<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: JUNE 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
August 9, 1999, was 6,262,351.




<PAGE>   2



                            MECHANICAL DYNAMICS, INC.

                                    FORM 10-Q
                                TABLE OF CONTENTS


                                                                            PAGE
 PART I -  FINANCIAL INFORMATION

  Item 1.  Financial Statements

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

           Condensed Consolidated Statements of Income
           Three and Six Months Ended June 30, 1999 and 1998.................. 4

           Condensed Consolidated Statements of Cash Flows
           Six Months Ended June 30, 1999 and 1998............................ 5

           Notes to Condensed Consolidated Financial Statements............... 6

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

  Item 3.  Quantitative and Qualitative Disclosures about Market Risk........ 14

 PART II - OTHER INFORMATION

  Item 4.  Submission of Matters to a Vote of Security Holders............... 15

  Item 6.  Exhibits and Reports on Form 8-K.................................. 15

SIGNATURES .................................................................. 16

INDEX TO EXHIBITS............................................................ 17









                                       2
<PAGE>   3


                         PART I - FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
                  CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>

                                                                                June 30,        December 31,
   in thousands                                                                   1999              1998
----------------------------------------------------------------------------------------------------------------
<S>                                                                                <C>               <C>
   Assets:                                                                      (Unaudited)
   Current assets:
     Cash and cash equivalents                                                     $15,874           $16,843
     Accounts receivable, net                                                       10,225             9,893
     Prepaid and deferred expenses                                                   2,175             1,873
----------------------------------------------------------------------------------------------------------------
       Total current assets                                                         28,274            28,609
----------------------------------------------------------------------------------------------------------------
   Property and equipment, net                                                       3,602             3,674
   Goodwill, net                                                                     3,636             3,820
   Other assets                                                                        229               144
----------------------------------------------------------------------------------------------------------------
   Total assets                                                                    $35,741           $36,247
----------------------------------------------------------------------------------------------------------------

   Liabilities and Shareholders' Equity:
   Current liabilities:
     Borrowings under lines of credit                                                 $199              $105
     Accounts payable                                                                1,149             1,781
     Accrued expenses                                                                2,987             3,544
     Deferred revenue                                                                5,330             4,745
----------------------------------------------------------------------------------------------------------------
       Total current liabilities                                                     9,665            10,175
----------------------------------------------------------------------------------------------------------------
   Minority interest                                                                   476               472
   Shareholders' equity:
     Common stock                                                                   22,473            22,332
     Preferred stock                                                                     0                 0
     Retained earnings                                                               3,044             3,073
     Cumulative translation adjustment                                                  83               195
----------------------------------------------------------------------------------------------------------------
       Total shareholders' equity                                                   25,600            25,600
----------------------------------------------------------------------------------------------------------------
   Total liabilities and shareholders' equity                                      $35,741           $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           Six Months Ended
                                                                                June 30,                     June 30,
                                                                        ---------------------------------------------------------
   in thousands except share and per share data                            1999          1998          1999           1998
---------------------------------------------------------------------------------------------------------------------------------
<S>                                                                          <C>           <C>           <C>           <C>
   Revenue:
     Software licenses                                                       $4,020        $4,621        $9,296        $9,437
     Services                                                                 5,138         4,284        10,228         8,203
---------------------------------------------------------------------------------------------------------------------------------
       Total revenue                                                          9,158         8,905        19,524        17,640
---------------------------------------------------------------------------------------------------------------------------------
   Cost of revenue:
     Software licenses                                                          781           291         1,649           800
     Services                                                                 2,868         2,287         5,557         4,486
---------------------------------------------------------------------------------------------------------------------------------
       Total cost of revenue                                                  3,649         2,578         7,206         5,286
---------------------------------------------------------------------------------------------------------------------------------
   Gross profit                                                               5,509         6,327        12,318        12,354
---------------------------------------------------------------------------------------------------------------------------------
   Operating expenses:
     Sales and marketing                                                      3,865         3,293         7,785         6,578
     Research and development                                                 1,434         1,295         2,756         2,512
     General and administrative                                                 931           851         1,884         1,689
     Goodwill amortization                                                      114            41           227            82
     Acquisition-related and non-recurring charges                                0             0             0         1,200
---------------------------------------------------------------------------------------------------------------------------------
       Total operating expenses                                               6,344         5,480        12,652        12,061
---------------------------------------------------------------------------------------------------------------------------------
   Operating income (loss)                                                     (835)          847          (334)          293
   Other income, net                                                            103           197           299           415
---------------------------------------------------------------------------------------------------------------------------------
   Income (loss) before income taxes and minority interest                     (732)        1,044           (35)          708
   Provision (credit) for income taxes                                         (219)          315           (10)          576
---------------------------------------------------------------------------------------------------------------------------------
   Net income (loss) before minority interest                                  (513)          729           (25)          132
   Minority interest in net income (loss) of subsidiary                         (10)           (4)            4            12
---------------------------------------------------------------------------------------------------------------------------------
   Net income (loss)                                                          ($503)         $733          ($29)         $120
---------------------------------------------------------------------------------------------------------------------------------

