<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, 1998

         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 13, 1998, was 6,214,386.




<PAGE>   2




                            MECHANICAL DYNAMICS, INC.

                                    FORM 10-Q
                                TABLE OF CONTENTS
<TABLE>
<CAPTION>


                                                                                                      PAGE
PART I - FINANCIAL INFORMATION
<S>                                                                                                  <C>
  Item 1.  Financial Statements

           Condensed Consolidated Balance Sheets
           June 30, 1998 and December 31, 1997......................................................     3

           Condensed Consolidated Statements of Income
           Three and Six Months Ended June 30, 1998 and 1997........................................     4

           Condensed Consolidated Statements of Cash Flows
           Six Months Ended June 30, 1998 and 1997..................................................     5

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

  Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations....     7

PART II -  OTHER INFORMATION

  Item 4.  Submission of Matters to a Vote of Security Holders......................................    13

  Item 6.  Exhibits and Reports on Form 8-K.........................................................    13

SIGNATURES..........................................................................................    14

INDEX TO EXHIBITS....................................................................................   15
</TABLE>



                                       2

<PAGE>   3

                         PART I - FINANCIAL INFORMATION

ITEM 1.   FINANCIAL STATEMENTS


                MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
                   CONDENSED CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>

                                                                               JUNE 30,       DECEMBER 31,
  in thousands                                                                   1998             1997
----------------------------------------------------------------------------------------------------------
                                                                             (Unaudited)
<S>                                                                             <C>              <C>    
  ASSETS:
  Current assets:
     Cash and cash equivalents                                                  $19,002          $20,261
     Accounts receivable                                                          7,982            8,000
     Prepaid and deferred expenses                                                1,332            1,206
----------------------------------------------------------------------------------------------------------
       Total current assets                                                      28,316           29,467
----------------------------------------------------------------------------------------------------------
  Net property and equipment                                                      3,427            2,887
  Other assets                                                                    1,848            1,793
----------------------------------------------------------------------------------------------------------
  Total assets                                                                  $33,591          $34,147
==========================================================================================================

