------------------
</TABLE>

              The accompanying notes are an integral part of these
                  condensed consolidated financial statements.

                                        5
<PAGE>   6
                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
                 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (UNAUDITED)
<TABLE>
<CAPTION>
                                                                                        NINE MONTHS ENDED
                                                                                          SEPTEMBER 30,
                                                                                ---------------------------------
   in thousands                                                                          1999            1998
-----------------------------------------------------------------------------------------------------------------
<S>                                                                                      <C>               <C>
   Supplemental disclosures of cash flow information:
     Cash paid during the period for:
       Interest                                                                          $ 13            $   10
       Income taxes                                                                      $172            $1,270
-----------------------------------------------------------------------------------------------------------------
   Details of acquisition of HGE, Inc.:
     Net liabilities, excluding cash acquired                                                             ($118)
     Purchase price in excess of the net assets acquired                                                  1,955
     Purchased in-process research and development                                                          203
-----------------------------------------------------------------------------------------------------------------
       Net cash used to acquire HGE, Inc.                                                                $2,040
-----------------------------------------------------------------------------------------------------------------
   Details of acquisition of DTI Asia Pte. Ltd.:
     Net liabilities, excluding cash acquired                                                              ($59)
     Purchase price in excess of the net assets acquired                                                    734
     Purchased in-process research and development                                                          980
     Stock issued                                                                                        (1,092)
-----------------------------------------------------------------------------------------------------------------
       Net cash used to acquire DTI Asia Pte. Ltd.                                                       $  563
-----------------------------------------------------------------------------------------------------------------
</TABLE>

              The accompanying notes are an integral part of these
                  condensed consolidated financial statements.

                                        6
<PAGE>   7



                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(1) - BASIS OF PRESENTATION

     The accompanying unaudited condensed consolidated financial statements
include the accounts of Mechanical Dynamics, Inc. ("MDI" or the "Company") and
its subsidiaries, and have been prepared in accordance with generally accepted
accounting principles for interim financial information and with Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. The Company believes all adjustments, consisting of normal
recurring adjustments considered necessary for a fair presentation, have been
included. For further information, refer to the consolidated financial
statements and footnotes thereto included in the Company's Form 10-K for the
year ended December 31, 1998.

     Operating results for the three and nine month periods ended September 30,
1999 and 1998 are not necessarily indicative of the results that may be expected
for the full year.


(2) - COMPREHENSIVE INCOME

     Comprehensive income is the total of net income and all other non-owner
changes in equity. Total comprehensive income (loss) was $912,000 and ($417,000)
for the three month periods ended September 30, 1999 and 1998, respectively, and
$771,000 and ($361,000) for the nine month periods ended September 30, 1999 and
1998, respectively. The difference between net income (loss), as reported in the
accompanying condensed consolidated statements of income, and comprehensive
income (loss) is the foreign currency translation adjustment for the respective
periods.


(3) - EARNINGS PER SHARE

     For the three and nine month periods ended September 30, 1999, there were
no dilutive options outstanding. For the three and nine month periods ended
September 30, 1998, the effect of stock options outstanding for the purchase of
45,759 and 34,956 shares, respectively, were not included in the net loss per
common share calculation because doing so would have been anti-dilutive.

(4) - DERIVATIVES

     In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS 133"). SFAS 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts and hedging activities. It requires that
an entity record all derivatives as either assets or liabilities at fair value.
Under certain conditions, a derivative may be designated as a hedge of (1)
potential changes in the fair value of an asset or liability or firm commitment,
(2) the foreign currency exposure of a forecasted transaction, or (3) the
foreign currency exposure of the net investment in a foreign operation. The
accounting for changes in the fair value of a derivative instrument depends on
the intended use of the derivative and the resulting designation. The statement
is effective for all fiscal quarters of fiscal years beginning after June 15,
2000. The Company's derivative activities are currently limited to entering into
forward contracts to hedge potential changes in the fair value of its
receivables denominated in certain foreign currencies.



