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                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549
                            ------------------------

                                   FORM 10-K
                       FOR ANNUAL AND TRANSITION REPORTS
                    PURSUANT TO SECTIONS 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934

(MARK ONE)

[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT OF 1934 [FEE REQUIRED]

For the fiscal year ended December 31, 1997.
                                       OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
    ACT OF 1934 [NO FEE REQUIRED]

For the transition period from
                               ---------------------- to -----------------------

                         COMMISSION FILE NUMBER 0-26964

                              CARNEGIE GROUP, INC.
             (Exact name of registrant as specified in its charter)

              DELAWARE                                     25-1435252
   (State or other jurisdiction of                      (I.R.S. Employer
    incorporation or organization)                     Identification No.)

FIVE PPG PLACE, PITTSBURGH, PENNSYLVANIA                     15222
(Address of principal executive offices)                   (Zip Code)



       Registrant's telephone number, including area code: (412) 642-6900

          Securities registered pursuant to Section 12(b) of the Act:

<TABLE>
<CAPTION>
             Title of each class                       Name of each exchange on which registered
             -------------------                       -----------------------------------------
<S>                                                  <C>
                     NONE                                            NOT APPLICABLE
</TABLE>

          Securities registered pursuant to Section 12(g) of the Act:

                     COMMON STOCK, PAR VALUE $.01 PER SHARE
                                (Title of class)

     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.  Yes [X]     No [ ]

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  [  ]

     As of March 20, 1998, the aggregate market value of voting common stock
held by non-affiliates of the registrant, based upon the last reported sale
price for the registrant's Common Stock on the Nasdaq National Market on such
date, as reported in The Wall Street Journal, was $15,189,210 (calculated by
excluding shares owned beneficially by directors and executive officers as a
group from total outstanding shares solely for the purpose of this response).

     The number of shares of the registrant's Common Stock outstanding as of the
close of business on March 20, 1998 was 6,499,635.

                      DOCUMENTS INCORPORATED BY REFERENCE

     Certain portions of the definitive Proxy Statement of Carnegie Group, Inc.
to be used in connection with the 1998 Annual Meeting of Stockholders (the
"Proxy Statement") are incorporated by reference into Part III of this Annual
Report on Form 10-K to the extent provided herein. Except as specifically
incorporated by reference herein, the Proxy Statement is not to be deemed filed
as part of this Annual Report on Form 10-K.
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                                     PART I
ITEM 1.  BUSINESS.

     Carnegie Group, Inc. ("Carnegie Group" or the "Company") provides business
and technical consulting, client/server and Internet-based custom software
development, third-party package implementation and systems integration
services. The Company focuses on two business areas in the information
technology professional services marketplace: customer interaction; and
logistics, planning and scheduling. Within these areas, the Company helps
clients in the financial services, government, manufacturing and
telecommunications industries improve business processes, customer relations,
productivity and market position.

     The Company's expertise encompasses a wide range of advanced software
technologies, including knowledge management systems, object-oriented
technology, advanced graphical user interfaces, constraint-directed search and
distributed computing. The Company captures certain aspects of its business area
experience and advanced technology expertise in a portfolio of reusable software
templates that can be used as building blocks to create software solutions
quickly and effectively. In addition, Carnegie Group employs its three-phased
RAPID methodology to help provide speed and repeatable reliability in creating
software solutions across different client engagements. RAPID begins with an
Analysis and Planning phase, is followed by an Implementation phase, and ends
with a Deployment phase.

     Since inception, Carnegie Group has emphasized relationships with leading
corporations in its targeted industries. These relationships have provided the
Company with opportunities for growth through the provision of additional
services to existing clients and through references to other companies within
the Company's targeted industries. Carnegie Group's clients include U S WEST
Communications, Inc., the United States Transportation Command, U.S. Army,
Diebold, BellSouth Telecommunications, Inc., First USA Bank, Highmark Blue Cross
Blue Shield and Philips Medical Systems.

INDUSTRY BACKGROUND

     Corporations increasingly seek to gain competitive advantages by
reengineering business processes in order to increase productivity, improve
responsiveness to market demands and facilitate comprehensive planning. The
knowledge and experience of workers involved in complex business processes can
be captured and disseminated through business process reengineering in order to
support and improve enterprise-wide decision-making.

     As computer speed and capacity have increased and computer hardware and
software costs have declined, corporations have decentralized their computing
infrastructures by distributing computing power to end-users. While centralized
computing infrastructures have historically collected, stored and manipulated
large volumes of information, the widespread installation of client/server
architectures has enabled multiple personal computers and workstations to be
linked together in various locations within an enterprise and has permitted
information to be disseminated to end-users. In addition, the Internet has
provided a global network through which information can be disseminated without
regard to specific computing platforms.

     The use of advanced software technologies within client/server and
Internet-based architectures has facilitated the creation of sophisticated
software solutions that capture, analyze and disseminate enterprise-wide
knowledge. These solutions allow end-users to access business rules and
accumulate corporate knowledge, and to use that information to make decisions
more quickly and exploit business opportunities more effectively.

     Successful implementation of sophisticated software solutions within
client/server and Internet-based architectures requires specialized expertise in
advanced software technologies. Generally, such expertise is not found in
corporations' internal information systems departments, because maintaining
specialized expertise in advanced software technologies is not believed to be
cost-effective. As a result, corporations are increasingly retaining information
technology service providers to develop the sophisticated software solutions
they require.

     The demand for sophisticated software solutions that automate and enhance
business processes has created significant opportunities for information
technology service providers. However, not all information technology service
providers have the expertise to provide sophisticated solutions within
client/server and Internet-based architectures. Some of these providers focus on
general business consulting or on the
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methodologies through which business processes can be reengineered, while others
focus on consulting for specific industries or on specific systems integration
services.

CARNEGIE GROUP'S STRATEGY

     Carnegie Group has recognized the demand for information technology
services from providers who combine expertise in a wide range of advanced
software technologies with experience in developing sophisticated software
solutions for specific industries. Carnegie Group's goal is to be a leading
provider of knowledge-based, user-centered client/server and Internet-based
software development services that integrate advanced technologies with clients'
existing computing infrastructures to automate and enhance business processes in
two business areas: customer interaction; and logistics, planning and
scheduling. To attain that goal, the Company employs the following strategies:

     Apply Advanced Software Technologies to Develop High-Value
Solutions.  Carnegie Group focuses on performing software development, systems
integration and technical consulting services that apply advanced software
technologies to develop high-value software solutions that improve its clients'
productivity and competitive market position. The Company's expertise
encompasses a wide range of advanced software technologies, including: knowledge
management systems; object-oriented technology; advanced graphical user
interfaces; constraint-directed search; and distributed computing. Carnegie
Group intends to continue to focus on applying advanced software technologies as
new technologies are developed that can be used to build high-value solutions
for its clients.

     Employ Reusable Software Templates to Leverage Business Area
Experience.  Carnegie Group captures certain aspects of its business area
experience and advanced technology expertise, developed principally in the
course of engagements for clients, in a portfolio of reusable software
templates. The Company selects templates for use in new engagements where
appropriate, and then modifies and enhances these templates to serve as the
building blocks of complete knowledge-intensive software solutions. Carnegie
Group believes that its portfolio of reusable software templates reduces
development time and project costs and enhances project quality, allowing it to
quickly provide sophisticated software solutions to its clients. The Company
plans to continue to employ reusable software templates within appropriate
application niches and to develop new templates as it performs engagements for
its clients.

     Continue to Grow Significant Client Relationships.  Carnegie Group has
emphasized relationships with leading organizations in its targeted industries.
These organizations are characterized by business areas (such as customer
interaction, and logistics, planning and scheduling) to which the Company's
services and technology are particularly well-suited, and by participants who
possess the financial resources and scale of operations necessary to support the
engagement of service providers such as the Company. In each relationship, the
Company seeks to capitalize on its success in completing an initial engagement
by offering additional services that automate and enhance other business
processes for that client. Carnegie Group expects that its focus on providing
additional software solutions for existing clients will continue to be an
important component of its marketing efforts.

     Expand Client Base in Targeted Industries.  Carnegie Group is focused upon
expanding its client base in the financial services, government, manufacturing
and telecommunications industries. The Company believes that successful
engagements for existing clients create opportunities for client references that
enhance the Company's reputation and enable it to attract additional clients in
its targeted industries. Carnegie Group also intends to target additional
industries in which its business area experience and advanced software
technology expertise can be applied.

     Apply RAPID Methodology to Facilitate Rapid Custom Software
Development.  In the course of performing its engagements, Carnegie Group
employs its three-phased RAPID methodology to help provide speed and repeatable
reliability in creating software solutions across different client engagements.
RAPID begins with an Analysis and Planning phase, is followed by an
Implementation phase, and ends with a Deployment phase. This methodology
encourages client feedback and leads to greater congruence with client needs and
expectations. The Company believes that this approach enables the rapid
deployment of knowledge-intensive software solutions for its clients.

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     Strategic Acquisition.  Carnegie Group acquired Advantage kbs, Inc. in
March 1998. Advantage provides problem solving resolution software and
professional services for automating customer support. The Company believes that
the acquisition of Advantage will enhance its customer interaction and call
center strategy by enabling the Company to offer Advantage's IQSupport
Application Suite in the call center and help desk market. See "Recent
Development." The Company will continue evaluating acquisitions of businesses,
products and technologies that complement the Company's business.

SERVICES AND SOLUTIONS

     Carnegie Group's project teams provide software development, systems
integration and technical consulting services to create knowledge-intensive
software solutions that improve business processes, customer relations,
productivity, and market position.

  Services

     Carnegie Group provides its services through project teams comprised of
engineers, project managers and sales and marketing personnel that are assigned
to client engagements. These professionals apply industry, advanced technology
and business area expertise to create a solution that is intended to meet the
client's needs. The Company's project teams generally perform services in three
phases (which are usually the subjects of separate contracts but which may be
governed by one contract covering all phases):

     Phase I typically consists of a "proof of concept" or feasibility
assessment for the client which identifies the specific problem and proposes the
solution to be created by Carnegie Group, including the technology likely to be
employed during the engagement and the engagement milestones for each phase. The
first phase is generally completed in one to three months and is usually
performed on a fixed-price basis. Successful completion of phase one may lead to
the continuation of the project into phase two, although there is no obligation
for the client to engage Carnegie Group to continue the project following the
completion of the first phase.

     Phase II generally lasts three to nine months and involves completing a
solution for the client. The solution may include a licensed software component
such as a reusable software template. In designing software solutions, the
Company applies an iterative or "spiral" approach that starts with the client's
identification of its requirements during Phase I, from which Carnegie Group
proceeds to construct a prototype that is then tested with the client against,
and used to refine, the original requirements. Carnegie Group then produces
successive new versions of the software, each of which is again tested with the
client against project requirements.

     Phase III generally consists of deploying the solution at additional client
sites or throughout the client's business enterprise. The project specification
may be further customized during this phase to incorporate changing client
needs. The third phase may take from six months to more than a year. The
majority of the Company's engagement contracts in the second and third phases
are performed on a time-and-materials basis.

  Solutions

     Carnegie Group creates software solutions for two business areas: customer
interaction; and logistics, planning and scheduling.

     Customer Interaction.  Carnegie Group develops knowledge-based agent
software that enables business managers to consistently deliver corporate
knowledge and business strategy to all points of customer contact across an
enterprise. Knowledge-based agents deliver corporate knowledge and strategy to
human decision makers in the form of recommendations that can help solve
problems and sell products and services. This technology enables organizations
to affect the quality of customer encounters and optimize all interactions to
generate greater revenue, improve customer satisfaction and achieve other
critical business goals.

     A solution designed for Philips Medical Systems helps customer support
engineers make a repair at the customer's site, where time and performance are
critical. Using Carnegie Group's TestBench(TM) diagnostic software, engineers
are able to service the customer immediately. TestBench automates the process of
accessing information and gives customer support engineers the instantaneous
access to knowledge bases,
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consisting of technical expertise and legacy data, that they need to perform
their job more efficiently and effectively. At Philips, TestBench enables
engineers to repair the company's medical equipment efficiently and on the first
call whenever possible. The engineer determines a machine's symptoms, queries
the knowledge base, and plays out scenarios to reach a solution. Repair cycles
are shortened, unnecessary service calls are eliminated, spare parts inventory
is reduced, and solutions are shared among engineers' peers.

     A solution designed for U S WEST Communications, Inc. ("U S WEST"), a
subsidiary of a regional Bell operating company, helps make U S WEST's call
center more responsive and efficient and improves customer service and
satisfaction. To help U S WEST maximize its share of their Mass Market
environment, Carnegie Group developed a Front End Screen & Route (FES&R) system
as the central component of U S WEST's Call Handling program. The FES&R system
shortens call routing time to call centers and improves the match between the
caller (customer) and the call handler (customer service/collection teams) so
that each call gets to the call handler best equipped to help with the
customer's particular needs. The FES&R system handles any call, any time,
anywhere and supports a seven-day/24-hour call center operation covering
multiple voice response units (VRU's) and automatic call distributors in the
14-state U S WEST Mass Market territory. The system provides a front end for
VRU's to enable customer self-help. Flexible business rules, combined with
customer, network, and market intelligence information, are used to provide
advanced call control capabilities and load balancing for intelligent call
routing and screening.

     A solution designed for First USA Bank, a subsidiary of Banc One, helps
utilize First USA's call center in a variety of critical customer service
functions. To help First USA develop a call center-based collections strategy to
assist card members in controlling their accounts, Carnegie Group developed a
Collections Support System. The Collections Support System enables customer
support representatives to focus on helping customers, rather than navigating a
computer system, by delivering the correct information as it is needed. This
capability speeds the customer service representative's ability to answer
questions and anticipate customer needs.

     A solution designed for BellSouth Telecommunications, helps make its web
site provide more than company information to its customers. Carnegie Group
provided the knowledge engineering and teamed with BellSouth on the software
development for Solution Advisor, an interactive web site that enables small
business customers to obtain the information and services they need, when they
need them. When accessed via the Worldwide Web, an animated on-line "agent"
greets the customer and presents a series of questions about specific business
requirements. Based on the customer's response, Solution Advisor provides
instant recommendations for telecommunications solutions customized to the
customer's business, as well as pricing tailored to each business location.
Opening this new channel gives BellSouth's web-based customers a chance to use a
smart solution for self-help while reducing the number of calls to BellSouth's
call center.