   Basic net income (loss) per common share                                  ($0.08)        $0.12         $0.00         $0.02
---------------------------------------------------------------------------------------------------------------------------------
   Weighted average common shares                                         6,247,776     6,195,229     6,241,446     6,153,296
---------------------------------------------------------------------------------------------------------------------------------

   Diluted net income (loss) per common share                                ($0.08)        $0.12         $0.00         $0.02
---------------------------------------------------------------------------------------------------------------------------------
   Weighted average common and common equivalent shares                   6,247,776     6,317,690     6,241,446     6,211,480
---------------------------------------------------------------------------------------------------------------------------------
</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>

                                                                                          Six Months Ended
                                                                                               June 30,
                                                                                -----------------------------------
   in thousands                                                                          1999             1998
-------------------------------------------------------------------------------------------------------------------
<S>                                                                                      <C>               <C>
   Cash flows from operating activities:
     Net income (loss)                                                                   ($29)             $120
     Adjustments to reconcile net income to net cash
      provided by (used in) operating activities:
       Acquisition-related and non-recurring charges                                        0             1,200
       Depreciation and amortization                                                      871               701
       Loss on disposal of assets, net                                                     26                 5
       Minority interest in net income of subsidiary                                        4                12
       Changes in assets and liabilities:
         Accounts receivable                                                             (900)               64
         Prepaid and deferred expenses                                                   (381)             (123)
         Other assets                                                                    (115)               23
         Accounts payable                                                                (283)             (771)
         Accrued expenses                                                                (370)             (932)
         Deferred revenue                                                                 706              (114)
-------------------------------------------------------------------------------------------------------------------
            Net cash provided by (used in) operating activities                          (471)              185
-------------------------------------------------------------------------------------------------------------------
   Cash flows from investing activities:
     Proceeds from the sale of property and equipment                                       0                19
     Purchases of property and equipment                                                 (744)           (1,189)
     Purchase of DTI Asia Pte. Ltd., net of cash acquired                                   0              (563)
-------------------------------------------------------------------------------------------------------------------
            Net cash used in investing activities                                        (744)           (1,733)
-------------------------------------------------------------------------------------------------------------------
   Cash flows from financing activities:
     Net borrowings under line of credit agreements                                        94                95
     Proceeds from the issuance of common stock                                           141               262
-------------------------------------------------------------------------------------------------------------------
            Net cash provided by financing activities                                     235               357
-------------------------------------------------------------------------------------------------------------------
   Effect of exchange rate changes on cash                                                 11               (68)
-------------------------------------------------------------------------------------------------------------------
   Net decrease in cash and cash equivalents                                             (969)           (1,259)
   Cash and cash equivalents at beginning of period                                    16,843            20,261
-------------------------------------------------------------------------------------------------------------------
   Cash and cash equivalents at end of period                                         $15,874           $19,002
-------------------------------------------------------------------------------------------------------------------
   Supplemental disclosures of cash flow information:
     Cash paid during the period for:
       Interest                                                                            $5                $8
       Income taxes                                                                      $370            $1,003
-------------------------------------------------------------------------------------------------------------------
   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.