                                       7
<PAGE>   8


ITEM 2.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

     The following discussion provides an analysis of the Company's financial
condition and results of operations, and should be read in conjunction with the
Company's consolidated financial statements and the notes included in Item 1 of
this Form 10-Q.

OVERVIEW

     The Company develops, markets and supports virtual prototyping solutions.
The Company's virtual prototyping software allows an engineer or designer to
design a complete product by simulating, both visually and mathematically, a
product in motion. The Company's principal software product, ADAMS Full
Simulation Package, is used by customers to simulate mechanical systems. The
Company's revenue has in the past been, and is expected to be in the future,
derived primarily from its ADAMS Full Simulation Package and related software
products and services.

FORWARD-LOOKING INFORMATION IS SUBJECT TO RISK AND UNCERTAINTY

     Except for the historical information contained in this report, the matters
herein contain "forward-looking" statements (as defined in the Private
Securities Litigation Reform Act of 1995) that involve risk and uncertainty.
These forward-looking statements include, but are not limited to, revenue
levels, including the level of international revenue, certain costs and
operating expense levels, the level of other income, the Company's liquidity and
capital needs and various business environment and trend information. Actual
future results and trends may differ materially depending on a variety of
factors, including the volume and timing of orders received during the quarter;
the mix of and changes in distribution channels through which the Company's
products are sold; the timing and acceptance of new products and product
enhancements by the Company or its competitors; changes in pricing; the level of
the Company's sales of third-party products; purchasing patterns of distributors
and customers; competitive conditions in the industry; business cycles affecting
the markets in which the Company's products are sold; extraordinary events, such
as litigation; risks inherent in seeking and consummating acquisitions,
including the diversion of management attention to the assimilation of the
operations and personnel of the acquired business; fluctuations in foreign
exchange rates; the impact of undetected errors or defects, including those
associated with Year 2000 date functions, on the Company's current products,
vendors and internal systems; and economic conditions generally or in various
geographic areas. All of the foregoing factors are difficult to forecast. The
future operating results of the Company may fluctuate as a result of these and
other risk factors detailed from time to time in the Company's Securities and
Exchange Commission reports.

     Due to all of the foregoing factors, the Company believes that
period-to-period comparisons of its results of operations are not necessarily
meaningful and should not be relied upon as an indication of future performance.
It is likely that, in some future quarters, the Company's operating results will
be below the expectations of stock market analysts and investors. In such an
event, the price of the Company's common stock would likely be materially
adversely affected.

RESULTS OF OPERATIONS

   REVENUE

<TABLE>
<CAPTION>
                                             THREE MONTHS ENDED SEPTEMBER 30,          NINE MONTHS ENDED SEPTEMBER 30,
                                       -----------------------------------------  ---------------------------------------
   dollars in thousands                         1999        1998    % CHANGE          1999         1998       % CHANGE
-------------------------------------------------------------------------------------------------------------------------
<S>                                            <C>         <C>         <C>            <C>         <C>            <C>
   Software licenses                           $4,572      $4,093      11.7%          $13,868     $13,530        2.5%
    % of total revenue                           47.0%       50.0%                       47.4%       52.4%

   Services                                    $5,157      $4,087      26.2%          $15,385     $12,290       25.2%
    % of total revenue                           53.0%       50.0%                       52.6%       47.6%

------------------------------------------------------------------------------------------------------------------------
   Total revenue                               $9,729      $8,180      18.9%          $29,253     $25,820       13.3%
-------------------------------------------------------------------------------------------------------------------------
</TABLE>


                                       8
<PAGE>   9

    The Company's total revenue increased 18.9% and 13.3% during the three and
nine month periods ended September 30, 1999, respectively, as compared to the
corresponding periods in 1998. The growth in revenue resulted primarily from
increased services provided to the Company's customers, as well as from
increased sales of third party software products licensed through the Company's
European and Canadian subsidiaries. The revenue growth experienced by the
Company during the three month period ended September 30, 1999 was also a result
of increased sales of the Company's software products.