     Logistics, Planning and Scheduling.  Carnegie Group's knowledge-based
logistics, planning and scheduling solutions are intended to optimize the
allocation of available resources, thereby increasing efficiency and reducing
costs. These solutions provide advanced decision-support to planners by modeling
and manipulating complex information, and by simulating and analyzing multiple
scenarios. The Company's logistics, planning and scheduling solutions help to
reduce lead times and to match resources with requirements.

     A solution designed for the U.S. Transportation Command (TRANSCOM) is
helping U.S. military patient movement planners synchronize operations with
evacuation processes. The TRANSCOM Regulatory And Command & Control Evacuation
System (TRAC(2)ES) is the result of a Department of Defense directive that
tasked TRANSCOM with establishing a global system for patient movement,
integrating medical regulating and evacuation. Prior to TRAC(2)ES, medical
regulation and evacuation were two separate processes. With little or no
correlation between a patient's needs and the capabilities at hand to transport
patients to proper care, TRAC(2)ES consolidates medical regulation and
evacuation through an advanced decision-support system. This system determines
the appropriate time-and-resource-sensitive information and how it should be
presented to support planners in getting patients where they need to go for the
best treatment.

     Another solution, developed for a steel producer, provides mill operators
with advanced decision-support for planning and scheduling continuous slab
caster and melt shop facilities. This solution arranges slab requirements into
possible production sequences and helps the operator evaluate alternative
sequences before
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scheduling actual production. This solution assists the client in reducing costs
by improving yield and cutting inventory, while simultaneously improving
customer service by creating more reliable production schedules. The solution is
based on the Company's Caster Planning and Scheduling System (CaPSS) software
template.

TECHNOLOGY

  Advanced Software Technologies

     Carnegie Group's engineering staff is experienced in applying advanced
software technologies to create solutions within enterprise-wide client/server
and Internet-based architectures. The architecture of the Company's software
solutions typically contains three tiers or layers: a "presentation layer" which
contains the user interface; a "functionality layer" which embodies the business
logic, knowledge base and application logic of the system; and a "data layer"
which is comprised of both data created with existing systems and new data
created with the solution.

     To create its solutions within three-tiered client/server and
Internet-based environments, Carnegie Group's engineers are skilled at employing
advanced software technologies, including: knowledge-based systems;
object-oriented technology; advanced graphical user interfaces;
constraint-directed search; and distributed computing.

     Knowledge management systems are software systems that can make reasoned
decisions about complicated processes and that enable those processes to be
completed with little or no human intervention. Knowledge-based systems access
detailed information about the process, apply underlying reasoning and recommend
decisions.

     Object-oriented technology is a methodology for designing a software system
using an object-oriented programming language, which represents concepts, things
and actions by describing their attributes. Once a concept, thing, or action has
been described, that description and its accompanying software code can be
reused broadly.

     Advanced graphical user interfaces combine screen icons, text and pointing
devices to allow computer users to direct a computer's activities by
manipulating images. Well-designed interfaces distill powerful and complex
functions into simple and intuitive graphic representations.

     Constraint-directed search is a software system that searches for desired
data or decisions across a large range of alternatives, with limiting factors
attached to the search. Such a search may, for example, be constrained by dates
or by certain characteristics of available resources. In a knowledge-based
system, the sets of constraints imposed on the search may be many, complex and
interdependent.

     Distributed computing refers to computer transactions, such as information
transfer, that may take place between different types of computers, which may or
may not be at the same location. Distributed computing and transaction
processing software automates and enables enterprise-wide information exchanges
that might not otherwise be available.

     Other advanced software technologies employed by the Company include
case-based reasoning and relational and object-oriented database management
systems.

  Reusable Software Templates

     Carnegie Group captures certain aspects of its business area experience and
advanced technology expertise in a portfolio of reusable software templates.
Generally, these templates are developed and refined in the course of performing
services for clients. The Company selects templates for use as building blocks
in new engagements where appropriate, and then modifies and enhances these
templates to form complete, customized, knowledge-intensive solutions. The
Company believes that its reusable software templates reduce development time
and project costs and enhance project quality, allowing it to quickly provide
sophisticated software solutions to its clients. The Company's reusable software
templates include the following:

     Recommender is a customer contact software template that consolidates
valuable knowledge from sales and marketing personnel, and disseminates it to
sales consultants and customer service representatives.

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Customer Xpress helps the user navigate through the process of defining customer
needs and exploring options among available products. It is intended to enable
the end-user to increase revenue from each customer contact, improve the quality
of service and reduce service representative training time and costs.

     TestBench is a customer service software template that is designed to
increase the accuracy and efficiency of help desk, technical assistance center
and stand-alone field support. TestBench enables organizations to capture human
troubleshooting expertise and deploy that expertise rapidly and inexpensively to
end-users. This template can be integrated with or embedded in other
conventional computing environments. TestBench is also available from the
Company as a stand-alone software product.

     WorkBench is a reusable customer service software template developed from a
user-centric perspective. It provides a consistent, graphical interface into
service applications while allowing data to be shared between these
applications. Service representatives can access the information they need
quickly and easily, and share information through the system.

RECENT DEVELOPMENT

       On March 19, 1998, the Company acquired all the outstanding stock of
Advantage kbs, Inc. (Advantage) for a purchase price of $5m, plus an additional
contingent payment of up to $2.5m which is dependent upon revenue and earnings
of Advantage for the year ending December 31, 1998. Based in Edison, New Jersey,
Advantage provides problem resolution software and professional services for
automating customer support. The Company believes that the acquisition of
Advantage will enhance its customer interaction and call center strategy by
enabling the Company to offer Advantage's IQSupport Application Suite in the
call center and help desk markets. In addition, the Company believes that the
acquisition will broaden its capacity to offer business consulting services to
its customers. The integration of Advantage is subject to certain risks. The
possible business and financial advantages of the acquisition may not be
achieved unless the operations of Advantage are successfully integrated with the
Company in a timely manner. See "Risk Factors--Risks Associated with Integration
of Advantage." A Current Report on Form 8-K is being filed with respect to the
acquisition of Advantage.

MARKETING, SALES AND CLIENTS

     Carnegie Group markets its services directly to clients in its targeted
industries of financial services, government, manufacturing and
telecommunications. These industries are characterized by business areas (such
as customer interaction, and logistics, planning and scheduling) to which the
Company's services and technology are particularly well-suited, and by
participants who possess the financial resources and scale of operations
necessary to support the engagement of service providers such as the Company.

     The Company identifies leading organizations in each industry and seeks to
provide an initial solution that builds on one of the Company's reusable
software templates. Once an initial project has been successfully completed,
Carnegie Group seeks to offer additional services that automate and enhance
other business processes for the client. Carnegie Group intends to target
additional industries in which its business area experience and advanced
software technology expertise can be applied.

     The Company markets its services to clients throughout the United States
from its headquarters in Pittsburgh, Pennsylvania. In addition, the Company
maintains offices in Denver, Colorado, Atlanta, Georgia, and Oakland, California
focusing upon clients in the telecommunications industry. The offices in
Fairview Heights, Illinois and Arlington, Virginia service government industry
clients. Of the 257 people employed or engaged by the Company as of December 31,
1997, 25 were involved directly in sales and marketing and were supported by 36
project managers and 162 project engineers focused upon the industries that the
Company serves.

     The Company employs a variety of business development and marketing
techniques to communicate directly with current and prospective clients. These
techniques include exhibiting at trade shows, authoring articles and presenting
papers regarding the Company's solutions and technology, holding seminars for
clients and prospective clients on technology and industry issues and marketing
through direct mail initiatives. In accordance with government contracting
requirements, the Company's marketing and sales efforts toward

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government industry clients that are governmental agencies or instrumentalities
are limited to responding to requests for proposals and participating in
competitive bidding. Periodically, the Company responds to requests by these
clients for bids on projects in which the technology to be employed or services
to be rendered are available from only one or a limited number of sources.

     1997 saw the addition of a channels marketing program called the Carnegie
Alliance Team. The Carnegie Alliance Team participates in the third-party
package implementation business by securing partnerships with leading product
and tool set vendors in the customer interaction business area. These product
and tool set providers rely on services firms like Carnegie Group to
successfully implement their products and integrate them with clients' existing
information systems. In 1997, the Carnegie Alliance Team concentrated its
efforts on a relationship with Genesys Telecommunications Laboratories, Inc.
Genesys develops, markets and sells computer telephony integration (CTI)
software products and tool sets. CTI products enable information to flow more
easily between telecommunications switching equipment and the desktop computers
in customer interaction or call center environments. This improved information
flow leverages information contained at the switch and in existing data
structures and creates a richer information environment for customer interaction
business personnel to improve management and customer support and service.

     In 1997, total revenue from billings to each of the United States
Transportation Command, U S WEST Communications, Inc. and BellSouth
Telecommunications accounted for more than 10% of the Company's total revenue.
In 1996, total revenue from billings to the United States Transportation
Command, the U S Army, Caterpillar, Inc. and BellSouth Telecommunications
accounted for more than 10% of the Company's total revenue. The Company expects
to continue to derive a significant portion of its revenue from a relatively
limited number of major clients.

BACKLOG

     The Company only includes in backlog signed contracts that either have
milestones yet to be attained or for which the Company can make a reasonable
estimate of work yet to be performed. The Company's backlog totaled $8.7 million
at December 31, 1997, compared to $9.6 million at December 31, 1996.

     Contracts included in backlog are generally performed within 12 months. In
accordance with industry practice, most of the Company's contracts are
terminable by the Company or the client upon short or no notice. There can be no
assurance that contracts reflected in backlog will not be canceled or delayed.
Accordingly, the Company believes that backlog is not a reliable measure of
future revenue.

COMPETITION

     The information technology services market, which includes the market for
the Company's services and solutions, is comprised of a large number of
participants, is subject to rapid change and is highly competitive. Primary
competitors include: the consulting practices of the "Big Six" accounting firms;
systems consulting and integration firms such as American Management Systems,
Inc. and Cambridge Technology Partners Inc.; and the professional services
groups of large companies, such as International Business Machines Corporation,
Digital Equipment Corporation and AT&T Corporation. Many participants in the
information technology services market have significantly greater financial,
technical and marketing resources and greater name recognition than does
Carnegie Group. Moreover, clients may elect to use their internal information
systems resources to satisfy their needs for the software development, systems
integration and technical consulting services that the Company offers. The
Company also faces competition from organizations providing outsourcing services
to the information systems departments of existing and potential clients. In
addition, the information technology services market is highly fragmented and is
served by numerous firms; some of these firms compete nationally and
internationally, while others serve only their respective local markets. While
the Company has not experienced competition from foreign providers of
information technology services, there can be no assurance that the Company will
not experience such competition in the future. Carnegie Group has targeted, and
expects to continue to target, industries that are characterized by business
areas (such as customer interaction, and logistics, planning and scheduling) to
which the Company's services and technology are particularly well-suited, and by
participants who possess the financial resources and scale of operations

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necessary to support the engagement of service providers such as the Company. A
growing number of professional services firms are seeking engagements from that
same client group.

     The Company believes that the principal competitive factors in the
information technology services market include the nature of the service
offering, quality of service, timeliness, responsiveness to client needs,
experience with the client's industry and competitive environment, technical
expertise, access to replicable technology such as software templates and price.
The Company believes that it competes favorably with respect to these factors.
The Company believes that its ability to compete also depends in part upon a
number of competitive factors outside its control, including: the ability of its
competitors to hire, retain and motivate project managers, engineers and sales
and marketing personnel; competitors' ownership of or access to software and
technology used by potential clients; the development by others of software that
is competitive with the Company's solutions and services; the price at which
others offer comparable services; and the extent of competitors' responsiveness
to customer needs.

EMPLOYEES

     As of December 31, 1997, the Company had a total staff of 257 employees and
independent contractors, comprised of 198 technical personnel (of whom 36 were
project managers and 162 were project engineers), 25 sales and marketing
personnel and 34 corporate services personnel. The Company's professional
personnel have a variety of educational backgrounds, including degrees in
software engineering, electrical engineering, computer science, mechanical
engineering, linguistics and business administration; there were 106 employees
at December 31, 1997 with advanced degrees. The Company has historically filled
a portion of its engineering staffing needs through the retention of independent
contractors at a cost not materially greater than the cost of retaining its own
employees. The Company believes that its practice of retaining independent
contractors on a per engagement basis provides it with access to specialized
knowledge when needed, as well as greater flexibility in adjusting staffing
levels in response to changes in the demand for its services.

     The Company believes that its future success will depend in large part upon
its ability to attract, retain and motivate highly skilled managerial,
technical, marketing and support personnel. None of the Company's employees is
subject to a collective bargaining agreement. The Company believes that its
relations with its employees are excellent.

     After giving effect to the acquisition of Advantage, the total number of
employees of the Company and Advantage is 294.

INTELLECTUAL PROPERTY

     The Company relies upon a combination of patent, trade secret,
non-disclosure and other contractual arrangements, and patent, copyright and
trademark laws, to protect its proprietary rights and the proprietary rights of
third parties from whom the Company licenses intellectual property. The Company
enters into confidentiality agreements with its employees, consultants, clients
and potential clients and limits access to and distribution of proprietary
information. There can be no assurance that the steps taken by the Company in
this regard will be adequate to deter misappropriation of proprietary
information or that the Company will be able to detect unauthorized use and take
appropriate steps to enforce its intellectual property rights.

     The Company's business includes the development of custom software
solutions in connection with specific client engagements. Ownership of certain
custom components of such software is generally assigned to the client. The
Company has licensed through December 1998 certain custom software components
developed in the course of an engagement for a client. In addition, the Company
also develops core software technology and reusable software templates, often in
the course of engagements for clients, as well as object-oriented software
components and certain software "tools," which can be reused in software
application development and which generally remain the property of the Company.

     Although the Company believes that its services and solutions, including
its reusable software templates, do not infringe on the intellectual property
rights of others and that it has all rights necessary to utilize the
intellectual property employed in its business, the Company is subject to the
risk of litigation alleging infringement of third party intellectual property
rights. There can be no assurance that third parties, including

                                        8
<PAGE>   10

the parties for whom the Company has been engaged to develop solutions, from
which its reusable software templates have been derived, will not assert
infringement claims against the Company in the future with respect to
intellectual property utilized by the Company now or in the future. Any such
claims could require the Company to expend significant sums in litigation, pay
damages, develop noninfringing intellectual property or acquire licenses to the
intellectual property which is the subject of asserted infringement.