  LIABILITIES AND SHAREHOLDERS' EQUITY:
  Current liabilities:
     Borrowings under lines of credit                                              $140              $45
     Accounts payable                                                               727            1,474
     Accrued expenses                                                             2,879            3,734
     Deferred revenue                                                             4,351            4,462
----------------------------------------------------------------------------------------------------------
       Total current liabilities                                                  8,097            9,715
----------------------------------------------------------------------------------------------------------
  Minority interest                                                                 474              462
  Shareholders' equity:
     Common stock                                                                21,832           20,838
     Preferred stock                                                                  0                0
     Retained earnings                                                            3,410            3,290
     Cumulative translation adjustment                                             (222)            (158)
----------------------------------------------------------------------------------------------------------
       Total shareholders' equity                                                25,020           23,970
----------------------------------------------------------------------------------------------------------
  Total liabilities and shareholders' equity                                    $33,591          $34,147
==========================================================================================================
</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                  1998          1997          1998          1997
=================================================================================================================
<S>                                                         <C>           <C>           <C>           <C>
  Revenue:
     Software licenses                                         $4,621        $3,996        $9,437        $7,916
     Services                                                   4,284         3,209         8,203         5,990
-----------------------------------------------------------------------------------------------------------------
       Total revenue                                            8,905         7,205        17,640        13,906
-----------------------------------------------------------------------------------------------------------------
  Cost of revenue:
     Software licenses                                            291           189           800           292
     Services                                                   2,287         1,658         4,486         3,262
-----------------------------------------------------------------------------------------------------------------
       Total cost of revenue                                    2,578         1,847         5,286         3,554
-----------------------------------------------------------------------------------------------------------------
  Gross profit                                                  6,327         5,358        12,354        10,352
-----------------------------------------------------------------------------------------------------------------
  Operating expenses:
     Sales and marketing                                        3,315         2,897         6,622         5,491
     Research and development                                   1,307         1,061         2,536         2,135
     General and administrative                                   858           772         1,703         1,584
     Purchased in-process research and development                  0             0         1,200             0
-----------------------------------------------------------------------------------------------------------------
       Total operating expenses                                 5,480         4,730        12,061         9,210
-----------------------------------------------------------------------------------------------------------------
  Operating income                                                847           628           293         1,142
  Other income, net                                               197           189           415           356
-----------------------------------------------------------------------------------------------------------------
  Income before income taxes and minority interest              1,044           817           708         1,498
  Provision for income taxes                                      315           247           576           451
-----------------------------------------------------------------------------------------------------------------
  Net income before minority interest                             729           570           132         1,047
  Minority interest in net income (loss) of subsidiary             (4)          (19)           12           (19)
-----------------------------------------------------------------------------------------------------------------
  Net income                                                     $733          $589          $120        $1,066
=================================================================================================================
  Net income per common share - basic EPS                       $0.12         $0.10         $0.02         $0.18
=================================================================================================================
  Weighted average shares used in basic EPS                 6,195,229     5,770,681     6,153,296     5,765,558
=================================================================================================================
  Net income per common share - diluted EPS                     $0.12         $0.10         $0.02         $0.18
=================================================================================================================
  Weighted average shares used in diluted EPS               6,317,690     5,828,778     6,211,480     5,877,117
=================================================================================================================
</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                                                                            1998             1997
=================================================================================================================
<S>                                                                                    <C>              <C>   
  Cash flows from operating activities:
     Net income                                                                         $  120           $1,066
     Adjustments to reconcile net income to net cash
      provided by operating activities:
       Purchased in-process research and development                                     1,200                0
       Depreciation and amortization                                                       701              450
       Loss on disposal of assets, net                                                       5               13
       Minority interest in net income (loss) of subsidiary                                 12              (19)
       Changes in assets and liabilities:
         Accounts receivable                                                                64             (721)
         Prepaid and deferred expenses                                                    (123)              67
         Other assets                                                                       23              (14)
         Accounts payable                                                                 (771)            (407)
         Accrued expenses                                                                 (932)            (275)
         Deferred revenue                                                                 (114)             160
-----------------------------------------------------------------------------------------------------------------
           Net cash provided by operating activities                                       185              320
-----------------------------------------------------------------------------------------------------------------
  Cash flows from investing activities:
     Proceeds from the sale of property and equipment                                       19               22
     Purchases of property and equipment                                                (1,189)            (751)
     Purchase of DTI Asia Pte. Ltd., net of cash acquired                                 (563)               0
-----------------------------------------------------------------------------------------------------------------
           Net cash used in investing activities                                        (1,733)            (729)
-----------------------------------------------------------------------------------------------------------------
  Cash flows from financing activities:
     Net borrowings (payments) under line of credit agreements                              95               (7)
     Proceeds from the issuance of common stock                                            262              130
     Minority investment in consolidated subsidiary                                          0              467
-----------------------------------------------------------------------------------------------------------------
           Net cash provided by financing activities                                       357              590
-----------------------------------------------------------------------------------------------------------------
  Effect of exchange rate changes on cash                                                  (68)              33
-----------------------------------------------------------------------------------------------------------------
  Net increase (decrease) in cash and cash equivalents                                  (1,259)             214
  Cash and cash equivalents at beginning of period                                      20,261           20,570
-----------------------------------------------------------------------------------------------------------------
  Cash and cash equivalents at end of period                                           $19,002          $20,784
=================================================================================================================
  Supplemental disclosures of cash flow information: Cash paid during the period
     for:
       Interest                                                                             $8               $7
       Income taxes                                                                     $1,003             $403
=================================================================================================================
  Details of acquisition of DTI Asia Pte. Ltd.:
     Net liabilities, excluding cash acquired                                             ($59)
     Purchase price in excess of the net assets acquired                                   154
     Purchased in-process research and development                                       1,200
     Stock issued                                                                         (732)
================================================================================================
       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 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, 1997.