    Revenue from international customers accounted for approximately 59.8% and
62.5% of the Company's total revenue during the three months ended September 30,
1999 and 1998, respectively. International revenue accounted for approximately
61.3% and 63.0% of total revenue during the nine months ended September 30, 1999
and 1998, respectively. The decrease in international revenue as a percent of
total revenue was due primarily to a decline in revenue from Japan as a percent
of total revenue caused by the overall economic weakness in the region, as well
as incremental sales generated in North America by the Company's Canadian
subsidiary, which was established in August 1998 with the acquisition of the
Design Analysis Group and certain other assets of HGE, Inc. During the three and
nine months ended September 30, 1999, the decrease in international revenue was
also caused by the strengthening of the dollar relative to the European
currencies which negatively impacted the Company's revenue by approximately
$115,000 and $261,000, respectively. Since most of the Company's international
operating expenses were incurred in foreign currencies, the net impact of
exchange rate fluctuations on income from operations was considerably less than
the impact on revenue. If the U.S. dollar continues to strengthen in 1999
relative to the European currencies, the Company's international revenue will be
negatively impacted, which could have a material adverse effect on the Company's
consolidated results of operations.

    As discussed above and in previous quarterly filings with the Securities and
Exchange Commission, the Company's international revenue has been negatively
impacted by economic weakness in certain countries in Asia, including Japan. If
the economies in Asia deteriorate further in 1999, the Company's overall Asian
revenue could be adversely impacted, which could have a material adverse effect
on the Company's consolidated results of operations. Consequently, the Company
remains cautious in its overall outlook for Asian revenue in the fourth quarter
of 1999 and the first half of 2000. The Company expects that international
revenue will continue to account for a significant portion of its total revenue
in future periods.

    Software licenses revenue consists primarily of license fees for the
Company's software products and, to a lesser extent, license fees for third
party software products licensed through the Company's European and Canadian
subsidiaries. Software licenses revenue increased 11.7% and 2.5% during the
three and nine month periods ended September 30, 1999, respectively, as compared
to the corresponding periods in 1998. This increase resulted primarily from
increased sales of third party software products in Europe and Canada, and, to a
lesser extent, from increased sales of the Company's software products
throughout the world. Revenue from third party software products totaled
approximately $864,000, or 8.9% of total revenue during the three month period
ended September 30, 1999, as compared to $674,000, or 8.2% of total revenue
during the corresponding period in 1998. Revenue from third party products
totaled approximately $2.9 million, or 9.8% of total revenue during the nine
month period ended September 30, 1999, as compared to $1.6 million, or 6.1% of
total revenue during the corresponding period in 1998.

    Services revenue consists of revenue from software maintenance agreements
and professional services, including consulting, training and funded research
and development. Total services revenue increased 26.2% and 25.2% during the
three and nine month periods ended September 30, 1999, respectively, as compared
to the corresponding periods in 1998. Both the software maintenance and the
professional services components of services revenue experienced solid growth
during the first nine months of 1999. Software maintenance revenue grew 41.7%
and 33.6% during the three and nine month periods ended September 30, 1999,
respectively, as compared to the corresponding periods in 1998. Professional
services revenue grew 17.5% and 21.1% during the three and nine month periods
ended September 30, 1999, respectively, as compared to the corresponding periods
in 1998. The overall increase in services revenue reflects the Company's
continued emphasis on providing total solutions to its customers.