ITEM 2.  PROPERTIES.

     The Company's headquarters and principal administrative, sales and
marketing and software solutions development operations are located in
approximately 88,000 square feet of leased space in Pittsburgh, Pennsylvania.
The Company occupies these premises under a lease expiring in December 2004. The
Company also leases an additional 7,000 square feet of space under this lease;
this additional space is currently subleased to another tenant with a term
ending in March 1998. In addition, the Company leases office space in Denver,
Colorado, Atlanta, Georgia, Fairview Heights, Illinois, Arlington, Virginia, and
Oakland, California. Advantage, leases 8,700 square feet of office space in
Edison, New Jersey and additional office space in San Francisco, California. The
Company anticipates that additional space will be required as business expands
and believes that it will be able to obtain suitable space as needed.

ITEM 3.  LEGAL PROCEEDINGS

     The Company is not a party to any material litigation.

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

     Not applicable

                      EXECUTIVE OFFICERS OF THE REGISTRANT

     The following table sets forth certain information regarding the executive
officers of the Company.

<TABLE>
<CAPTION>
          NAME             AGE                              POSITION
          ----             ---                              --------
<S>                        <C>       <C>
Dennis Yablonsky           45        President, Chief Executive Officer and Director
John W. Manzetti           50        Executive Vice President, Chief Financial Officer,
                                     Treasurer, Secretary and Director
Bruce D. Russell           52        Senior Vice President
</TABLE>

     Mr. Yablonsky has served as President and Chief Executive Officer and as a
director of the Company since August 1987. Before joining the Company, Mr.
Yablonsky was President and Chief Operating Officer of Cincom Systems of
Cincinnati, Ohio, a privately-held company that markets software products to the
manufacturing, government and academic markets.

     Mr. Manzetti has served as Executive Vice President, Chief Financial
Officer and Treasurer and as a director of the Company since February 1995.
Prior to becoming an Executive Vice President, Mr. Manzetti served as Vice
President, Finance and Administrative Services and Chief Financial Officer from
October 1988 to February 1993, and as Vice President and Division Manager and
Chief Financial Officer from February 1993 to February 1995. Mr. Manzetti has
been Secretary since February 1989.

     Dr. Russell has served as Senior Vice President, Software Delivery since
December 1997. Prior to that, he served as Executive Vice President, Chief
Operating Officer and as a director of the Company since February 1995. Prior to
becoming an Executive Vice President, Dr. Russell served as Vice President and
Division Manager from January 1989 through January 1995.

                                        9
<PAGE>   11

                                    PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

     The Common Stock of the Company is traded on the Nasdaq National Market
under the symbol "CGIX." The following table sets forth the range of high and
low sale prices of the Common Stock as reported on the Nasdaq National Market
for the periods indicated.

<TABLE>
<CAPTION>
                                                               HIGH          LOW
                                                               ----          ---
<S>                                                           <C>           <C>
1996:
First Quarter (ended 3/31/96)...............................  $10.250       $6.625
Second Quarter (ended 6/30/96)..............................  $10.750       $8.250
Third Quarter (ended 9/30/96)...............................  $ 8.750       $5.000
Fourth Quarter (ended 12/31/96).............................  $ 8.500       $5.250

1997:
First Quarter (ended 3/31/97)...............................  $ 7.750       $5.375
Second Quarter (ended 6/30/97)..............................  $ 7.750       $5.000
Third Quarter (ended 9/30/97)...............................  $ 8.000       $6.500
Fourth Quarter (ended 12/31/97).............................  $ 8.000       $2.813
</TABLE>

     On March 20, 1998, the last reported sale price of the Common Stock on the
Nasdaq National Market was $3.63 per share. As of such date there were
approximately 4,100 holders of record of the Company's Common Stock.

     The Company has never declared or paid cash dividends on its capital stock.
The Company currently anticipates that it will retain future earnings, if any,
to fund the development and growth of its business and does not anticipate
paying any cash dividends in the foreseeable future.

ITEM 6.  SELECTED FINANCIAL DATA.

<TABLE>
<CAPTION>
                                                         YEAR ENDED DECEMBER 31,
                                           ---------------------------------------------------
                                            1993       1994       1995       1996       1997
                                            ----       ----       ----       ----       ----
<S>                                        <C>        <C>        <C>        <C>        <C>
Statement of Operations Data:
Total revenue............................  $12,817    $17,875    $25,650    $28,409    $29,406
Income (loss) from operations............   (2,065)     1,159      2,847      2,301       (548)
Income (loss) before income taxes........   (2,021)     1,162      2,849      2,928        182
Income tax benefit (provision)...........       --        277      1,827        432        (72)
Net income (loss)........................   (2,021)     1,439      4,676      3,360        110
Basic earnings (loss) per share of common
  stock..................................  ($ 0.42)   $  0.31    $  0.99    $  0.54    $  0.02
Diluted earnings (loss) per share of
  common stock...........................  ($ 0.42)   $  0.25    $  0.82    $  0.47    $  0.02
</TABLE>

<TABLE>
<CAPTION>
                                                               DECEMBER 31
                                           ---------------------------------------------------
                                            1993       1994       1995       1996       1997
                                            ----       ----       ----       ----       ----
<S>                                        <C>        <C>        <C>        <C>        <C>
Balance Sheet Data:
Working Capital..........................  $ 1,196    $ 2,055    $16,139    $19,793    $18,795
Total assets.............................    6,025      8,943     24,989     28,489     29,591
Obligations under capital
  leases-noncurrent portion..............       --         90         40         --         --
Total stockholders' equity...............    2,761      4,200     19,729     23,638     24,070
</TABLE>

                                       10
<PAGE>   12

ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS.

OVERVIEW

     Carnegie Group, Inc. founded in 1983, derives its revenue primarily from
the performance of software services, and to a lesser extent from the sale of
software licenses. Carnegie Group provides business and technical consulting,
client/server and Internet-based custom software development, third-party
package implementation and systems integration services. The Company focuses on
two business areas in the information technology professional services
marketplace: customer interaction; and logistics, planning and scheduling.
Within these areas, the Company helps clients in the financial services,
government, manufacturing and telecommunications industries improve business
processes, customer relations, productivity and market position.

     The market for the Company's services and solutions is highly fragmented
and is served by numerous firms. In providing services to clients in its
targeted industries, the Company competes with, among others, the consulting
practices of the "Big Six" accounting firms, systems consulting and integration
firms and the professional services groups of large companies. In addition,
clients may elect to use their internal information systems resources to satisfy
their needs for the software development, systems integration and technical
consulting services that the Company offers.

     Revenue from software services represented 95.1% of the Company's total
revenue in 1997. Fees for software services provided by the Company typically
are based on Carnegie Group staffing requirements and the overall scope and
timing of the project as agreed upon with the client. The Company has
historically filled a portion of its engineering staffing needs through the
retention of independent contractors. The Company believes that its practice of
retaining independent contractors on a per engagement basis provides it with
access to specialized knowledge when needed, as well as greater flexibility in
adjusting staffing levels in response to changes in the demand for its services.
The Company's software services are generally performed on a time-and-materials
basis, although the Company also provides certain software services on a
fixed-price or cost-plus-fixed-fee basis, depending on the overall project
scope, risks and client requirements. The Company records software services
revenue at estimated realizable rates as labor hours are recorded, or as project
milestones or deliverables are met, whichever most accurately reflects project
completion status. Adjustments are made to software services revenue as required
using the percentage-of-completion method of accounting.

     Revenue from software licenses, which represented 4.9% of the Company's
total revenue in 1997, includes fees for licenses, education and training,
maintenance revenue and miscellaneous revenue. Revenue from software licenses
includes fees for reusable software templates as well as fees for templates sold
on a stand-alone basis. The Company records revenue on licenses of reusable
software templates when the license agreement is executed, the client purchase
order is received and the software has been shipped to the client. Because
development costs of these templates have been fully amortized in previous
periods (as described below), current costs of software licenses revenue are
insignificant. The Company does not believe that the effects of costs of
software licenses revenue on the Company's aggregate gross margins or software
licenses gross margins are material. Maintenance revenue with respect to
software licenses is recorded ratably over the term of the maintenance
agreement. Miscellaneous revenue includes fees received from various joint
marketing arrangements with other companies.

     Historically, a significant portion of the Company's total revenue has been
attributable to sales to a limited number of clients. In 1997, total revenue
from billings to each of the United States Transportation Command, U S WEST
Communications, Inc. and BellSouth Telecommunications, Inc. accounted for more
than 10% of the Company's total revenue. In 1996, total revenue from billings to
the United States Transportation Command, US Army, Caterpillar, Inc. and
BellSouth Telecommunications accounted for more than 10% of the Company's total
revenue. The Company expects to continue to derive a significant portion of its
revenue from a relatively limited number of major clients.

     In accordance with applicable accounting principles, the Company presents
revenue from related parties and cost of revenue from related parties as
separate line items in its statements of operations. Software license revenue
from related parties is not presented because it is not significant. Related
parties for these purposes

                                       11
<PAGE>   13

include: U S West Communications, Inc., the ultimate parent corporation of which
has a representative on the Company's Board of Directors, and Ford Motor
Company, which holds approximately 8.6% of the Company's Common Stock
outstanding as of March 20, 1998. Because the Company's business is
characterized by significant customer concentration and relatively large
projects, the timing of performance for each client engagement can result in
significant variability in the Company's total revenue and total cost of revenue
from period to period; both revenue and cost of revenue from software services
from related parties have varied accordingly.

     Research and development expenses consist primarily of expenses for the
development of licensable software for sale as stand-alone products, rather than
development work performed in the course of client project engagements.
Development efforts with respect to TestBench represent investments in new or
updated functions or features. Research and development expenses have increased
as a percentage of total revenue and have remained a significant percentage of
software license revenue. Over the past six years, the Company has also
benefitted from the development of reusable software templates in the course of
performing engagements for clients. No software development costs were
capitalized in 1995, 1996 or 1997. Based on the Company's product development
process, technological feasibility is not established until completion of a
working model. Costs incurred by the Company between completion of the working
model and the point at which the product is ready for general release have been
insignificant in recent years.

RESULTS OF OPERATIONS

     The following table sets forth, for the periods indicated, the percentage
relationship to total revenue of certain items in the Company's consolidated
statement of operations.

<TABLE>
<CAPTION>
                                                               YEAR ENDED DECEMBER 31
                                                          ---------------------------------
                                                          1995          1996          1997
                                                          ----          ----          ----
<S>                                                       <C>           <C>           <C>
Revenue:
  Software services-Unrelated parties...................   81.8%         84.6%         68.4%
  Software services-Related parties.....................   12.6          10.3          26.7
                                                          -----         -----         -----
     Total Software services............................   94.4          94.9          95.1
  Software licenses.....................................    5.6           5.1           4.9
                                                          -----         -----         -----
     Total revenue......................................  100.0         100.0         100.0
Costs and expenses:
  Cost of revenue-Unrelated parties.....................   53.1          56.1          46.5
  Cost of revenue-Related parties.......................    6.9           6.4          18.4
                                                          -----         -----         -----
     Total cost of revenue..............................   60.0          62.5          64.9
  Research and development..............................    2.2           3.2           5.4
  Selling, general and administrative...................   26.7          26.2          28.9
  Restructuring charge..................................     .0            .0           2.7
                                                          -----         -----         -----
     Total costs and expense............................   88.9          91.9         101.9
Income (loss) from operations...........................   11.1           8.1          (1.9)
Other income, net.......................................     --           2.2           2.5
                                                          -----         -----         -----
Income before income taxes..............................   11.1          10.3            .6
Income tax benefit (provision)..........................    7.1           1.5           (.2)
Net income..............................................   18.2%         11.8%           .4%
                                                          -----         -----         -----
</TABLE>

COMPARISON OF YEARS ENDED DECEMBER 31, 1997 AND DECEMBER 31, 1996.

     Revenue.  Total revenue was $29.4 million in 1997 compared to $28.4 million
in 1996, an increase of $1.0 million or 3.5%. This growth resulted principally
from volume increases in sales of software services.

     Total software services revenue was $28.0 million in 1997 compared to $27.0
million in 1996, an increase of $1.0 million or 3.7%. This increase was
primarily attributable to customer contact engagements for clients in the
telecommunications industry. Revenue from software services-unrelated parties
was $20.1 million in 1997

                                       12
<PAGE>   14

compared to $24.0 million in 1996, a decrease of $3.9 million or 16.2%. This
decrease was due primarily to a funding gap for a logistics, planning and
scheduling engagement for a government industry client. Revenue from software
services-related parties was $7.8 million in 1997 compared to $2.9 million in
1996, an increase of $4.9 million or 167.3%. This increase was primarily
attributable to multiple customer interaction engagements for a
telecommunications industry client.

     Revenue from software licenses was unchanged at $1.4 million in 1997
compared to $1.4 million in 1996.

     Cost of Revenue.  Cost of revenue consists primarily of salaries and
related benefits for personnel, and also includes an allocated portion of rent,
building services and computer equipment services and expenses. Total cost of
revenue was $19.1 million in 1997 compared to $17.8 million in 1996, an increase
of $1.3 million or 7.5%. This increase was primarily attributable to additional
professional staff hired to perform the increased volume of software services.
Total cost of revenue was 64.9% of total revenue in 1997, compared to 62.5% of
total revenue in 1996. This percentage increase was primarily attributable to
increased costs associated with the use of contract labor on some customer
interaction engagements and an increase in project related travel. Cost of
revenue-unrelated parties was $13.7 million in 1997 compared to $15.9 million in
1996, a decrease of $2.2 million or 14.3%. This decrease, as mentioned earlier
in relation to a decrease in revenue, was affected due to a funding gap on a
logistics, planning and scheduling engagement for a government industry client.
Cost of revenue from software services-related parties was $5.4 million in 1997
compared to $1.8 million in 1996 an increase of $3.6 million or 199.1%. This
increase was directly related to the increase in software services-related
parties revenue mentioned earlier.

     Research and Development.  Research and development expenses were $1.6
million in 1997 compared to $.9 million in 1996, an increase of $.7 million or
76.4%. This increase was primarily attributable to continued investment in
template and methodology development.