    Operating results for the three and six month periods ended June 30, 1998
and 1997 are not necessarily indicative of the results that may be expected for
the full year.


(2) - ACQUISITIONS

    In August 1998, the Company acquired the Design Analysis Group of H.G.E.
Inc., an engineering software and services firm focusing on the aerospace
industry. The aggregate purchase price of approximately $2.0 million consisted
entirely of cash. The acquisition has been accounted for under the purchase
method of accounting. In connection with the acquisition, the Company will
record a non-recurring charge to operations in the third quarter of 1998 of
approximately $200,000 to $300,000, associated with the write-off of in-process
research and development acquired in the transaction that had not reached
technological feasibility. The remaining excess of the aggregate purchase price
over the fair value of the net assets acquired will be recognized as goodwill.

    In January 1998, the Company acquired 100% of the outstanding capital stock
of DTI Asia Pte. Ltd. ("DTI"), a provider of mechanical design simulation
software embedded in the AutoCAD and Mechanical Desktop product lines from
Autodesk, Inc. The aggregate purchase price of approximately $1.3 million
consisted of $563,000 in cash and 142,540 shares of the Company's common stock
valued at $732,000. The acquisition has been accounted for under the purchase
method of accounting. In connection with the acquisition, the Company recorded a
non-recurring charge to operations in the first quarter of 1998 of approximately
$1.2 million, associated with the write-off of in-process research and
development acquired in the transaction that had not reached technological
feasibility. The remaining excess of the aggregate purchase price over the fair
value of the net assets acquired of approximately $154,000 has been recognized
as goodwill and will be amortized over a ten-year period. The operating results
of DTI have been included in the consolidated results of operations from the
date of acquisition.


(3) - COMPREHENSIVE INCOME

    In July 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS
130"). SFAS 130 establishes standards for reporting and display of comprehensive
income and its components in a full set of financial statements. The objective
of SFAS 130 is to report a measure of all changes in equity of an enterprise
that result from transactions and other economic events of the period other than
transactions with owners. Comprehensive income is the total of net income and
all other non-owner changes in equity. The Company adopted this standard
effective January 1, 1998. Total comprehensive income was $700,000 and $629,000
for the three month periods ended June 30, 1998 and 1997, respectively, and
$56,000 and $1,056,000 for the six month periods ended June 30, 1998 and 1997,
respectively. The difference between net income, as reported in the accompanying
condensed consolidated statements of income, and total comprehensive income was
the foreign currency translation adjustment for the respective periods.



                                       6
<PAGE>   7



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 condensed consolidated financial statements and the notes thereto
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 the 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 in the future to be,
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 of 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 or acquisitions, including related charges, 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,
including Item 1 of the Company's Form 10-K filed on March 24, 1998.

    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.


                                       7
<PAGE>   8



RESULTS OF OPERATIONS

   REVENUE


<TABLE>
<CAPTION>
                                          THREE MONTHS ENDED JUNE 30,             SIX MONTHS ENDED JUNE 30,
                                         ------------------------------       ---------------------------------
  dollars in thousands                    1998       1997      % CHANGE         1998        1997      % CHANGE
===============================================================================================================
<S>                                      <C>        <C>          <C>          <C>         <C>           <C>  
  Software licenses                      $4,621     $3,996       15.6%        $ 9,437     $ 7,916       19.2%
    % of total revenue                    51.9%      55.5%                      53.5%       56.9%

  Services                               $4,284     $3,209       33.5%        $ 8,203     $ 5,990       36.9%
    % of total revenue                    48.1%      44.5%                      46.5%       43.1%
---------------------------------------------------------------------------------------------------------------
  Total revenue                          $8,905     $7,205       23.6%        $17,640     $13,906       26.9%
===============================================================================================================
</TABLE>


    The Company's total revenue increased 23.6% and 26.9% during the three and
six month periods ended June 30, 1998, respectively, as compared to similar
periods in 1997. The growth in revenue primarily resulted from an increase in
the services provided to the Company's customers, as well as from increased
sales of the Company's software products. The Company achieved revenue growth in
excess of 20% in each of its major sales geographies including North America,
Europe and Japan during the second quarter of 1998 as compared to the second
quarter of 1997.