                                       9
<PAGE>   10

   COST OF REVENUE


<TABLE>
<CAPTION>
                                           THREE MONTHS ENDED SEPTEMBER 30,           NINE MONTHS ENDED SEPTEMBER 30,
                                       -----------------------------------------  ---------------------------------------
   dollars in thousands                         1999         1998    % CHANGE          1999         1998     % CHANGE
-------------------------------------------------------------------------------------------------------------------------
<S>                                            <C>         <C>         <C>             <C>         <C>          <C>
   Cost of software licenses                   $  871      $  689      26.4%           $2,520      $1,489       69.2%
    Gross profit margin on software
     licenses revenue                            80.9%       83.2%                       81.8%       89.0%

   Cost of services                            $2,797      $2,414      15.9%           $8,354      $6,900       21.1%
    Gross profit margin on services
     revenue                                     45.8%       40.9%                       45.7%       43.9%
-------------------------------------------------------------------------------------------------------------------------
</TABLE>


     Cost of software licenses includes software royalty fees, media costs,
payroll and other costs attributable to software documentation and distribution,
and an allocation of depreciation, utilities and other overhead expenses
incurred by the Company. Cost of software licenses revenue increased 26.4% and
69.2% during the three and nine month periods ended September 30, 1999,
respectively, as compared to the corresponding periods in 1998. The increase in
cost of software licenses was due to higher royalties paid to third parties
whose products were licensed through the Company's Canadian and European
subsidiaries.

     Gross profit margin on software licenses revenue was 80.9% and 83.2% during
the three month periods ended September 30, 1999 and 1998, respectively. Gross
profit margin on software licenses revenue was 81.8% and 89.0% during the nine
month periods ended September 30, 1999 and 1998, respectively. The decline in
gross profit margin was due to the increased sales of third party software
products as a percent of total software licenses revenue. The gross profit
margin derived from sales of third party software products has historically been
lower than the gross profit margin derived from sales of the Company's software
products.

     Cost of services includes payroll and overhead expenses attributable to
hotline support, consulting, training and funded research and development. Cost
of services revenue grew 15.9% and 21.1% during the three and nine month periods
ended September 30, 1999, respectively, as compared to the corresponding periods
in 1998. This increase in cost of services was primarily due to the hiring of
additional employees to support the growth in services provided to the Company's
customers during 1999.

     Gross profit margin on services revenue was 45.8% and 40.9% during the
three month periods ended September 30, 1999 and 1998, respectively. Gross
profit margin on services revenue was 45.7% and 43.9% during the nine month
periods ended September 30, 1999 and 1998, respectively. Changes in the gross
profit margin on services revenue are principally due to fluctuations in the mix
of services revenue, as well as fluctuations in the profit margins realized by
the Company on consulting projects performed during the periods. Historically,
revenue from software maintenance agreements has generated higher profit margins
than revenue from professional services.


                                       10
<PAGE>   11


 OPERATING EXPENSES

<TABLE>
<CAPTION>
                                             THREE MONTHS ENDED SEPTEMBER 30,         NINE MONTHS ENDED SEPTEMBER 30,
                                        -----------------------------------------  --------------------------------------
   dollars in thousands                         1999        1998     % CHANGE           1999       1998       % CHANGE
-------------------------------------------------------------------------------------------------------------------------
<S>                                            <C>         <C>          <C>           <C>         <C>           <C>
   Sales and marketing                         $3,631      $3,499       3.8%          $11,416     $10,077       13.3%
    % of total revenue                           37.3%       42.8%                       39.0%       39.0%

   Research and development                    $1,362      $1,358       0.3%          $ 4,118      $3,870        6.4%
    % of total revenue                           14.0%       16.6%                       14.1%       15.0%

   General and administrative                  $  886      $  881       0.6%          $ 2,770      $2,570        7.8%
    % of total revenue                            9.1%       10.8%                        9.5%       10.0%

   Goodwill amortization                       $  113      $   75      50.7%          $   340      $  157      116.6%
    % of total revenue                            1.2%        0.9%                        1.2%        0.6%

   Acquisition-related and
    non-recurring charges                      $    0      $  203                     $     0      $1,403
    % of total revenue                            0.0%        2.5%                        0.0%        5.4%
-------------------------------------------------------------------------------------------------------------------------
</TABLE>


     During the third quarter of 1999, the Company realized sequential declines
in each major category of operating expense, including sales and marketing,
research and development, and general and administrative expenses. In aggregate,
these operating expenses declined by $351,000 from the second quarter of 1999,
primarily as a result of cost management initiatives put in place by the
Company's management in an effort to return the Company to profitability. These
cost management initiatives involved various measures that would not have a
direct impact on revenue generation, including delays in hiring or replacing
employees as well as reductions in discretionary spending. An overall
comparative analysis of each item in operating expense follows.