     Selling, General and Administrative.  Selling, general and administrative
expenses include costs of proposal development and proposal writing, marketing
communications and advertising, sales and management staff and corporate
services functions, including accounting, human resources and legal services,
along with corporate executive staff. Selling, general and administrative
expenses were $8.5 million in 1997 compared to $7.4 million in 1996, an increase
of $1.1 million or 14.1%. This increase resulted primarily from increases in
sales and marketing expenses needed to support the Company's channels marketing
program. Also, contributing to the increase were additions to the human resource
staff and their related expenses and the cost to recruit technical staff.

     Restructuring.  Restructuring costs of $.8 million were incurred in 1997 in
response to the significant funding gap in a government engagement mentioned
previously. These one-time charges were for a reduction in force and the
write-down of certain assets related to underutilized capacity.

     Other Income.  Total other income for 1997 was $731,000 compared to total
other income of $627,000 in 1996, an increase of $104,000 or 16.4%. This
increase was due primarily to compounded interest income earned on the net
proceeds received in December 1995 from the Company's initial public offering,
which were invested in an interest-bearing account.

     Income Tax Provision.  An income tax provision of $72,000 was recorded in
1997. The effective income tax rate in 1997 was higher than the effective income
tax rate in 1996 due to benefit recognized in 1996 as a result of the Company's
estimate of the deferred tax asset believed more likely than not to be realized.
See "Income Tax Considerations."

COMPARISON OF YEARS ENDED DECEMBER 31, 1996 AND DECEMBER 31, 1995

     Revenue.  Total revenue was $28.4 million in 1996 compared to $25.7 million
in 1995, an increase of $2.7 million or 10.8%. This growth resulted principally
from volume increases in sales of software services.

     Total software services revenue was $27.0 million in 1996 compared to $24.2
million in 1995, an increase of $2.8 million or 11.4%. This increase was
primarily attributable to an extension of a logistics, planning and scheduling
engagement for a government industry client and the continuation of a customer
contact engagement for a client in the telecommunications industry. Revenue from
software services-unrelated parties

                                       13
<PAGE>   15

was $24.0 million in 1996 compared to $21.0 million in 1995, an increase of $3.0
million or 14.6%. This increase was primarily attributable to the extension of a
logistics, planning and scheduling engagement and of a customer interaction
engagement, both of which are described above. Revenue from software services-
related parties was $2.9 million in 1996 compared to $3.2 million in 1995, a
decrease of $.3 million or 9.7%. This decrease was primarily attributable to the
completion of customer interaction engagements for a telecommunications industry
client. Also, results for 1996 were affected by the renegotiation of a
fixed-price contract, which resulted in engineers related to that contract being
underutilized for a portion of the year.

     Revenue from software licenses was unchanged at $1.4 million in 1996
compared to $1.4 million in 1995.

     Cost of Revenue.  Cost of revenue consists primarily of salaries and
related benefits for personnel, and also includes an allocated portion of rent,
building services and computer equipment services and expenses. Total cost of
revenue was $17.8 million in 1996 compared to $15.4 million in 1995, an increase
of $2.4 million or 15.5%. This increase was primarily attributable to additional
professional staff hired to perform the increased volume of software services.
Total cost of revenue was 62.5% of total revenue in 1996, compared to 60.0% of
total revenue in 1995. This percentage increase was primarily attributable to
increased costs associated with the renegotiation of a fixed-price contract for
a telecommunications industry client. Cost of revenue-unrelated parties was
$15.9 million in 1996 compared to $13.6 million in 1995, an increase of $2.3
million or 17.1%. This increase was primarily attributable to additional
professional staff hired or reassigned to perform the increased volume of
software services following the completion of customer contact engagements for a
telecommunications client. Also, as mentioned earlier, the increased revenue
from software services-unrelated parties for the extension of a logistics,
planning and scheduling engagement for a government industry client required an
increase in associated costs. Cost of revenue from software services-related
parties was $1.8 million in 1996 compared to $1.8 million in 1995.

     Research and Development.  Research and development expenses were $908,000
in 1996 compared to $568,000 in 1995, an increase of $340,000 or 59.9%. This
increase was primarily due to product development of various templates for the
services areas of the business.

     Selling, General and Administrative.  Selling, general and administrative
expenses include costs of proposal development and proposal writing, marketing
communications and advertising, sales and management staff and corporate
services functions, including accounting, human resources and legal services,
along with corporate executive staff. Selling, general and administrative
expenses were $7.4 million in 1996 compared to $6.9 million in 1995, an increase
of $.5 million or 8.5%. This dollar increase resulted primarily from increases
in sales and marketing expenses needed to support the Company's total revenue
growth along with increased insurance and professional services expenses related
to being a newly public company. These expenses decreased as a percentage of
total revenue from 26.7% in 1995 to 26.2% in 1996 as a result of lower Company
fixed costs as a percentage of total revenue.

     Other Income.  Total other income for 1996 was $627,000 compared to total
other income of $2,000 in 1995, an increase of $625,000. This increase was due
primarily to interest income earned on the net proceeds received in December
1995 from the Company's initial public offering, which were invested in an
interest-bearing account.

     Income Tax Benefit.  An income tax benefit of $432,000 was recorded in
1996. The effective income tax rate in 1996 was higher than the effective income
tax rate in 1995 due to changes in the amount of benefit recognized as a result
of the Company's current estimate of the deferred tax asset believed more likely
than not to be realized. See "Income Tax Considerations."

LIQUIDITY AND CAPITAL RESOURCES

     The Company has funded its operations in recent years primarily through
cash generated from operations and the use of cash reserves. In 1995 the Company
also funded its operations in part through borrowing under available lines of
credit and through the net proceeds of the initial public offering of its Common
Stock. There were no borrowings in 1996 or 1997.

                                       14
<PAGE>   16

     During 1997, the Company had net income of $110,000 and had a net use of
cash of $1.2 million. The net use of cash was primarily attributable to various
changes in elements of working capital and to capital expenditures.

     The Company experienced a drop in revenue earned but not yet billed when
comparing the year ended December 31, 1997 to the year ended December 31, 1996.
Invoicing of amounts to clients generally occurs within 45 days of time and
materials cost occurrence, unless a specific schedule is agreed upon, and
payment follows invoicing in accordance with customary terms. The Company has
not experienced any significant write-downs of receivables, nor does the Company
expect that the payments are doubtful; accordingly, the Company has not made an
allowance for doubtful accounts.

     Advanced billings and deferred revenue increased at December 31, 1997 when
compared to the year ended December 31, 1996. Advanced billings and deferred
revenue balances normally will change from period to period. Any increase would
reflect billings in advance of revenue earned, but which were billed in
accordance with established or agreed billings schedules. These amounts are
recorded as deferred revenue until earned. The timing and magnitude of such
advance billings vary from contract to contract and from client to client.

     The Company has a committed line of credit agreement in the amount of $3.5
million in place with PNC Bank, N.A. (the "Bank"). No borrowings were
outstanding against the committed line of credit at December 31, 1997 and
December 31, 1996. Borrowings under this agreement are collateralized by
accounts receivable. This line of credit bears interest at the Bank's prime
interest rate and the Bank charges a 0.15% fee per annum on the unused portion
of that line of credit. The Bank's prime interest rate at December 31, 1997 was
8-1/2% compared to 8-1/4% at December 31, 1996.

     The Company believes that current cash balances, together with cash
generated from operations and borrowing available under its lines of credit,
will satisfy the Company's working capital and capital expenditure requirements
during fiscal year 1998 and the foreseeable period thereafter. In the longer
term, the Company may require additional sources of liquidity to fund future
growth. Such sources of liquidity may include additional equity offerings or
debt financings. Capital expenditures are typically made for computing
equipment, software, physical plant and furniture and fixtures in order to seek
enhancements in the productivity of the Company's employees and to support
growth.

     On March 19, 1998, the Company acquired all the outstanding stock of
Advantage kbs, Inc. for a purchase price of $5.0 million, plus an additional
contingent payment of up to $2.5 million, depending on revenue and earnings of
Advantage for the year ending December 31, 1998. A Current Report on Form 8-K is
being filed with respect to the acquisition of Advantage.

INCOME TAX CONSIDERATIONS

     At December 31, 1997, the Company had net operating loss carryforwards of
approximately $8.6 million available to reduce federal taxable income through
2012. If an "ownership change" were to occur, within the meaning of the Internal
Revenue Code of 1986, as amended, the utilization of net operating loss
carryforwards would be subject to an annual limitation. Generally, an "ownership
change" occurs with respect to a corporation if shareholders who own, directly
or indirectly, 5% or more of the capital stock of the corporation increase their
aggregate percentage ownership of such stock by more than 50 percentage points
over the lowest percentage of such stock owned by such shareholders at any time
during a prescribed testing period. If the annual limitation were to apply, the
amount of the limitation would equal the product of (i) the fair market value of
the Company's equity on the date of the ownership change, with certain
adjustments, including an adjustment to exclude capital contributions made in
the two years preceding the date of the ownership change and (ii) a long-term
tax exempt bond rate of return published monthly by the Internal Revenue
Service. Should the annual limitation apply, the Company believes that it would
affect the timing of the use of, but not the ultimate ability of the Company to
use, the net operating loss carryforwards to reduce future income tax
liabilities. The applicability of the limitation is not expected to affect the
income tax provision (benefit) reported for financial accounting purposes.

                                       15
<PAGE>   17

     SFAS No. 109, "Accounting for Income Taxes," requires a valuation allowance
when it is "more likely than not that some portion or all of the deferred tax
assets will not be realized." It further states that "forming a conclusion that
a valuation allowance is not needed is difficult when there is negative evidence
such as cumulative losses in recent years." The ultimate realization of its
deferred income tax asset depends on the Company's ability to generate
sufficient taxable income in the future. The Company has weighed the positive
evidence of profitability over the last four years and future income
expectations against the negative evidence of dependence upon a limited number
of customers and other uncertainties and concluded that retaining a valuation
allowance related to net operating losses was not necessary at December 31, 1996
and continues to be unnecessary at December 31, 1997.

     In estimating the amount of its realizable deferred tax asset, the Company
gives substantial weight to recent historical results. Significant changes in
circumstances or in enacted tax laws which affect the valuation allowance are
recorded when they occur. The Company's annual strategic business planning
process takes place in the fourth quarter of the year, and the valuation
allowance is adjusted for future years' income expectations resulting from that
process. When preparing subsequent interim and annual financial statements, the
Company reevaluates whether there has been any significant change in the
assumptions underlying its plan and adjusts the valuation allowance as
necessary. For example, in the fourth quarter of 1996 and 1995, as a result of
its annual strategic business planning process, the Company reevaluated its
future years' income expectations and recorded a discrete income tax benefit as
an adjustment to the valuation allowance in each of those quarters.

OTHER

     SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than
Pensions," and SFAS No. 112, "Employers' Accounting for Postemployment
Benefits," did not affect the Company's financial position or results of
operations because the Company has not offered such benefits.

     SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets to be
Disposed of," became effective in 1996. The adoption of this standard did not
have a material effect on the results of operations or the financial position of
the Company.

     SFAS No. 123, "Accounting for Stock-Based Compensation," defines a fair
value based method of accounting for an employee stock option but allows
companies to continue recording compensation cost using currently accepted
measurement principles. Beginning in 1996, companies electing to continue using
currently accepted recognition principles are required to make pro forma
disclosures of net income as if the fair value based method of accounting had
been applied. Carnegie Group continues accounting for its stock-based employee
compensation plans under currently accepted recognition principles and has
presented the pro forma disclosures required under this statement in the notes
to the financial statements. Accordingly, the adoption of this statement had no
affect on the results of operations or financial position of Carnegie Group.

     SFAS No. 128, "Earnings per Share," the objective of which is to simplify
the computation of earnings per share and to make the U.S. standard for
computing earnings per share more compatible with the earnings per share
standards of other countries and with that of the International Accounting
Standards Committee, was issued in 1997. The Company adopted the provisions of
SFAS No. 128 for the year ended December 31, 1997, and has restated earnings per
share amounts for all periods presented in conformity with the new standard.

     Also in 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income," and SFAS No. 131, "Disclosures about Segments of an Enterprise and
Related Information." SFAS No. 130 establishes standards for the reporting and
display of comprehensive income and its components. The Company is required to
adopt the provisions of SFAS No. 130 beginning with its consolidated financial
statements for the three months ended March 31, 1998. SFAS No. 131 requires
certain disclosures about segment information in interim and annual financial
statements and related information about products and services, geographic areas
and major customers. The Company must adopt the provisions of SFAS No. 131 for
its consolidated financial statements for the year ending December 31, 1998. The
adoptions of SFAS Nos. 130 and 131 are not expected to have a material effect on
the Company's financial position, results of operations or cash flows.

                                       16
<PAGE>   18

     Impact of Year 2000 Issue: The Year 2000 Issue is the result of computer
programs being written using two digits rather than four to define the
applicable year. Any of the Company's computer programs that have date-sensitive
software may recognize a date using "00" as the year 1900 rather than the year
2000. This could result in a system failure or miscalculations of operations,
including, among other things, a temporary inability to process transactions, or
engage in similar normal business activities.

     During 1997, the Company began a strategic project to replace and enhance
its existing financial systems technology. While the decision to embark on this
project was solely business related, the new software that the Company
implemented is year 2000 compliant. Therefore, the Year 2000 issue will not pose
significant operational problems for the Company's computer systems.

     The Company has designed a systems environment that is Year 2000 compliant
and all systems are verified for Year 2000 compliance prior to purchase from
suppliers. However, there can be no guarantee that the systems of other
companies on which the Company's system rely will be timely converted, or that a
failure to convert by another company, or a conversion that is incompatible with
the Company's systems, would not have material adverse effect on the Company.
The Company believes that it has no material exposure to contingencies related
to the Year 2000 Issue for systems it has developed for its clients.

     The Company is and will continue to utilize both internal and external
resources to implement and test the software for Year 2000 modifications. The
Company plans to complete the Year 2000 project within one year or not later
than December 31, 1998. The total cost of the Year 2000 project is estimated at
$550,000 and is being funded through operating cash flows. Of the total project
cost, approximately $150,000 is attributed to the purchase of new software which
was purchased and capitalized in 1997. The remaining $80,000, some of which will
be capitalized or expensed as incurred over the next year, is not expected to
have a material effect on the results of operations. To date, the Company has
capitalized or expensed approximately $470,000 related to the assessment of, and
preliminary efforts in connection with, its Year 2000 project.