    Revenue from international customers accounted for approximately 64.5% and
67.4% of the Company's total revenue during the three months ended June 30, 1998
and 1997, respectively. International revenue accounted for approximately 63.2%
and 63.6% of total revenue during the six months ended June 30, 1998 and 1997,
respectively. The decrease in international revenue as a percent of total
revenue was due primarily to the strengthening of the dollar in 1998 relative to
the European and Japanese currencies. The strengthening of the dollar negatively
affected the Company's international revenue during the first six months of 1998
by approximately $625,000. 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 dollar continues to strengthen in 1998 relative to the European
and Japanese 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.

    The Company's consolidated operations to date have not been materially
adversely affected by the recent uncertainty in the Asian markets. During the
six month period ended June 30, 1998, the Company experienced a decrease in
revenue from Korea; however, this decrease was more than offset by revenue
growth in Japan. If the economies in Asia continue to deteriorate in 1998 and
beyond, the Company's overall Asian revenue could be materially adversely 
impacted, which could have a material adverse effect on the Company's 
consolidated results of operations. 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 subsidiaries.
Software licenses revenue increased 15.6% and 19.2% during the three and six
month periods ended June 30, 1998, respectively, as compared to similar periods
in 1997. This increase resulted primarily from a higher volume of sales of the
Company's ADAMS Full Simulation Package and several add-on and
application-specific products, as well as third party software products licensed
through the Company's European subsidiaries.

    Services revenue consists of revenue from software maintenance agreements
and professional services, including consulting, training and funded research
and development. Total services revenue increased 33.5% and 36.9% during the
three and six month periods ended June 30, 1998, respectively, as compared to
similar periods in 1997. Both the software maintenance and the professional
service components of services revenue experienced solid growth during the first
six months of 1998. Software maintenance revenue grew 21.4% and 21.5% during the
three and six month periods ended June 30, 1998, respectively, as compared to
similar periods in 1997. Professional services revenue grew 45.3% and 49.0%
during the three and six month 

                                       8

<PAGE>   9

periods ended June 30, 1998, respectively, as compared to similar periods in
1997. The overall increase in services revenue reflects the Company's continued
emphasis on providing total solutions to its customers.


  COST OF REVENUE

<TABLE>
<CAPTION>
                                           THREE MONTHS ENDED JUNE 30,             SIX MONTHS ENDED JUNE 30,
                                         ------------------------------       ---------------------------------
  dollars in thousands                    1998        1997      % CHANGE         1998        1997     % CHANGE
===============================================================================================================
<S>                                      <C>        <C>          <C>          <C>         <C>           <C>  
  Cost of software licenses              $  291     $  189        54.0%        $  800      $  292       174.0%
    % of software licenses revenue         6.3%       4.7%                       8.5%        3.7%

  Cost of services                       $2,287     $1,658        37.9%        $4,486      $3,262        37.5%
    % of services revenue                 53.4%      51.7%                      54.7%       54.5%
===============================================================================================================
</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 54.0% and
174.0% during the three and six month periods ended June 30, 1998, respectively,
as compared to similar periods in 1997. These increases were due to higher
royalties paid to third parties whose products were licensed through the
Company's European subsidiaries, and, to a lesser extent, additional royalties
paid to third parties whose products are embedded in the Company's ADAMS
software.

    Cost of services includes payroll and overhead expenses attributable to
hotline support, consulting, training and funded research and development. Cost
of services revenue grew 37.9% and 37.5% during the three and six month periods
ended June 30, 1998, respectively, as compared to similar periods in 1997. These
increases resulted from the hiring of additional employees to support the growth
in services provided to the Company's customers during 1998.