     Sales and marketing expenses include costs associated with the Company's
sales channels, such as personnel, commissions, sales office costs, travel,
promotional events, sales order processing, including license administration and
order fulfillment, and advertising and public relations programs. Sales and
marketing expenses also include an allocation of overhead expenses incurred by
the Company. The absolute dollar increase in sales and marketing expenses during
the three and nine month periods ended September 30, 1999, as compared to the
corresponding periods in 1998, resulted from the Company's expanded worldwide
sales and marketing organization. The Company's sales and marketing employees
totaled 92 at September 30, 1999, an increase of 2.2% from 90 at September 30,
1998. The Company expects to continue to invest significant resources in sales
and marketing, and will plan to expand its sales and marketing organization as
necessary to meet a growing demand for its products and services.

     Research and development expenses include all payroll costs attributable to
research and development activities. Research and development expenses also
include an allocation of overhead expenses incurred by the Company. Costs
associated with funded research and development projects are included in cost of
services. The increase in research and development expenses during the three and
nine month periods ended September 30, 1999, as compared to the corresponding
periods in 1998, primarily resulted from an increase in costs to support the
Company's expanded development efforts. The Company intends to continue to
invest significant resources in research and development in the future.

     General and administrative expenses include the cost of salaries, employee
benefits and other payroll costs associated with the Company's finance,
accounting, human resources, information systems and executive management
functions. General and administrative expenses also include an allocation of
overhead expenses incurred by the Company. General and administrative expenses
increased 0.6% and 7.8% during the three and nine month periods ended September
30, 1999, respectively, as compared to the corresponding periods in 1998. The
absolute dollar increase in these expenses was primarily due to additional
expenses incurred to support the Company's worldwide growth.


                                       11
<PAGE>   12


     Goodwill amortization includes the amortization of purchase price in excess
of net assets on the Company's acquisitions. Goodwill amortization increased
50.7% and 116.6% during the three and nine month periods ended September 30,
1999, respectively, as compared to the corresponding periods in 1998, due to
increased goodwill associated with the Company's acquisitions throughout 1998.
The Company amortizes goodwill over the periods estimated to be benefited from
the acquisitions, after considering such factors as demand, competition, service
lives of employees and expected actions of competitors.

     Acquisition-related and non-recurring charges were approximately $203,000
and $1.4 million, respectively, in the three and nine month periods ended
September 30, 1998, and consist primarily of the write-off of purchased
in-process research and development ("R&D") associated with the Company's
acquisitions of DTI Asia Pte. Ltd ("DTI") in January 1998 and the Design
Analysis Group of HGE, Inc. ("HGE") in August 1998. The value assigned to
in-process R&D was determined by an independent appraisal of the acquired
company's assets, both tangible and intangible. The portion of the aggregate
purchase price assigned to in-process R&D was determined by identifying research
projects for which technological feasibility had not yet been established. The
appraisal considered such factors as the estimated percent complete of each
project in process at the date of acquisition, the estimated remaining costs to
develop the in-process R&D into commercially viable products and the estimated
discounted net future cash flows from such products. If the Company were unable
to complete the R&D projects in a timely manner or lost key personnel from the
acquired companies, revenue and operating income in future periods could be
adversely impacted.