     The costs of the project and the date on which the Company plans to
complete the Year 2000 modifications are based on management's best estimates,
which were derived utilizing numerous assumptions of future events including the
continued availability of certain resources, third party modifications and other
factors. However, there can be no guarantee that these estimates will be
achieved and actual results could differ materially from those plans. Specific
factors that might cause such material differences include, but are not limited
to, the availability and cost of personnel trained in this area, the ability to
locate and correct all relevant computer codes, and similar uncertainties.

     Inflation is not expected to have a significant effect upon the Company's
business in the near future.
                            ------------------------

     This report contains forward-looking statements with respect to, among
other things, the market for the Company's services, certain plans and
objectives of the Company's management and prospects. These statements are
indicated by phrases such as "the Company will" or use of verbs such as
"believes," "plans," "intends," "anticipates," or words of similar impact. The
following are certain factors that may cause the company's actual results to
differ materially from those which are the subject of any such forward looking
statements.

     Dependence Upon Limited Number of Clients.  The Company has derived in the
past, and expects to derive in the future, a significant portion of its revenue
from a relatively limited number of major clients. For example, approximately
79%, 83% and 87% of total software services revenue in the years ended December
31, 1997, 1996 and 1995, respectively, was derived from the Company's five
largest clients in each such period. In 1997, revenue from billings to each of
the United States Transportation Command, U S WEST Communications, Inc. and
BellSouth Telecommunications accounted for more than 10% of the Company's total
revenue. In 1996, revenue from billings to the United States Transportation
Command, the U S Army, Caterpillar, Inc. and BellSouth Telecommunications
accounted for more than 10% of the Company's total revenue. The Company's
business depends in large part upon its ability to establish and maintain
relationships with a limited number of large clients. The loss of, or any
significant reduction in the services provided to, any existing major clients,
or the failure of the Company to establish and maintain relationships with new
major clients, would have a material adverse effect on the Company's business,
financial position and results of operations.

                                       17
<PAGE>   19

     Project Risks.  Many of the Company's engagements involve projects which
are critical to the operations of its clients' businesses and which provide
benefits that may be difficult to quantify. Moreover, many of these engagements
are significant to the Company, in that each may represent a significant portion
of the Company's total revenue. For example, the Company's ten largest
engagements accounted for approximately 68%, 76%, and 68% of total software
services revenue in the years ended December 31, 1997, 1996 and 1995,
respectively. The Company's failure or inability to meet a client's expectations
in the performance of an engagement could have a material adverse effect on the
Company's business, financial position and results of operations, including
damage to the Company's reputation that could adversely affect its ability to
attract new business. In addition, the Company's engagements generally are
terminable by clients on short or no notice. An unanticipated termination of a
major engagement could require the Company either to maintain under-utilized
employees, resulting in a higher than expected number of unassigned persons and
concomitant lower utilization rate, or to terminate such employees, resulting in
higher severance expenses. The Company must maintain a sufficient number of
senior professionals to oversee existing client engagements and to participate
with the Company's sales force in securing new client engagements; thus,
professional staff expenses are relatively fixed. Although the majority of the
Company's contracts are performed on a time-and-materials basis, some contracts
are performed on a fixed-price basis, exposing the Company to the risks of cost
overruns and inflation.

     Risks Associated with the Integration of Advantage.  On March 19, 1998, the
Company acquired all the outstanding capital stock of Advantage which became a
wholly owned subsidiary of the Company. The integration of companies in the
information technology services industry may be more difficult to achieve than
in other industries. There can be no assurance that the acquisition of Advantage
will result in any business and financial benefits to the Company. The
realization of any such benefit requires, among other things, that the
operations of Advantage be successfully integrated with those of the Company in
a timely manner. The successful integration of the Company and Advantage will
require the coordination of research and development and sales and marketing
efforts. The difficulties of such integration may be increased by the need to
coordinate geographically separated organizations and integrating personnel with
disparate business backgrounds. In addition, the Company's senior management has
not had previous experience in integrating acquisitions. There can be no
assurance that the Company will be able successfully to manage the integration
of Advantage.

     Variability of Quarterly Operating Results; Future Operating Results
Uncertain.  The Company has experienced significant quarterly and other
variations in revenue and operating results. Because the Company's business is
characterized by significant client concentration and relatively large projects,
the timing of performance for each client engagement can result in significant
variability in the Company's revenue and cost of revenue from quarter to
quarter. In addition, variations in the Company's revenue and operating results
occur as a result of a number of other factors, such as employee hiring and
utilization rates and the number of working days in a quarter. The timing of
revenue is difficult to forecast because the Company's sales cycle is relatively
long and may depend on factors such as the size and scope of assignments and
general economic conditions. Because a high percentage of the Company's
expenses, particularly employee compensation, are relatively fixed, a variation
in the timing of the initiation or completion of client engagements, especially
at or near the end of any quarter, can cause significant variations in operating
results from quarter to quarter and could result in quarterly losses. Future
revenue and operating results may vary as a result of these and other factors,
including the demand for the Company's services and solutions and the
competitive conditions in the industry. Moreover, much of the Company's revenue
from software licenses is realized upon the licensing of individual copies of
software, rather than in the course of a specific services engagement.
Accordingly, the timing of software license revenue can be difficult to predict
and may vary significantly from quarter to quarter. Many of the factors that
could result in quarterly variations are not within the Company's control. The
Company believes that quarter-to-quarter comparisons of its financial results
are not necessarily meaningful and should not be relied upon as an indication of
future performance.

     In addition, quarterly variations, together with the Company's dependence
upon a limited number of clients and the Company's experience of adverse
operating results in years prior to 1994, make it difficult for management to
engage in strategic planning that contemplates a horizon of more than three
years. Thus, income expectations beyond three years are viewed by management as
more uncertain, and management's

                                       18
<PAGE>   20

assessment of its ability to realize its deferred tax asset through future
taxable income reflects this. The Company's interim and annual financial
statements include a valuation allowance that is intended to reflect
management's estimation, in light of these and other risk factors, of the
realizability of its deferred tax asset. In determining the amount of the
valuation allowance and the possible need to adjust that amount, the Company
weighs the negative evidence of its dependence upon a limited number of clients
and the other risks described herein, on the one hand, against the positive
evidence of recent results and future expectations, on the other hand. The
Company then adjusts the valuation allowance to reflect the portion of the
deferred tax asset that the Company believes it will, more likely than not, be
unable to realize. The valuation allowance reflects the Company's belief that it
is more likely than not to realize most but not all of its deferred tax assets.

     Dependence on Key Management Personnel.  The Company's success depends in
significant part upon the retention of key senior management and technical
personnel. The Company does not have employment agreements with any of its
personnel other than Dennis Yablonsky, its President and Chief Executive
Officer, nor does it maintain key man life insurance on any of its personnel.
The loss of one or more of its key management employees or the inability to
attract and retain other qualified management employees could have a material
adverse effect on the Company's business, financial position and results of
operations.

     Attraction and Retention of Employees.  Carnegie Group's business involves
the delivery of software development services and is labor-intensive. The
Company's success depends in large part upon its ability to attract, retain and
motivate highly skilled employees, particularly project managers, sales and
marketing personnel, engineers and other senior personnel. Qualified project
managers and engineers are in particularly great demand and are likely to remain
a limited resource in the foreseeable future. Although the Company expects to
continue to attract sufficient numbers of highly skilled employees and to retain
existing project managers, sales and marketing personnel, engineers and other
senior personnel for the foreseeable future, there can be no assurance that the
Company will be able to do so. The Company, like others in the information
technology services industry, is subject to a relatively high annual rate of
turnover in personnel. The loss of project managers, sales and marketing
personnel, engineers and other senior personnel could have a material adverse
effect on the Company's business, financial position and results of operations,
including its ability to secure and complete engagements. No project managers,
sales and marketing personnel, engineers or other senior personnel have entered
into employment agreements, other than Dennis Yablonsky, the Company's President
and Chief Executive Officer.

     Management of Growth.  The Company was founded in 1983 by computer
scientists at Carnegie Mellon University in Pittsburgh, Pennsylvania. The
Company was initially funded through equity investments and technology alliances
with Digital Equipment Corporation, Generale de Service Informatique, The Boeing
Company, Texas Instruments Incorporated, Ford Motor Company and U S WEST, Inc.
From January 1, 1997 through December 31, 1997, the size of the Company's staff
increased from 238 to 257 employees and independent contractors. In addition,
the Company has opened offices in Atlanta, Georgia, Fairview Heights, Illinois,
Oakland, California and Arlington, Virginia since January 1, 1995. In order to
manage any further growth in its staff and facilities, the Company must continue
to improve its operational, financial and other internal systems, and to
attract, train, motivate and manage its personnel. If the Company is unable to
manage growth effectively and new personnel are unable to achieve anticipated
performance levels, the Company's business, financial position and results of
operations would be adversely affected.

     Competition.  The information technology services market includes a large
number of participants, is subject to rapid change and is highly competitive.
The Company competes with and faces potential competition for client assignments
and experienced personnel from a number of companies that have significantly
greater financial, technical and marketing resources and greater name
recognition. Primary competitors include: the consulting practices of the "Big
Six" accounting firms; systems consulting and integration firms such as American
Management Systems, Inc. and Cambridge Technology Partners, Inc.; and the
professional services groups of large companies, such as International Business
Machines Corporation, Digital Equipment Corporation and AT&T Corporation. In
addition, clients may elect to use their internal information systems resources
to satisfy their needs for software development, systems integration and
technical consulting services, rather than using those services offered by the
Company. The Company also faces competition from organizations providing
outsourcing services to the information systems departments of existing and
potential clients. In addition, the information technology services market is
highly fragmented and
                                       19
<PAGE>   21

is served by numerous firms; some of these firms compete nationally and
internationally, while others serve only their respective local markets. While
the Company has not experienced competition from foreign providers of
information technology services, there can be no assurance that the Company will
not experience such competition in the future. Carnegie Group has targeted, and
expects to continue to target, industries that are characterized by business
areas (such as customer interaction, and logistics, planning and scheduling) to
which the Company's services and technology are particularly well-suited, and by
participants who possess the financial resources and scale of operations
necessary to support the engagement of service providers such as the Company. A
growing number of professional services firms are seeking engagements from that
same client group. The Company believes that the principal competitive factors
in the information technology services industry include the nature of the
service offering, quality of service, timeliness, responsiveness to client
needs, experience with the client's industry and competitive environment,
technical expertise, access to replicable technology, such as software
templates, and price. The Company believes that its ability to compete also
depends in part upon a number of competitive factors outside its control,
including: the ability of its competitors to hire, retain and motivate project
managers, sales and marketing personnel and engineers; competitors' ownership of
or access to software and technology used by potential clients; the development
by others of software that is competitive with the Company's solutions and
services; the price at which others offer comparable services; and the extent of
competitors' responsiveness to customer needs.

     While the information technology services market remains highly fragmented
and continues to be served by numerous firms, the Company notes that this market
has been subject to recent consolidation. Accordingly, the Company from time to
time considers possible acquisitions, consolidations and other strategic
alternatives. In addition, business combinations among the Company's competitors
may result in the creation of additional large information technology service
providers with greater financial, marketing and other resources, than those
provided by the company.

     Developing Market; Technological Advances.  The market for client/server
software development services is continuing to develop. The Company's success is
dependent in part upon the acceptance of information processing systems
utilizing client/server architectures. While the Company believes that
corporations and government agencies will continue to accept the use of
client/server architectures, a decline in this trend could have a material
adverse effect on the Company's business, financial position and results of
operations. The Company's success will also depend in part on its ability to
develop software solutions that incorporate and keep pace with continuing
changes in advanced software technologies, evolving industry standards and
changing client preferences. There can be no assurance that the Company will be
successful in adequately addressing these developments on a timely basis or
that, if these developments are addressed, the Company will be successful in the
marketplace. The Company's failure to address these developments could have a
material adverse effect on the Company's business, financial position and
results of operations. In addition, there can be no assurance that products or
technologies developed by others will not render the Company's services
uncompetitive or obsolete.

     Intellectual Property Rights.  The Company's success is dependent in part
upon reusable software templates and other intellectual property. The Company's
business includes the development of custom software solutions in connection
with specific client engagements. Ownership of certain custom components of such
software is generally assigned to the client. The Company has licensed through
December 1998 certain custom software components developed in the course of an
engagement for a client. In addition, the Company also develops core software
technology and reusable software templates, often in the course of engagements
for clients, as well as object-oriented software components and certain software
"tools," which can be reused in software application development and which
generally remain the property of the Company.

     The Company relies upon a combination of patent, trade secret,
non-disclosure and other contractual arrangements, and patent, copyright and
trademark laws, to protect its proprietary rights and the proprietary rights of
third parties from whom the Company licenses intellectual property. The Company
enters into confidentiality agreements with its employees, consultants, clients
and potential clients and limits access to and distribution of proprietary
information. There can be no assurance that the steps taken by the Company in
this regard will be adequate to deter misappropriation of proprietary
information or that the Company will be able to detect unauthorized use and take
appropriate steps to enforce its intellectual property rights.

                                       20
<PAGE>   22

     Although the Company believes that its services and solutions (including
its reusable software templates) do not infringe on the intellectual property
rights of others and that it has all rights necessary to utilize the
intellectual property employed in its business, the Company is subject to the
risk of litigation alleging infringement of third party intellectual property
rights. There can be no assurance that third parties (including the parties for
whom the Company has been engaged to develop solutions, from which its reusable
software templates have been derived) will not assert infringement claims
against the Company in the future with respect to intellectual property utilized
by the Company now or in the future. Any such claims could require the Company
to expend significant sums in litigation, pay damages, develop non-infringing
intellectual property or acquire licenses to the intellectual property which is
the subject of asserted infringement.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

                                       21
<PAGE>   23

                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors
and Stockholders of Carnegie Group, Inc.

     In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, of stockholders' equity and of
cash flows present fairly, in all material respects, the financial position of
Carnegie Group, Inc. and its subsidiaries (the Company) at December 31, 1995,
1996 and 1997, and the results of their operations and their cash flows for the
years then ended in conformity with generally accepted accounting principles.
These financial statements are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements based
on our audits. We conducted our audits of these statements in accordance with
generally accepted auditing standards which require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for the opinion expressed
above.