  OPERATING EXPENSES

<TABLE>
<CAPTION>
                                          THREE MONTHS ENDED JUNE 30,             SIX MONTHS ENDED JUNE 30,
                                         ------------------------------       ---------------------------------
 dollars in thousands                    1998       1997      % CHANGE         1998        1997      % CHANGE
===============================================================================================================
<S>                                      <C>        <C>        <C>             <C>         <C>        <C>  
  Sales and marketing                     $3,315     $2,897       14.4%         $6,622      $5,491       20.6%
    % of total revenue                     37.2%      40.2%                      37.5%       39.5%

  Research and development                $1,307     $1,061       23.2%         $2,536      $2,135       18.8%
    % of total revenue                     14.7%      14.7%                      14.4%       15.4%

  General and administrative              $  858     $  772       11.1%         $1,703      $1,584        7.5%
    % of total revenue                      9.6%      10.7%                       9.7%       11.4%

  Purchased in-process research
    and development                       $    0     $    0                     $1,200      $    0
    % of total revenue                      0.0%       0.0%                       6.8%        0.0%
===============================================================================================================
</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 


                                       9


<PAGE>   10


expenses during the three and six month periods ended June 30, 1998, as compared
to similar periods in 1997, resulted from the Company's continued expansion of
its worldwide sales and marketing organization. Total sales and marketing
employees increased to 85 at June 30, 1998, an increase of 39.3% from 61 at June
30, 1997. The Company expects to continue to expand its sales and marketing
organization in the future to meet the 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 absolute dollar increase in research and development expenses
during the three and six month periods ended June 30, 1998, as compared to
similar periods in 1997, 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 11.1% and 7.5% during the three and six month periods ended June 30,
1998, respectively, as compared to similar periods in 1997. The absolute dollar
increase in these expenses was primarily due to additional expenses incurred to
support the Company's worldwide growth. The Company expects general and
administrative expenses to increase in absolute dollars in the future. However,
these expenses may vary as a percentage of total revenue from period to period.

     Purchased in-process research and development includes a non-recurring
charge to operations of approximately $1.2 million associated with the write-off
of in-process research and development that had not reached technological
feasibility as of the date of acquisition. The write-off was recorded in
connection with the purchase of DTI Asia Pte. Ltd. in January 1998. The
accounting for the acquisition of DTI Asia Pte. Ltd. is summarized in Note 2 of
Notes to Condensed Consolidated Financial Statements.




  OTHER INCOME, NET

<TABLE>
<CAPTION>
                                          THREE MONTHS ENDED JUNE 30,             SIX MONTHS ENDED JUNE 30,
                                         -----------------------------        --------------------------------
  dollars in thousands                    1998       1997     % CHANGE         1998        1997      % CHANGE
==============================================================================================================
<S>                                      <C>        <C>       <C>             <C>         <C>        <C>  
  Other income, net                       $197       $189        4.2%           $415        $356       16.6%
    % of total revenue                    2.2%       2.6%                       2.4%        2.6%
==============================================================================================================
</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 increase in other income, net during the three and six month
periods ended June 30, 1998, as compared to similar periods in 1997, primarily
resulted from additional interest earned on cash generated from operations over
the past year, as well as decreased foreign currency transaction losses. 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 81.4% and 30.1% for the first
six months of 1998 and 1997, respectively. 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 write-off of in-process research and development incurred in connection
with Company's acquisition of DTI Asia Pte. Ltd. Excluding this charge, the
Company's effective tax rate for the first six months of 1998 would have been
30.2%.




                                       10

<PAGE>   11


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 (LOSS) OF SUBSIDIARY

    In April 1997, the Company established a Japanese subsidiary, Mechanical
Dynamics Japan K.K., through a joint venture agreement with Information Services
International-Dentsu, Ltd. ("ISI-Dentsu"), the distributor of the Company's
software in Japan. The $12,000 and ($19,000) in minority interest in net income
(loss) of subsidiary for the six months ended June 30, 1998 and 1997,
respectively, represents ISI-Dentsu's 34% interest in the net income or loss of
Mechanical Dynamics Japan K.K.