     DTI was a start-up company, established in 1994, and consisted of four
employees located on three continents whose time was primarily dedicated to
developing motion simulation technology for the mid-range CAD market.
Significant projects in process at the date of acquisition included: (1)
integrating the Company's ADAMS solution engine with the acquired company's
existing technology; (2) developing advanced "wizards" to increase ease of use;
and (3) adding finite element analysis capabilities. The value of the in-process
R&D was appraised using the milestone approach, and involved the following
assumptions: the net cash inflows from the in-process R&D commencing in the
fourth quarter of 1998, operating expenses consistent with historical levels and
a risk-adjusted discount rate of 35.0%. Since the acquisition, the Company has
completed integration of the ADAMS solution engine and released a new version of
the acquired company's product line featuring increased ease of use. Costs
associated with the completion of these projects were consistent with the
assumptions used in the valuation.

     The technology acquired from HGE consisted of a metal stamping analysis
program that simulates strain in thin metal sheets. Significant projects in
process at the date of acquisition included the incorporation of springback
functionality into the acquired company's technology. The value of the
in-process R&D was appraised using the income approach, and involved the
following assumptions: the net cash inflows from the in-process R&D commencing
in the second half of the year 2000, operating expenses consistent with
historical levels and a risk-adjusted discount rate of 32.5%. Costs associated
with the completion of these projects were consistent with the assumptions used
in the valuation.

   OTHER INCOME, NET

<TABLE>
<CAPTION>
                                              THREE MONTHS ENDED SEPTEMBER 30,         NINE MONTHS ENDED SEPTEMBER 30,
                                       -----------------------------------------  ---------------------------------------
   dollars in thousands                          1999        1998   % CHANGE             1999       1998     % CHANGE
-------------------------------------------------------------------------------------------------------------------------
<S>                                              <C>         <C>       <C>               <C>         <C>        <C>
   Other income, net                             $116        $207     -44.0%             $415        $622      -33.3%
    % of total revenue                            1.2%        2.5%                        1.4%        2.4%
-------------------------------------------------------------------------------------------------------------------------
</TABLE>

     Other income, net consists of net interest income (expense), foreign
currency transaction gain (loss) and gain (loss) on the disposal of property and
equipment. The decrease in other income, net during the three and nine month
periods ended September 30, 1999, as compared to the corresponding periods in
1998, primarily resulted from a decrease in interest earned on the Company's
cash and cash equivalents due to an increasing share of the Company's
investments being made in tax-exempt securities, as well as increased foreign
currency transaction losses due to the strengthening of the U.S. dollar against
European currencies. From time to time, the Company may enter into


                                       12
<PAGE>   13



forward exchange contracts to hedge exposures related to significant foreign
currency transactions. The Company does not use any other types of derivatives
to hedge such exposures nor does it speculate in foreign currency.

   PROVISION FOR INCOME TAXES

     The Company's effective income tax rate was (306.0%) and (1733.3%) for the
first nine months of 1999 and 1998, respectively. The difference between the
Company's effective rate and the 34.0% statutory federal rate during the nine
month period ended September 30, 1999 resulted primarily from research and
development tax credits earned by the Company as a result of its investment in
new technologies during 1999 as well as certain prior years. Excluding these
credits, the company's effective tax rate for the nine month period was 30.0%.
The remaining difference from the 34.0% statutory federal rate was due to
tax-exempt interest income earned by the Company as well as tax benefits gained
from the Company's foreign sales corporation. The difference between the
Company's effective rate and the 34.0% statutory federal rate during the nine
month period ended September 30, 1998 was primarily due to the non-deductibility
of the $1.4 million in acquisition-related and non-recurring charges incurred by
the Company during the period. Excluding this charge, the Company's effective
tax rate for the first nine months of 1998 would have been 30.2%. The remaining
difference from the 34.0% statutory federal rate resulted from tax-exempt
interest income earned by the Company as well as tax benefits gained from the
Company's foreign sales corporation.

   MINORITY INTEREST IN NET INCOME OF SUBSIDIARY

     The Company owns a 66% interest in its Japanese subsidiary, Mechanical
Dynamics Japan K.K. ("MDI-Japan"), through a joint venture agreement with
ISI-Dentsu of Tokyo, Japan, the distributor of the Company's software in Japan.
The ($2,000) and $26,000 in minority interest in net income (loss) of subsidiary
for the nine months ended September 30, 1999 and 1998, respectively, represents
ISI-Dentsu's 34% interest in the net income of MDI-Japan.