Price Waterhouse LLP

Pittsburgh, Pennsylvania
February 3, 1998, except for Note 14 which is as of March 19, 1998

                                       22
<PAGE>   24

                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

                          CONSOLIDATED BALANCE SHEETS

                        DECEMBER 31, 1995, 1996 AND 1997

<TABLE>
<CAPTION>
                                                                   DECEMBER 31,
                                                     -----------------------------------------
                                                        1995           1996           1997
                                                        ----           ----           ----
<S>                                                  <C>            <C>            <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents..........................  $12,394,588    $14,691,765    $13,483,284
Accounts receivable (Note 3).......................    5,131,922      2,751,316      2,955,241
Accounts receivable from related parties (Notes 3
  and 12)..........................................  76,296.....        769,223      3,396,859
Accounts receivable--unbilled (Note 3).............    2,048,609      3,660,765      1,390,650
Accounts receivable related parties--unbilled
  (Notes 3 and 12).................................       87,690        188,302        211,885
Deferred income taxes (Note 13)....................    1,222,061      2,179,426      2,005,855
Other current assets...............................      397,883        403,508        871,931
                                                     -----------    -----------    -----------
     Total current assets..........................   21,359,049     24,644,305     24,315,705
                                                     -----------    -----------    -----------
Property and equipment, net of accumulated
  depreciation and amortization (Note 4)...........    1,812,894      2,046,415      2,568,758
Deferred income taxes (Note 13)....................    1,779,792      1,775,480      1,910,760
Long term notes receivable from officers...........           --             --        584,984
Other assets.......................................       36,900         23,055        210,597
                                                     -----------    -----------    -----------
     Total assets..................................  $24,988,635    $28,489,255    $29,590,804
                                                     ===========    ===========    ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Trade accounts payable.............................  $ 1,107,592    $   614,458    $   663,667
Payables to related parties (Note 12)..............      967,673      1,034,608        182,145
Accrued compensation...............................    1,130,479        706,965        933,004
Advance billings and deferred revenue..............      537,541      1,101,221      2,388,660
Accrued rent (Note 5)..............................      626,253        538,641        330,981
Accrued restructuring (Note 6).....................           --             --        598,723
Other accrued liabilities..........................      801,544        821,752        423,544
Obligations under capital leases--current portion
  (Note 5).........................................       48,691         33,242             --
                                                     -----------    -----------    -----------
     Total current liabilities.....................    5,219,773      4,850,887      5,520,724
                                                     -----------    -----------    -----------
Obligations under capital leases--noncurrent
  portion (Note 5).................................       39,671             --             --
                                                     -----------    -----------    -----------
     Total liabilities.............................    5,259,444      4,850,887      5,520,724
                                                     -----------    -----------    -----------
STOCKHOLDERS' EQUITY (NOTES 7 AND 8):
Common stock, $.01 par value; 20,000,000 shares
  authorized, 6,386,200, 6,512,038 and 6,707,934
  shares issued at December 31, 1995, 1996, and
  1997, respectively...............................       63,862         65,120         67,079
Capital in excess of par value.....................   30,836,317     31,384,080     31,704,241
Accumulated deficit................................  (10,695,988)    (7,335,832)    (7,226,240)
Treasury stock, 190,000 shares at December 31,
  1995, 1996, and 1997 (at cost)...................     (475,000)      (475,000)      (475,000)
                                                     -----------    -----------    -----------
     Total stockholders' equity....................   19,729,191     23,638,368     24,070,080
                                                     -----------    -----------    -----------
Commitments (Note 5)...............................
                                                     -----------    -----------    -----------
     Total liabilities and stockholders' equity....  $24,988,635    $28,489,255    $29,590,804
                                                     ===========    ===========    ===========
</TABLE>

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

                                       23
<PAGE>   25

                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF OPERATIONS

                 YEARS ENDED DECEMBER 31, 1995, 1996, AND 1997

<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                     -----------------------------------------
                                                        1995           1996           1997
                                                        ----           ----           ----
<S>                                                  <C>            <C>            <C>
Revenue (Notes 11 and 12):
  Software services--Unrelated parties.............  $20,972,461    $24,039,258    $20,138,562
  Software services--Related parties...............    3,245,219      2,931,565      7,837,364
                                                     -----------    -----------    -----------
     Total software services.......................   24,217,680     26,970,823     27,975,926
  Software licenses................................    1,432,628      1,438,225      1,430,335
                                                     -----------    -----------    -----------
     Total revenue.................................   25,650,308     28,409,048     29,406,261
                                                     -----------    -----------    -----------
Costs and expenses:
  Cost of revenue--Unrelated parties...............   13,618,798     15,948,615     13,669,530
  Cost of revenue--Related parties.................    1,757,072      1,810,554      5,416,175
                                                     -----------    -----------    -----------
     Total cost of revenue.........................   15,375,870     17,759,169     19,085,705
  Research and development.........................      567,710        907,976      1,601,525
  Selling, general and administrative..............    6,859,608      7,441,487      8,493,030
  Restructuring charges (Note 6)...................           --             --        774,608
                                                     -----------    -----------    -----------
     Total costs and expenses......................   22,803,188     26,108,632     29,954,868
                                                     -----------    -----------    -----------
Income (loss)from operations.......................    2,847,120      2,300,416       (548,607)
Other income (expense):
  Interest income..................................       58,660        617,764        718,412
  Other income.....................................       24,447         27,428         25,447
  Interest expense.................................      (81,124)       (17,665)       (13,293)
                                                     -----------    -----------    -----------
     Total other income............................        1,983        627,527        730,566
                                                     -----------    -----------    -----------
Income before income taxes.........................    2,849,103      2,927,943        181,959
Income tax benefit (provision) (Note 13)...........    1,826,926        432,213        (72,367)
                                                     -----------    -----------    -----------
     Net income....................................  $ 4,676,029    $ 3,360,156    $   109,592
                                                     ===========    ===========    ===========
Basic earnings per share...........................  $       .99    $       .54    $       .02
                                                     ===========    ===========    ===========
Diluted earnings per share.........................  $       .82    $       .47    $       .02
                                                     ===========    ===========    ===========
</TABLE>

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

                                       24
<PAGE>   26

                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

                  YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

<TABLE>
<CAPTION>
                                             CAPITAL
                                 COMMON     IN EXCESS      TREASURY    ACCUMULATED
                                  STOCK    OF PAR VALUE     STOCK        DEFICIT         TOTAL
                                  -----    ------------     -----        -------         -----
<S>                              <C>       <C>            <C>          <C>            <C>
Balance at December 31, 1994...   47,559    19,999,834      (475,000)   (15,372,017)    4,200,376
                                 -------   -----------    ----------   ------------   -----------
1995:
  Exercise of stock options--
     130,330 shares at
     $1.25-$5.625 per share....    1,303       463,974            --             --       465,277
  Initial Public
     Offering--1,500,000 shares
     at $8.00 per share (less
     issuance costs)...........   15,000    10,372,509            --             --    10,387,509
  Net income...................       --            --            --      4,676,029     4,676,029
                                 -------   -----------    ----------   ------------   -----------
Balance at December 31, 1995...   63,862    30,836,317      (475,000)   (10,695,988)   19,729,191
                                 -------   -----------    ----------   ------------   -----------
1996:
  Exercise of stock options--
     123,847 shares at
     $1.15-$5.00 per share.....    1,238       359,593            --             --       360,831
  Issuance of common stock
     under employee stock
     purchase plan.............       20        15,887            --             --        15,907
  Income tax benefit from stock
     option plan activity......       --       196,863            --             --       196,863
  Initial Public Offering
     costs.....................       --       (24,580)           --             --       (24,580)
  Net Income...................       --            --            --      3,360,156     3,360,156
                                 -------   -----------    ----------   ------------   -----------
Balance at December 31, 1996...   65,120    31,384,080      (475,000)    (7,335,832)   23,638,368
                                 -------   -----------    ----------   ------------   -----------
  Exercise of stock options--
     184,393 shares at
     $0.03-$6.38 per share.....    1,844       161,676            --             --       163,520
  Issuance of common stock
     under employee stock
     purchase plan.............      115        53,860            --             --        53,975
  Income tax benefit from stock
     option plan activity......       --       104,625            --             --       104,625
  Net Income...................       --            --            --        109,592       109,592
                                 -------   -----------    ----------   ------------   -----------
Balance at December 31, 1997...  $67,079   $31,704,241    $ (475,000)  $ (7,226,240)  $24,070,080
                                 =======   ===========    ==========   ============   ===========
</TABLE>

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

                                       25
<PAGE>   27

                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF CASH FLOWS

                  YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                     -----------------------------------------
                                                        1995           1996           1997
                                                        ----           ----           ----
<S>                                                  <C>            <C>            <C>
Cash flows from operating activities:
  Net income.......................................  $ 4,676,029    $ 3,360,156    $   109,592
  Adjustments to reconcile net income to net cash
   (used in) provided by operating activities:
     Depreciation and amortization.................      704,312        982,208      1,294,374
     (Gain) loss on the disposal of fixed assets...        2,176         (1,833)        44,976
     Deferred income taxes.........................   (1,988,361)      (953,053)        38,291
     Changes in working capital component:
       Accounts receivable.........................   (3,406,927)       768,450      2,066,190
       Accounts receivable--Related parties........    1,574,087       (793,539)    (2,651,219)
       Other assets................................     (184,449)         8,220       (655,965)
       Interest receivable.........................           --             --         (9,984)
       Trade accounts payable......................      (50,496)      (493,134)        49,209
       Payables to related parties.................      396,461         66,935       (852,463)
       Accrued compensation........................       44,975       (423,514)       226,039
       Accrued rent................................      (68,761)       (87,612)      (207,660)
       Accrued restructuring charge................           --             --        598,723
       Other accrued liabilities...................      606,817        217,071       (293,583)
       Advance billings and deferred revenue.......     (361,444)       563,680      1,287,439
                                                     -----------    -----------    -----------
          Net cash provided by operating
            activities.............................    1,944,419      3,214,035      1,043,959
                                                     -----------    -----------    -----------
Cash flows from investing activities:
  Proceeds from the sales of fixed assets, net.....       18,420          4,585          1,000
  Long term notes receivable from officers.........           --             --       (575,000)
  Capital expenditures.............................   (1,285,752)    (1,218,481)    (1,862,693)
                                                     -----------    -----------    -----------
          Net cash used in investing activities....   (1,267,332)    (1,213,896)    (2,436,693)
                                                     -----------    -----------    -----------
Cash flows from financing activities:
  Borrowings on line of credit.....................    5,125,000             --             --
  Repayments on line of credit.....................   (5,125,000)            --             --
  Principal payments under capital lease
     obligations...................................      (50,522)       (55,120)       (33,242)
  Proceeds from sales of common stock, net.........   10,852,786        352,158        217,495
                                                     -----------    -----------    -----------
          Net cash provided by financing
            activities.............................   10,802,264        297,038        184,253
                                                     -----------    -----------    -----------
Net change in cash and cash equivalents............   11,479,351      2,297,177     (1,208,481)
Cash and cash equivalents:
  Beginning of period..............................      915,237     12,394,588     14,691,765
  End of period....................................  $12,394,588    $14,691,765    $13,483,284
                                                     ===========    ===========    ===========
Supplementary information:
  Cash paid during the period for income taxes.....  $    32,474    $   157,250    $   172,585
  Cash paid during the period for interest.........  $    63,358    $     5,667    $     6,326
</TABLE>

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

                                       26
<PAGE>   28

                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1995, 1996 AND 1997

1. DESCRIPTION OF THE BUSINESS

     Carnegie Group, Inc. ("Carnegie Group" or the "Company") provides business
     and technical consulting, client/server and Internet-based custom software
     development, third-party package implementation and systems integration
     services. The Company focuses on two business areas in the information
     technology professional services marketplace: customer interaction; and
     logistics, planning and scheduling. Within these areas, the Company helps
     clients in the financial services, government, manufacturing and
     telecommunications industries improve business processes, customer
     relations, productivity and market position.

2. SIGNIFICANT ACCOUNTING POLICIES

  USE OF ESTIMATES

     The preparation of financial statements in conformity with generally
     accepted accounting principles requires management to make estimates and
     assumptions that affect the reported amounts of assets and liabilities and
     disclosure of contingent assets and liabilities at the date of the
     financial statements and the reported amounts of revenues and expenses
     during the reporting period. Actual results could differ from those
     estimates.

  PRINCIPLES OF CONSOLIDATION

     The consolidated financial statements include Carnegie Group, Inc., and its
     wholly owned subsidiaries, Carnegie Group Investments, Inc., Carnegie
     Investment Services, Inc., Carnegie Services, Inc., and Carnegie Federal
     Systems Corporation. All significant intercompany balances and transactions
     have been eliminated.

  REVENUE RECOGNITION

     Software services.  Revenue from software services contracts is recognized
     as time and material costs are incurred, or as project milestones or
     deliverables are met, and is adjusted using the percentage-of-completion
     method of accounting, as required. When a loss is anticipated for a
     software services contract, a provision for such loss is recorded in the
     period in which the loss becomes evident. The difference between
     contractual amounts billed in advance to customers and amounts recorded as
     revenue is included in advance billings. Amounts earned but not billed to
     the customer are included in accounts receivable.

     Software licenses.  Revenue from software licenses is recognized when a
     license agreement is executed, the client purchase order is received and
     the software is shipped to the customer. No significant vendor and
     post-contract support obligations remain at the time revenue is recognized.
     Revenue applicable to insignificant post-contract support is deferred and
     recognized ratably as the obligations are fulfilled. Revenue from customer
     support and training is recognized over the period in which the services
     are rendered.

  SOFTWARE DEVELOPMENT COSTS

     Certain internal development costs, primarily coding and testing of new
     products and enhancements to existing products, are capitalized after
     technological feasibility has been established. Capitalized software costs
     are amortized on a straight-line basis over the estimated useful life of
     each product, not to exceed five years, or the ratio of current revenue to
     the total of current and anticipated future revenue, whichever is the
     greater annual charge. Based on the Company's product development process,
     technological feasibility is not established until completion of a working
     model. Costs incurred by the Company between completion of the working
     model and the point at which the product is ready for general release

                                       27
<PAGE>   29
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

     have been insignificant in recent years. Accordingly, no software
     development costs were capitalized in 1995, 1996 or 1997.

     Research and development expenses consist primarily of expenses for the
     development of licensable software for sale as stand-alone products.
     Research and development costs, including software costs incurred prior to
     establishing technological feasibility, are expensed as incurred.

  CASH AND CASH EQUIVALENTS

     Cash equivalents consist of short-term interest-bearing deposits with
     original maturities of less than 90 days.