                                       5
<PAGE>   6
                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
                     NOTES TO CONDENSED 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 six month periods ended June 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 ($526,000) and $700,000
for the three month periods ended June 30, 1999 and 1998, respectively, and
($141,000) and $56,000 for the six month periods ended June 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

     The following table reconciles the weighted average number of shares in the
basic net income (loss) per common share calculation to the number of shares in
the diluted net income (loss) per common share calculation:

<TABLE>
<CAPTION>

                                                             THREE MONTHS ENDED             SIX MONTHS ENDED
                                                                  JUNE 30,                      JUNE 30,
                                                       ------------------------------- ----------------------------
                                                               1999           1998          1999        1998
------------------------------------------------------ ---------------- -------------- ------------ ---------------
<S>                                                       <C>             <C>            <C>          <C>
 Weighted average common shares used in basic net
    income (loss) per common share....................     6,247,776      6,195,229      6,241,446    6,153,296
    Effect of stock options...........................            --        122,461             --       58,184
                                                           ---------    -----------    -----------  -----------
 Weighted average common and common equivalent
    shares used in diluted net income (loss) per
    common share......................................     6,247,776      6,317,690      6,241,446    6,211,480
                                                           =========    ===========    ===========  ===========
</TABLE>

For the three and six month periods ended June 30, 1999, the effect of stock
options outstanding for the purchase of 0 and 9 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





                                       6
<PAGE>   7

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 June 30,             Six Months Ended June 30,
                                     -------------------------------------  -------------------------------------
dollars in thousands                    1999       1998      % Change          1999       1998      % Change
-----------------------------------------------------------------------------------------------------------------
<S>                                      <C>        <C>         <C>            <C>         <C>           <C>
Software licenses                        $4,020     $4,621      -13.0%          $ 9,296     $9,437       -1.5%
% of total revenue                        43.9%      51.9%                        47.6%      53.5%

Services                                 $5,138     $4,284       19.9%          $10,228     $8,203       24.7%
% of total revenue                        56.1%      48.1%                        52.4%      46.5%

-----------------------------------------------------------------------------------------------------------------
Total Revenue                            $9,158     $8,905        2.8%          $19,524     $17640       10.7%
-----------------------------------------------------------------------------------------------------------------
</TABLE>




                                       8
<PAGE>   9

     The Company's total revenue increased 2.8% and 10.7% during the three and
six month periods ended June 30, 1999, respectively, as compared to the
corresponding periods in 1998. The growth in revenue resulted from an increase
in the 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. This growth was partially offset by decreased sales
of the Company's software products.

     Revenue from international customers accounted for approximately 60.6% and
64.5% of the Company's total revenue during the three months ended June 30, 1999
and 1998, respectively. International revenue accounted for approximately 62.1%
and 63.2% of total revenue during the six months ended June 30, 1999 and 1998,
respectively. The decrease in international revenue as a percent of total
revenue was due primarily to decreased sales in Japan 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 H.G.E., Inc. During the three months ended June 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 $182,000. 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 1999. 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 decreased 13.0% and 1.5% during the
three and six month periods ended June 30, 1999, respectively, as compared to
the corresponding periods in 1998. This decrease resulted primarily from a lower
volume of sales of the Company's software products in North America and Japan
partially offset by increased sales of the Company's software products in Europe
and third party software products worldwide. Revenue from third party software
products totaled approximately $930,000, or 10.2% of total revenue during the
three month period ended June 30, 1999, as compared to $419,000, or 4.7% of
total revenue during the corresponding period in 1998. Revenue from third party
products totaled approximately $2.0 million, or 10.2% of total revenue during
the six month period ended June 30, 1999, as compared to $901,000, or 5.1% of
total revenue during the corresponding period in 1998. The increase in revenue
from third party software products is a result of incremental sales generated by
the Company's Canadian subsidiary.