   EMPLOYEES

     The number of the Company's worldwide employees increased 2.5% to 283 at
September 30, 1999, compared with 276 at September 30, 1998.

   YEAR 2000 COMPLIANCE

     The Year 2000 issue is the result of computer programs using a two-digit
format, as opposed to four digits, to indicate the year. Such computer systems
will be unable to interpret dates beyond the year 1999, which could cause a
system failure or other computer errors. The Company has assessed and identified
risks in four areas of its business and has developed a plan for Year 2000
information systems compliance in each. The areas are: (1) the Company's
products, including third party software embedded in the Company's products, (2)
business management and accounting systems, (3) computing and communications
infrastructure, and (4) the Company's suppliers.

     Since the Company's products perform few date processing tasks, there is
not a significant risk of a material disruption as a result of the Year 2000.
The Company has completed testing on current versions of the Company's primary
products, including the software delivery and license systems of the products.
No areas of non-compliance were noted which required modification to the
Company's software. The Company's product development group has added Year 2000
readiness to its quality assurance process for all products to ensure no Year
2000 problems are introduced during the development of software and maintenance
activities. The Company's primary business management and accounting systems
were replaced by the Company effective January 1999. The cost of the new
systems, including certain hardware upgrades, was approximately $150,000. These
systems are based on third-party products that have been certified for Year 2000
compliance. The Company's computing and communications infrastructure has been
reviewed. An inventory of all infrastructure components was established. The
items in inventory were prioritized based on their overall impact to the
Company's operations. Substantially all critical components of the
infrastructure have been migrated to Year 2000 readiness with final testing of
this migration to be completed in the fourth quarter of 1999. A list of key
suppliers to the Company has been developed. Key suppliers were contacted and
asked to show adequate readiness. Responses were reviewed and prioritized based
on importance to the Company's operations beyond 1999. The Company has worked
with certain suppliers to apply


                                       13
<PAGE>   14

patches or upgrade to Year 2000 compliant versions of products. This process is
substantially complete with any remaining issues expected to be addressed during
the fourth quarter of 1999.

     The Company has not incurred significant costs to address its Year 2000
needs and does not expect that the remaining costs will be material to its
consolidated financial position or results of operations. While the Company
believes that its efforts to address Year 2000 issues for which it is
responsible should be successful, it is possible that there will be undetected
errors or defects associated with Year 2000 date functions in the Company's
products and internal systems or those of its key suppliers. If this should
occur, it is possible that the Company could be involved in litigation. Further,
although the Company does not believe that it has any obligation to continue to
support prior versions of its products after the termination of maintenance
contracts covering those products, nor any obligation to make prior versions of
its products, including custom applications written by the Company, Year 2000
compliant, it is possible that its customers may take a contrary position and
initiate litigation. Because of the unprecedented nature of litigation in this
area, it is uncertain how the Company may be affected by it. In the event of
such litigation or the occurrence of one or more problems associated with Year
2000 compliance, the Company's business, financial condition, or results of
operations could be materially adversely affected.

   EURO CONVERSION

     In January 1999, 11 of the 15 member countries of the European Union
established fixed conversion rates between their existing sovereign currencies
and the Euro, making the Euro their common legal currency on that date. There
will be a transition period from January 1, 1999 to January 1, 2002, during
which the old currencies will remain legal tender in the participating countries
as denominations of the Euro. During the transition period, public and private
parties may pay for goods and services using either the Euro or the
participating country's former currency. Conversion rates, however, will no
longer be computed directly from one former currency to another.