  CREDIT RISKS

     Financial instruments that subject the Company to concentrations of credit
     risks consist primarily of billed and unbilled receivables. The Company's
     clients are primarily involved in the financial services, government,
     manufacturing and telecommunications industries (Notes 3 and 12).
     Concentrations of credit risk with respect to billed and unbilled accounts
     receivable are limited due to the Company's credit evaluation process.
     Historically, the Company has not incurred any significant credit-related
     losses.

  PROPERTY AND EQUIPMENT

     Properties are recorded at cost. Equipment under capital lease is recorded
     at the lower of fair market value or the present value of future minimum
     lease payments. For financial reporting purposes, depreciation and
     amortization are provided under the straight-line method over the estimated
     useful lives of the respective assets, which range up to 5 years but are
     primarily 3 years or less. The Company uses accelerated methods for income
     tax purposes.

  EMPLOYEE BENEFIT PLAN

     The Company has a Section 401(k) Savings Plan (the Plan). The Plan allows
     employees to contribute up to 20 percent of their annual compensation,
     subject to statutory limitations. Company contributions to the Plan are
     discretionary. The company contributed $113,734 to the plan in 1997, no
     Company contributions were made in prior years.

  INCOME TAXES

     The Company accounts for income taxes in accordance with Statement of
     Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income
     Taxes," which requires an asset and liability approach in accounting for
     income taxes. The asset and liability approach requires the recognition of
     deferred tax assets and liabilities for the expected future tax
     consequences of temporary differences between carrying amounts and the tax
     bases of all assets and liabilities.

  PER SHARE AMOUNTS

     All share and per share data have been adjusted to give effect to the 2:5
     "reverse" stock split of the Company's common stock which became effective
     on September 18, 1995.

     The Company has adopted SFAS No. 128 (SFAS 128), "Earnings per Share" which
     establishes standards for computing and disclosing basic and diluted
     earnings per common share. Basic earnings per common share is computed by
     dividing net income by the weighted average number of common shares
     outstanding during the period. Diluted earnings per common share is
     computed by dividing net income by the weighted average number of common
     shares outstanding plus all dilutive potential common shares outstanding
     during the period. Dilutive common shares are determined using the treasury
     stock method.

                                       28
<PAGE>   30
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

     Earnings per common share for 1997, 1996 and 1995 have been restated to
     reflect the adoption of SFAS 128. (See Note 9)

  STOCK-BASED COMPENSATION

     Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting
     for Stock-Based Compensation," encourages, but does not require companies
     to record compensation cost for stock-based employee compensation plans at
     fair value. The Company has chosen to continue to account for stock-based
     compensation using the intrinsic value method prescribed in Accounting
     Principles Board Opinion No. 25 (APBO 25), "Accounting for Stock Issued to
     Employees," and related Interpretations. Accordingly, compensation cost for
     stock options is measured as the excess, if any, of the quoted market price
     of the Company's stock at the date of the grant over the amount an employee
     must pay to acquire the stock. (See Note 10)

3. ACCOUNTS RECEIVABLE

     Accounts receivable are as follows:

<TABLE>
<CAPTION>
                                                       YEAR ENDED DECEMBER 31,
                                                --------------------------------------
                                                   1995          1996          1997
                                                   ----          ----          ----
<S>                                             <C>           <C>           <C>
U.S. government agencies:
     Billed...................................  $  277,060    $  663,877    $  753,242
     Unbilled.................................     946,192     2,269,340       321,460
Telecommunications companies, including
  $64,932, $852,122 and $3,608,213 from
  related parties
     Billed...................................   1,315,904     1,066,187     3,736,103
     Unbilled.................................     347,077       241,182       367,234
Other trade receivables, including $99,054,
  $105,402 and $531 from related parties
     Billed...................................   3,615,254     1,790,475     1,862,755
     Unbilled.................................     843,030     1,338,545       913,841
Allowance for doubtful accounts...............          --            --            --
                                                ----------    ----------    ----------
                                                $7,344,517    $7,369,606    $7,954,635
                                                ==========    ==========    ==========
</TABLE>

     Revenue earned but not yet billed to customers is generally billed to
     customers within 45 days of time and material cost incurrence unless a
     specific billing schedule is agreed. Retainage and claims are not
     significant.

                                       29
<PAGE>   31
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

4.  PROPERTY AND EQUIPMENT

     Property and equipment are as follows:
<TABLE>
<CAPTION>
                                                   YEAR ENDED DECEMBER 31,
                           -----------------------------------------------------------------------
                                   1995                     1996                     1997
                           ---------------------    ---------------------    ---------------------
                              OWNED       LEASED       OWNED       LEASED       OWNED       LEASED
                           ----------   --------    ----------   --------    ----------   --------
<S>                        <C>          <C>         <C>          <C>         <C>          <C>
Equipment (primarily
  computer equipment)....  $7,055,000   $     --    $8,124,460   $     --    $9,691,589   $     --
Furniture and fixtures...   1,430,806    419,494     1,541,005    419,494     1,807,426    419,494
Other....................     210,758         --       244,604         --       184,574         --
                           ----------   --------    ----------   --------    ----------   --------
                            8,696,564    419,494     9,910,069    419,494    11,683,589    419,494
Less--Accumulated
  depreciation and
  amortization...........   6,975,381    327,783     7,897,505    385,643     9,114,831    419,494
                           ----------   --------    ----------   --------    ----------   --------
                           $1,721,183   $ 91,711    $2,012,564   $ 33,851    $2,568,758   $     --
                           ==========   ========    ==========   ========    ==========   ========
</TABLE>

     There were no significant operating leases other than leases for office
     space (see Note 5).

     Depreciation expense for the years ended December 31, 1995, 1996 and 1997,
     was $646,608, $924,347, and $1,260,524 respectively.

     For the years ended December 31, 1995, 1996 and 1997, amortization expense
     was $57,704, $57,861, and $33,850 respectively.

5.  COMMITMENTS

     The Company leases office space in Pittsburgh, Pennsylvania, Denver,
     Colorado, Fairview Heights, Illinois and Atlanta, Georgia under agreements
     that provide for escalating rent. Rent expense is normalized over the term
     of the lease which expires in December 2004, December 2002, August, 1998
     and March 2002 respectively. The difference between cash payments and rent
     expense is carried as accrued rent.

     Future minimum lease payments under noncancelable operating leases as of
     December 31, 1997, are as follows:

<TABLE>
<CAPTION>
                                                               OPERATING
                                                               ---------
<S>                                                           <C>
1998........................................................  $ 1,645,121
1999........................................................    1,653,389
2000........................................................    1,668,852
2001........................................................    1,671,665
2002........................................................    1,604,868
Thereafter..................................................    2,750,398
                                                              -----------
Total minimum lease payments................................   10,994,293
                                                              ===========
</TABLE>

     Minimum payments under operating leases have not been reduced by minimum
     sublease rentals of $32,344 due in the future under noncancelable
     subleases. Rent expense under operating leases was $1,546,873, $1,592,215,
     and $1,794,241, and receipts under subleases were $288,821, $286,105 and
     $376,937 during the periods ended December 31, 1995, 1996 and 1997
     respectively.

6.  RESTRUCTURING CHARGES

     During 1997, the Company implemented a restructuring plan in response to a
     significant funding gap for a government contract. The restructuring
     involved a reduction in workforce and the write off of certain assets
     related to underutilized capacity.

                                       30
<PAGE>   32
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

     The statement of operations for the year ended December 31, 1997 included
     costs of $774,608, of which $598,723 is recorded as accrued restructuring
     in the December 31, 1997 balance sheet. Costs associated with the
     restructuring include employee severance costs of $413,932, the write off
     of certain assets related to underutilized capacity of $289,958 and other
     costs of $70,718. All costs associated with the restructuring are expected
     to be incurred by the end of 1998.

7.  BORROWINGS

     At December 31, 1995, the Company had a $3,000,000 line of credit
     agreement. Additionally, the Company had an agreement for a $500,000
     discretionary line of credit. The availability of those funds were subject
     to the lender's approval. Both the $3,000,000 committed line and the
     discretionary line expired on June 30, 1996.

     The agreement was amended by extending the expiration date to June 29, 1998
     and increasing the committed line to $3,500,000, while eliminating the
     $500,000 discretionary amount. Borrowings under this agreement are
     collateralized by accounts receivable. The line of credit bears interest at
     the bank's prime interest rate and the bank charges a 0.15% fee per annum
     on the unused portion of the line of credit. The line of credit agreement
     in place at December 31, 1995 bore interest at the bank's prime interest
     rate plus 0.75%, and the bank charged a 0.25% fee per annum on the unused
     portion. The bank's prime interest rate was 8.50%, 8.25% and 8.50% at
     December 31, 1995, 1996 and 1997, respectively. There were no borrowings
     outstanding at December 31, 1995, 1996 or 1997.

8.  STOCKHOLDERS' EQUITY

     On September 1, 1995, the Board of Directors authorized 5,000,000 shares of
     preferred stock, par value $.01 per share. Terms of any series of such
     preferred stock will be established by the Board of Directors at the time
     of issue.

     On January 7, 1998, the Board of Directors authorized the repurchase of up
     to 200,000 shares of Carnegie Group common stock, on the open market or in
     negotiated transactions. The authorization will remain in effect until June
     30, 1998, and purchases may be made from time to time during that period.

9.  EARNINGS PER COMMON SHARE

     The computation of basic and diluted earnings per common share for the
     years ended December 31, 1997, 1996 and 1995 is performed as follows:

<TABLE>
<CAPTION>
                                           1997          1996          1995
                                           ----          ----          ----
<S>                                     <C>           <C>           <C>
Net income............................  $  109,592    $3,360,156    $4,676,029
                                        ==========    ==========    ==========
Weighted average common shares
  outstanding.........................   6,358,221     6,250,964     4,709,818
Effect of dilutive options............     583,634       850,425       972,637
                                        ----------    ----------    ----------
Diluted shares outstanding............   6,941,854     7,101,389     5,682,455
                                        ==========    ==========    ==========
Earnings per common share
  Basic...............................  $      .02    $      .54    $      .99
                                        ==========    ==========    ==========
  Diluted.............................  $      .02    $      .47    $      .82
                                        ==========    ==========    ==========
</TABLE>

     Stock options to purchase 497,000 shares of common stock at exercise prices
     ranging from $9.88 to $6.38 per share outstanding at December 31, 1997 were
     not included in the computation of diluted earnings per common share
     because the options' exercise prices were greater than the average market
     price of the common shares for the year ended December 31, 1997. Stock
     options to purchase 434,000 shares of common stock at exercise prices
     ranging from $9.88 to $8.00 per share outstanding at December 31, 1996

                                       31
<PAGE>   33
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

     were not included in the computation of diluted earnings per common share
     because the options' exercise prices were greater than the average market
     price of the common shares for the year ended December 31, 1996. All stock
     options outstanding at December 31, 1995 were included in the computation
     of diluted earnings per common share for December 31, 1995.

10. STOCK OPTIONS

  1989 STOCK OPTION PLAN

     Incentive stock options granted under the Carnegie Group, Inc., 1989 Stock
     Option Plan expire 10 years from the date of grant, generally become
     exercisable over a four-year period and are adjusted pro forma for stock
     splits or dividends. All grants of incentive stock options under the plan
     are exercisable at prices that were at least 100% of the fair market value
     of the Company's common stock at the date of grant as determined by the
     Board of Directors. The plan provides that the payment for the shares may
     be in cash or by exchange of common stock previously held.

     In May 1992, the Company issued 4,000 nonqualified stock options under this
     plan to a newly elected member of the Board of Directors at an exercise
     price of $1.65 per share. The options become exercisable over a four-year
     period and expire on May 12, 2002. In March 1995, the Company issued 2,000
     nonqualified stock options under the plan to the same member of the Board
     of Directors at an exercise price of $4.65 per share. The options become
     exercisable over a four-year period and expire on March 6, 2005.

     The following table summarizes activity under the plan:

<TABLE>
<CAPTION>
                                                      OPTIONS
                                       AVAILABLE     GRANTED &     WEIGHTED AVERAGE
                                       FOR GRANT    OUTSTANDING     EXERCISE PRICE
                                       ---------    -----------     --------------
<S>                                    <C>          <C>            <C>
Balance, December 31, 1994...........   163,268       777,482           $3.96
Granted..............................   (43,060)       43,060           $4.65
Exercised............................        --       (56,170)          $3.53
Forfeitures..........................    12,530       (12,530)          $3.53
                                        -------       -------
Balance, December 31, 1995...........         *       751,842           $4.04
Granted..............................        --            --           $  --
Exercised............................        --       (94,793)          $4.19
Forfeitures..........................        --        (7,408)          $2.08
                                        -------       -------
Balance, December 31, 1996...........         *       649,641           $4.15
Granted..............................        --            --           $  --
Exercised............................        --       (46,500)          $2.60
Forfeitures..........................        --       (10,600)          $4.77
                                        -------       -------
Balance, December 31, 1997...........         *       592,541           $4.26
                                                      =======
</TABLE>

---------

*    See additional discussion below regarding the termination of the
     1989 stock option plan.

     At December 31, 1997, options to purchase 577,012 shares of the Company's
     common stock were exercisable under this plan.

     On February 7, 1995, the Board of Directors determined the estimated fair
     market value of the stock to be $4.65 per share. During 1995, options to
     acquire 43,060 shares were granted at this exercise price.

     NONQUALIFIED STOCK OPTIONS:  On September 30, 1985, in exchange for a
     six-month personal guarantee of a line of credit to the Company from a
     bank, an individual was granted an option to purchase 40,000 shares of
     common stock exercisable over a 10-year period at a price of $5.625 per
     share. The option was exercised on September 29, 1995.

                                       32
<PAGE>   34
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

     Not included in the table above are 108,000 nonqualified stock options
     (which do not qualify under Section 422A of the Internal Revenue Code),
     which were granted in August 1987, as part of the employment agreement with
     an officer, at an exercise price of $0.025 per share. These options became
     exercisable immediately upon grant. The options were exercised on August 5,
     1997.

  LONG-TERM INCENTIVE STOCK OPTION PLAN

     In 1991, the Company implemented the Carnegie Group, Inc. Long-Term
     Incentive Stock Option Plan to provide an incentive for the Company's key
     management employees to achieve long-term corporate objectives.