     Services revenue consists of revenue from software maintenance agreements
and professional services, including consulting, training and funded research
and development. Total services revenue increased 19.9% and 24.7% during the
three and six month periods ended June 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 six months of 1999. Software maintenance revenue grew 24.7% and
29.3% during the three and six month periods ended June 30, 1999, respectively,
as compared to the corresponding periods in 1998. Professional services revenue
grew 18.1% and 22.8% during the three and six month periods ended June 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 June 30,             Six Months Ended June 30,
                                     -------------------------------------  -------------------------------------
dollars in thousands                    1999       1998      % Change          1999       1998      % Change
-----------------------------------------------------------------------------------------------------------------
<S>                                        <C>        <C>       <C>             <C>          <C>       <C>
Cost of software licenses                $  781     $  291      168.4%          $1,649     $  800      106.1%
 Gross profit margin on software           80.6%      93.7%                       82.3%      91.5%
  licenses revenue
Cost of services                         $2,868     $2,287       25.4%          $5,557     $4,486       23.9%
 Gross profit margin on services
  revenue                                  44.2%      46.6%                       45.7%      45.3%
-----------------------------------------------------------------------------------------------------------------
</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 168.4% and
106.1% during the three and six month periods ended June 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 80.6% and 93.7% during
the three month periods ended June 30, 1999 and 1998, respectively. Gross profit
margin on software licenses revenue was 82.3% and 91.5% during the six month
periods ended June 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 25.4% and 23.9% during the three and six month periods
ended June 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 44.2% and 46.6% during the
three month periods ended June 30, 1999 and 1998, respectively. Gross profit
margin on services revenue was 45.7% and 45.3% during the six month periods
ended June 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 June 30,             Six Months Ended June 30,
                                  -------------------------------------  ------------------------------------
dollars in thousands                 1999       1998      % Change         1999        1998      % Change
-------------------------------------------------------------------------------------------------------------
<S>                                 <C>        <C>          <C>           <C>         <C>          <C>
Sales and marketing                 $ 3,865     $3,293       17.4%         $7,785      $6,578       18.3%
% of total revenue                     42.2%      37.0%                      39.9%       37.3%

Research and development            $ 1,434     $1,295       10.7%         $2,756      $2,512        9.7%
% of total revenue                     15.7%      14.5%                      14.1%       14.2%

General and administrative          $   931     $  851        9.4%         $1,884      $1,689       11.5%
% of total revenue                     10.2%       9.6%                       9.6%        9.6%

Goodwill amortization               $   114     $   41      178.0%         $  227      $   82      176.8%
% of total revenue                      1.2%       0.5%                       1.2%        0.5%

Acquisition-related and
non-recurring charges               $     0     $    0                     $    0      $1,200
% of total revenue                      0.0%       0.0%                       0.0%        6.8%
-------------------------------------------------------------------------------------------------------------
</TABLE>

     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 six month periods ended June 30, 1999, as compared to the
corresponding periods in 1998, resulted from the Company's continued expansion
of its worldwide sales and marketing organization. Total sales and marketing
employees increased to 97 at June 30, 1999, an increase of 14.1% from 85 at June
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
six month periods ended June 30, 1999, as compared to the corresponding periods
in 1998, primarily resulted from an increase in personnel and related costs in
support of 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 9.4% and 11.5% during the three and six month periods ended June 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.

     Goodwill amortization includes the amortization of purchase price in excess
of net assets on the Company's acquisitions. Goodwill amortization increased
178.0% and 176.8% during the three and six month periods ended June 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.


                                       11
<PAGE>   12

     Acquisition-related and non-recurring charges were approximately $1.2
million in the six month period ended June 30, 1998, and consist primarily of
the write-off of purchased in-process research and development ("R&D")
associated with the Company's acquisition of DTI Asia Pte. Ltd ("DTI"). 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.

   OTHER INCOME, NET

<TABLE>
<CAPTION>

                                     Three Months Ended June 30,             Six Months Ended June 30,
                                  -------------------------------------  ------------------------------------
dollars in thousands                 1999       1998      % Change         1999        1998      % Change
-------------------------------------------------------------------------------------------------------------
<S>                                 <C>        <C>        <C>             <C>         <C>        <C>
Other income net                     $ 103      $ 197      -47.7%          $ 299       $ 415      -28.0%
% of total revenue                     1.1%       2.2%                       1.5%        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 six month
periods ended June 30, 1999, as compared to the corresponding periods in 1998,
primarily resulted from a decrease in interest earned given the Company's lower
cash and cash equivalents balance 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 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 28.6% and 81.4% for the first
six months of 1999 and 1998, respectively. The difference between the Company's
effective rate and the 34.0% statutory federal rate during the six month period
ended June 30, 1999 resulted primarily from 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 six month period ended June 30, 1998 was
primarily due to the non-deductibility of the $1.2 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
six 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.