     The Company is currently evaluating the business implications of conversion
to the Euro, including technical adaptation of information technology and other
systems to accommodate Euro-denominated transactions, long-term competitive
implications of the conversion, and the effect on market risk with respect to
financial instruments. At this time, the Company does not expect that the Euro's
introduction will have a material adverse effect upon its results of operations
during or after the transition period. Substantially all of the Company's
business management and accounting systems are currently able to handle
transactions denominated in the Euro.

LIQUIDITY AND CAPITAL RESOURCES

     Cash and cash equivalents increased $279,000 during the first nine months
of 1999 to $17.1 million at September 30, 1999, compared with $16.8 million at
December 31, 1998. Through September 30, 1999, cash and cash equivalents
increased primarily as a result of the cash generated from operations of $1.1
million and $203,000 generated from the issuance of common stock, partially
offset by $1.0 million in cash used to purchase property and equipment.

     At September 30, 1999, the Company's principal commitments consisted of
obligations under operating leases for facilities and equipment. The Company had
no borrowings under long-term debt arrangements at September 30, 1999.

     The Company has an agreement with its principal bank for a $4.0 million
line of credit facility. No borrowings were outstanding under this agreement as
of September 30, 1999. The Company's subsidiaries in Germany, Italy, Sweden, and
France also have line of credit and overdraft facilities that provide for
aggregate borrowing availability of up to $510,000. Approximately $74,000 in
borrowings was outstanding under these facilities as of September 30, 1999.

     Long-term cash requirements, other than for normal operating expenses, are
anticipated for the development of new software products and enhancements of
existing products, financing growth, repurchases of the Company's common stock
and the possible acquisition of software products, technologies and businesses
complementary to the Company's business. The Company believes that cash flows
from operations, together with existing cash balances, and available borrowings
will be adequate to meet the Company's cash requirements for working capital,
capital


                                       14
<PAGE>   15

expenditures and stock repurchases for the next twelve months and the
foreseeable future. The Company has not paid dividends during the period from
1996 through the third quarter of 1999 and intends to continue its policy of
retaining earnings to finance future growth.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Other than as disclosed in this report on Form 10-Q, there have been no
significant changes in our market risk exposure as described in Management's
Discussion and Analysis of Financial Condition and Results of Operations
included as Item 7a. on Form 10-K for the year ended December 31, 1998 and
incorporated herein by reference.
























                                       15

<PAGE>   16


                           PART II - OTHER INFORMATION

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

(a)  EXHIBITS

<TABLE>
<CAPTION>

    NUMBER                                                    EXHIBIT
   --------                                                   -------
<S>             <C>
    (4.2)       Line of Credit Demand Note between the Company and KeyBank National Association dated August 6, 1999

   (10.18)      Lease Agreement between the Company and First Martin Corporation dated August 5, 1999

     (11)       Statement Re Computation of Per Share Earnings

     (27)       Financial Data Schedule
</TABLE>



(b)  REPORTS ON FORM 8-K

     No reports on Form 8-K were filed by the Company during the three months
ended September 30, 1999.






                                       16
<PAGE>   17


                                   SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.

Dated: November 10, 1999      MECHANICAL DYNAMICS, INC.
                              (Registrant)


                           By: /s/ Michael E. Korybalski
                              ------------------------------------------
                              Michael E. Korybalski
                              Chairman of the Board and  Chief Executive Officer
                              (Principal Executive Officer)


                           By:/s/ David Peralta
                              -------------------------------------------
                              David Peralta
                              Vice President and Chief Financial Officer
                              (Principal Financial and Accounting Officer)















                                       17
<PAGE>   18


                                INDEX TO EXHIBITS
<TABLE>
<CAPTION>
   NUMBER                               EXHIBIT TITLE
----------------------------------------------------------------------------------------------------
<S>            <C>
    (4.2)      Line of Credit Demand Note between the Company and KeyBank
               National Association dated August 6, 1999

   (10.18)     Lease Agreement between the Company and First Martin Corporation dated August 5, 1999

    (11)       Statement Re Computation of Per Share Earnings

    (27)       Financial Data Schedule
</TABLE>















                                       18