   EMPLOYEES

    The number of the Company's worldwide employees increased 36.4% to 255 at
June 30, 1998, compared with 187 at June 30, 1997. Employment increased
significantly to support the Company's growing operations worldwide.

   YEAR 2000

    The Company has completed testing to ensure its products are compliant with
the requirements to properly utilize dates beyond December 31, 1999. This
testing was limited to current versions of the Company's existing products. No
areas of non-compliance were noted which required modification to the Company's
software. Costs incurred to complete this testing were not material to the
Company's consolidated financial position or results of operations. The Company
is currently in the process of evaluating its internal information technology
infrastructure for Year 2000 compliance. The Company does not expect that the
cost to modify its information technology infrastructure to be Year 2000
compliant will be material to its consolidated financial position or results of
operations. The Company does not anticipate any material disruption in its
operations as a result of any failure by the Company to be in compliance.


LIQUIDITY AND CAPITAL RESOURCES

    Cash and cash equivalents decreased $1.3 million during the first six months
of 1998 to $19.0 million at June 30, 1998, compared with $20.3 million at
December 31, 1997. Through June 30, 1998, cash and cash equivalents decreased
primarily as a result of the $563,000 in cash used to acquire DTI Asia Pte. Ltd.
and $1.2 million in cash used to purchase property and equipment. These
decreases were partially offset by the $185,000 in cash generated from
operations and the $262,000 in proceeds from stock issued under the Company's
employee stock option and stock purchase plans.

    At June 30, 1998, 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, 1998.

    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, 1998. 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 $465,000. Approximately $140,000 in borrowings
were outstanding under these facilities as of June 30, 1998.

    In August 1998, the Company acquired the Design Analysis Group of H.G.E.
Inc., an engineering software and services firm focusing on the aerospace
industry. The aggregate purchase price of approximately $2.0 million consisted
entirely of cash. See Note 2 of Notes to Condensed Consolidated Financial
Statements.

    In January 1998, the Company acquired 100% of the outstanding capital stock
of DTI Asia Pte. Ltd., a provider of mechanical design simulation software
embedded in the AutoCAD and Mechanical Desktop product lines from Autodesk, Inc.
The aggregate purchase price of approximately $1.3 million consisted of $563,000
in cash and 142,540 shares of the Company's common stock valued at $732,000. See
Note 2 of Notes to Condensed Consolidated Financial Statements.

 
                                      11


<PAGE>   12


    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 and
capital expenditures for the next twelve months and the foreseeable future. The
Company has not paid dividends during the period from 1995 through the second
quarter of 1998 and intends to continue its policy of retaining earnings to
finance future growth.





                                       12


<PAGE>   13

                           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 14, 1998.
At the Annual Meeting, the shareholders of the Company (1) elected David E. Cole
as Director of the Company to hold office until the Annual Meeting of
Shareholders to be held in 2001; and (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, 1998. The votes were as
follows:

<TABLE>
<CAPTION>
                                                                         WITHHELD                     BROKER
                                                             FOR        OR AGAINST    ABSTAINED      NON-VOTES
================================================================================================================
<S>                                                        <C>           <C>          <C>            <C>
  (1)  Election of Directors:
         David E. Cole                                     4,229,366                     3,100

  (2)  Approval of Arthur Andersen:                        4,230,166       2,200           100
================================================================================================================
</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, 1998.


                                       13
<PAGE>   14



                                   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, 1998        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)



                                       14
<PAGE>   15



                                INDEX TO EXHIBITS


   NUMBER                        EXHIBIT TITLE
-------------------------------------------------------------------------------

    (11)       Statement Re Computation of Per Share Earnings

    (27)       Financial Data Schedule




                                       15