                                       12
<PAGE>   13


   MINORITY INTEREST IN NET INCOME OF SUBSIDIARY

     In April 1997, the Company established a 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 $4,000 and $12,000 in minority interest in net income of subsidiary for the
six months ended June 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 16.1% to 296 at
June 30, 1999, compared with 255 at June 30, 1998. Employment increased
significantly to support the Company's growing operations worldwide. This
increase in headcount includes 16 employees added from the Company's acquisition
of the Design Analysis Group of H.G.E. Inc.

   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 is
currently being reviewed. An inventory of all infrastructure components has been
established. 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 third and fourth quarters 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 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 third and fourth quarters 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


                                       13
<PAGE>   14
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.

LIQUIDITY AND CAPITAL RESOURCES

     Cash and cash equivalents decreased $969,000 during the first six months of
1999 to $15.9 million at June 30, 1999, compared with $16.8 million at December
31, 1998. Through June 30, 1999, cash and cash equivalents decreased primarily
as a result of the $471,000 in cash used in operations to fund working capital
needs and $744,000 in cash used to purchase property and equipment. These
decreases were partially offset by the $235,000 in aggregate proceeds from
borrowings under line of credit agreements and stock issued under the Company's
stock purchase plan.

     At June 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 June 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 June 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 $199,000 in
borrowings was outstanding under these facilities as of June 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 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 second 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.



                                       14
<PAGE>   15


                           PART II - OTHER INFORMATION

ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     The Annual Meeting of Shareholders of the Company was held on May 13, 1999.
At the Annual Meeting, the shareholders of the Company (1) elected Herbert S.
Amster and Joseph F. Gloudeman as Directors of the Company to hold office until
the Annual Meeting of Shareholders to be held in 2002; (2) ratified and approved
the Board of Directors' selection of Arthur Andersen LLP as the independent
auditors of the Company for the current fiscal year ending December 31, 1999;
(3) increased the number of shares available under the Company's 1996 Stock
Incentive Plan for Key Employees from 650,000 shares to 1,050,000 shares; and
(4) increased the number of shares available under the Company's Non-Employee
Director Stock Option Plan from 100,000 shares to 200,000 shares. The votes were
as follows:

<TABLE>
<CAPTION>

                                                             For          Withheld     Abstained       Broker
                                                                         or Against                   Non-votes
------------------------------------------------------------------------------------------------------------------
<S>                                                        <C>             <C>             <C>          <C>
   (1) Election of Directors:
       Herbert S. Amster                                   4,465,902       179,608         69,277
       Joseph F. Gloudeman                                 4,457,616       187,894         69,277

   (2) Approval of Arthur Andersen:                        4,672,806         2,669         39,312

   (3) Approval to Increase the Shares in the
       Company's 1996 Stock Incentive Plan for Key
       Employees:                                          3,198,742        382,491        44,145       1,089,409

   (4) Approval to Increase the Shares in the
       Company's Non-Employee Direct Stock
       Option Plan:                                        2,927,294        653,379        44,705       1,089,409
------------------------------------------------------------------------------------------------------------------
</TABLE>


ITEM 6.   EXHIBITS AND REPORTS ON FORM 8-K

(A) EXHIBITS


    NUMBER                          EXHIBIT
-------------------------------------------------------------------------------
     (11)       Statement Re Computation of Per Share Earnings

     (27)       Financial Data Schedule



(B) REPORTS ON FORM 8-K

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




                                       15
<PAGE>   16


                                   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: August 13, 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)














                                       16
<PAGE>   17


                                INDEX TO EXHIBITS


   NUMBER                           EXHIBIT TITLE
--------------------------------------------------------------------------------
    (11)       Statement Re Computation of Per Share Earnings

    (27)       Financial Data Schedule























                                       17