     The options under the Long-Term Incentive Plan become exercisable on
     September 29, 2001, subject to an acceleration clause. Each year,
     acceleration can be awarded based on predetermined Company performance
     criteria and individual performance criteria set by the Compensation
     Committee of the Board of Directors. Within 90 days after the previous
     year, the Committee determines the number of shares (allotted shares) to be
     accelerated for exercise, if any. Options subject to acceleration will
     become exercisable over a two-year period, with one-third becoming
     exercisable immediately upon the determination date and the remaining
     two-thirds becoming exercisable on each anniversary of the determination
     date.

     In October 1991, under this plan, 662,000 shares were granted to 16 key
     management employees at an option price of $1.25, which was the
     Board-determined fair market value at the date of grant.

     The following table summarizes activity under the plan:

<TABLE>
<CAPTION>
                                                      OPTIONS
                                       AVAILABLE     GRANTED &     WEIGHTED AVERAGE
                                       FOR GRANT    OUTSTANDING     EXERCISE PRICE
                                       ---------    -----------     --------------
<S>                                    <C>          <C>            <C>
Balance, December 31, 1994...........   149,840       512,160           $1.25
                                        -------       -------
Granted..............................   (24,000)       24,000           $4.65
Exercised............................        --       (34,160)          $1.25
Forfeitures..........................        --            --           $  --
                                        -------       -------
Balance, December 31, 1995...........         *       502,000           $1.45
Granted..............................        --            --           $  --
Exercised............................        --       (29,054)          $1.25
Forfeitures..........................        --       (19,706)          $1.25
                                        -------       -------
Balance, December 31, 1996...........         *       453,240           $1.43
Granted..............................        --            --           $  --
Exercised............................        --       (29,393)          $1.25
Forfeitures..........................        --        (9,328)          $4.17
                                        -------       -------
Balance, December 31, 1997...........         *       414,519           $1.38
                                                      =======
</TABLE>

---------
*    See additional discussion below regarding the termination of the
     long term incentive stock option plan.

     Of the total options outstanding as of December 31, 1997, the number of
     shares subject to accelerated exercise was 394,828 and 275,972 shares had
     become exercisable.

  1995 STOCK OPTION PLAN

     In 1995, the Company implemented the 1995 Stock Option Plan (1995 Stock
     Option Plan) under which stock option awards may be made to eligible
     employees of the Company. Awards to employees under the 1995 Stock Option
     Plan may take the form of incentive stock options or nonqualified stock
     options. The

                                       33
<PAGE>   35
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

     term of each option will be determined by the Board of Directors, but no
     option will be exercisable more than 10 years after the date of grant. The
     exercise price for incentive stock options must be at least equal to 100%
     of the fair market value of the common stock on the date of grant. The
     exercise price of nonqualified options will be determined by the Board of
     Directors at the time of grant. The maximum number of shares of common
     stock which may be issued or delivered and as to which awards may be
     granted under the 1995 Stock Option Plan is 800,000 shares. In 1995, the
     Board of Directors terminated the 1989 Stock Option and Long-Term Incentive
     Plans and directed that options under the plans which thereafter become
     available for grant (because outstanding options expire or terminate
     unexercised) will become available for award under the 1995 Stock Option
     Plan.

     The following table summarizes activity under the plan:

<TABLE>
<CAPTION>
                                                      OPTIONS
                                       AVAILABLE     GRANTED &     WEIGHTED AVERAGE
                                       FOR GRANT    OUTSTANDING     EXERCISE PRICE
                                       ---------    -----------     --------------
<S>                                    <C>          <C>            <C>
Balance, September 8, 1995...........   800,000            --              --
Granted..............................  (436,000)      436,000           $8.00
Forfeitures 1989 Plan................     3,710            --           $  --
                                       --------       -------
Balance, December 31, 1995...........   367,710       436,000           $8.00
Granted..............................   (69,500)       69,500           $9.22
Exercised............................        --            --           $  --
Forfeitures..........................    86,114       (59,000)          $8.06
                                       --------       -------
Balance, December 31, 1996...........   384,324       446,500           $8.18
Granted..............................  (154,000)      154,000           $6.24
Exercised............................        --          (500)          $6.38
Forfeitures..........................   102,928       (83,000)          $8.06
                                       --------       -------
Balance, December 31, 1997...........   333,252       517,000           $7.62
                                       ========       =======           =====
</TABLE>

     At December 31, 1997, options to purchase 195,875 shares of the Company's
     stock were exercisable under this plan.

SUMMARY STOCK OPTION INFORMATION

     The Company applies APBO 25 and related interpretations in accounting for
     its three stock-based compensation plans. No compensation cost has been
     recognized for its stock option plans and its stock purchase plan. The pro
     forma data below reflects the effect had compensation cost for the
     Company's three stock-based compensation plans been determined based on the
     fair value at the grant dates for awards under those plans consistent with
     SFAS 123.

<TABLE>
<CAPTION>
                                                                        1996          1997
                                                                        ----          ----
        <S>                                     <C>                  <C>           <C>
        Net income (loss)                       As reported........  $3,360,156    $  109,592
                                                Pro forma..........  $2,411,481    $ (542,169)
        Basic earnings (loss) per common share  As reported........  $      .54    $      .02
                                                Pro forma..........  $      .39    $     (.09)
        Diluted earnings (loss) per common
          share                                 As reported........  $      .47    $      .02
                                                Pro forma..........  $      .34    $     (.09)
</TABLE>

     The fair value of each option grant is estimated on the date of grant using
     the Black-Scholes option-pricing model with the following assumptions used
     for grants in 1996 and 1997, respectively: risk-free interest rates of
     5.68-6.97 percent and 5.91-6.65 percent; dividend yields of zero in both
     years; expected terms of 9.7-10.0 years and 9.8-10.0 years, and volatility
     (based on an analysis of "peer" companies) of 69.7 percent and 68.7
     percent.

                                       34
<PAGE>   36
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

     The following table summarizes information about stock options outstanding
     under all of the Company's stock option plans at December 31, 1997:

<TABLE>
<CAPTION>
                                        OPTIONS OUTSTANDING                         OPTIONS EXERCISABLE
                         --------------------------------------------------   -------------------------------
                            NUMBER      WEIGHTED-AVERAGE                         NUMBER
           RANGE OF      OUTSTANDING       REMAINING       WEIGHTED-AVERAGE   EXERCISABLE    WEIGHTED-AVERAGE
        EXERCISE PRICES  AT 12/31/97    CONTRACTUAL LIFE    EXERCISE PRICE    AT 12/31/97     EXERCISE PRICE
        ---------------   ---------     ----------------    ---------------   -----------     ---------------
        <S>              <C>            <C>                <C>                <C>            <C>
          $1.15-$1.65       513,074           3.86              $1.25            379,196          $1.26
          $4.50-$6.38       629,986           3.27              $5.23            487,788          $5.02
          $7.13-$9.88       381,000           7.84              $8.14            181,875          $8.15
                          ---------                                            ---------
                          1,524,060                                            1,048,859
                          =========                                            =========
</TABLE>

     The weighted average fair value of options granted during 1996 and 1997
     under the 1995 Stock Option Plan were $7.35 and $6.24, respectively.

  1995 EMPLOYEE STOCK PURCHASE PLAN

     In 1995, the Company implemented the 1995 Employee Stock Purchase Plan
     (1995 Stock Purchase Plan). Under the 1995 Stock Purchase Plan, eligible
     employees will have the opportunity to purchase up to an aggregate of
     200,000 shares of common stock. Shares of common stock purchased under the
     1995 Stock Purchase Plan will be paid for by payroll deductions. Each
     participant will be deemed to be granted purchase rights to acquire the
     whole number of shares of common stock that can be purchased with
     accumulated payroll deductions at an amount equal to 85% (or such higher
     amount as the Board of Directors may establish) of the fair market value of
     the common stock as of the offering commencement date (January 1, April 1,
     July 1 or October 1) or the offering termination date, whichever is less.
     Under the 1995 Stock Purchase Plan the Company sold 1,991 shares to
     employees during 1996 and 10,350 during 1997 at 95% of the fair market
     value as of the offering commencement date. The 1995 Stock Purchase Plan is
     intended to be an "employee stock purchase plan" under section 423 of the
     Internal Revenue Code and noncompensatory under SFAS 123.

11. MAJOR CUSTOMERS

     For the years ended December 31, 1995, 1996, and 1997, clients who
     individually accounted for 10% or more of the Company's revenue were as
     follows:

<TABLE>
<CAPTION>
                                              YEAR ENDED DECEMBER 31,
                                      ----------------------------------------
                                         1995          1996           1997
                                         ----          ----           ----
<S>                                   <C>           <C>            <C>
Client A............................  $2,769,000    $         *    $ 7,808,000
Client B............................   9,060,000     12,340,000     12,370,000
Client C............................   3,787,000      3,340,000              *
Client D............................   3,706,000      2,937,000      3,401,000
</TABLE>

---------
*    Less than 10%

     Receivables from these clients were $3,984,468, $2,368,735 and $4,489,345
     at December 31, 1995, 1996 and 1997, respectively.

12.  RELATED PARTIES

     The Company provides software services to four companies (Ford Motor
     Company, Digital Equipment Corporation, Texas Instruments Incorporated, and
     U S WEST Inc.) which have been significant stockholders of the Company; one
     of these companies has a representative on the Company's Board of
     Directors. Revenue from software services from these companies is reported
     as from related parties. U S WEST Inc. and Ford Motor Company are major
     customers (Note 10).

                                       35
<PAGE>   37
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

     The Company and Carnegie Mellon University, through its Center for Machine
     Translation, were parties to a License and Affiliate Agreement dated
     January 31, 1991 (as amended, the License Agreement) and a Subcontract
     Agreement dated February 1, 1991 (as amended, the Subcontract Agreement).
     Carnegie Mellon University's Center for Machine Translation is headed by a
     director and stockholder of the Company. Under the License Agreement,
     Carnegie Mellon University granted to the Company several perpetual,
     non-exclusive, worldwide licenses, some of which are royalty-bearing, to
     use and distribute certain base software and to access Center personnel,
     computational resources and technical information. The term of each of the
     License Agreement and the Subcontract Agreement expired on December 31,
     1997. Pursuant to the Subcontract Agreement, the Company engaged Carnegie
     Mellon University, through its Center for Machine Translation, to perform
     certain software development services and to furnish certain deliverable
     items. All of the deliverables developed under the Subcontract Agreement
     belong exclusively to the Company. Expenses incurred under the agreement
     were $1,996,987, $1,904,473 and $444,385 for the years ended December 31,
     1995, 1996 and 1997, respectively. Total payables at December 31, 1995,
     1996 and 1997 under these agreements amounted to $967,673, $959,608,and
     $182,145 respectively.

13.  INCOME TAXES

     The Company accounts for income taxes in accordance with SFAS 109, which
     requires an asset and liability approach in accounting for income taxes.

     The Company and its subsidiaries file a consolidated federal income tax
     return. The income tax (benefit)/provision consists of the following for
     the years ended December 31, 1995, 1996 and 1997:

<TABLE>
<CAPTION>
                                                           YEAR ENDED DECEMBER 31,
                                                   ---------------------------------------
                                                      1995           1996          1997
                                                      ----           ----          ----
        <S>                                        <C>            <C>           <C>
        Current:
          Federal................................  $    54,659    $  333,897    $  (70,552)
          State..................................      106,776        28,227            --
                                                   -----------    ----------    ----------
                                                       161,435       362,124       (70,552)
                                                   -----------    ----------    ----------
        Deferred:
          Federal................................   (1,891,057)     (829,309)      182,197
          State..................................      (97,304)       34,972       (39,278)
                                                   -----------    ----------    ----------
                                                    (1,988,361)     (794,337)      142,919
                                                   -----------    ----------    ----------
        Net income tax (benefit) provision.......  $(1,826,926)   $ (432,213)   $   72,367
                                                   ===========    ==========    ==========
</TABLE>

     The income tax expense differs from the amount computed by applying the
     statutory rate of 34 percent to income (loss) before taxes as shown in the
     following table:

<TABLE>
<CAPTION>
                                                           YEAR ENDED DECEMBER 31,
                                                   ---------------------------------------
                                                      1995           1996          1997
                                                      ----           ----          ----
        <S>                                        <C>            <C>           <C>
        Federal income tax provision (benefit),
          at statutory rate......................  $   968,695    $1,002,875    $   61,866
        Effect of valuation allowance
          adjustments............................   (2,936,159)   (1,779,675)           --
        Prior year adjustments and other.........       26,906       302,876        36,424
        State income tax, net of federal
          benefit................................      113,632        41,711       (25,923)
                                                   -----------    ----------    ----------
        Net income tax (benefit) provision.......  $(1,826,926)   $ (432,213)   $   72,367
                                                   ===========    ==========    ==========
</TABLE>

                                       36
<PAGE>   38
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

     Deferred tax assets and liabilities consist of the following as of December
31, 1995, 1996 and 1997:

<TABLE>
<CAPTION>
                                                           YEAR ENDED DECEMBER 31,
                                                   ---------------------------------------
                                                      1995           1996          1997
                                                      ----           ----          ----
        <S>                                        <C>            <C>           <C>
        Deferred tax assets:
          Net operating losses...................  $ 3,728,724    $2,838,951    $3,036,699
          Tax credit carryforwards...............      644,299       693,585       690,724
          Executive compensation.................      375,575       378,773            --
          Expense accruals.......................      294,548       338,725       491,695
          Prior years write-off of investments in
             affiliates..........................      252,833       254,991       256,707
          Depreciation...........................      107,789        61,014        68,397
          Deferred revenue.......................       48,751        50,106        46,675
                                                   -----------    ----------    ----------
          Total deferred tax assets..............    5,452,519     4,616,145     4,590,897
             Less--Valuation allowance...........   (2,351,116)     (571,441)     (571,441)
                                                   -----------    ----------    ----------
          Net deferred tax assets................  $ 3,101,403    $4,044,704    $4,019,456
                                                   ===========    ==========    ==========
        Deferred tax liabilities:
          Capital leases.........................  $    94,139    $   77,953    $   97,576
          Expense accrual........................           --            --            --
          Other..................................        5,411        11,845         5,265
                                                   -----------    ----------    ----------
          Total deferred tax liabilities.........  $    99,550    $   89,798    $  102,841
                                                   ===========    ==========    ==========
</TABLE>

     Income tax benefits of $196,863 and $104,625 associated with the exercise
     of employee stock options were credited to equity in 1996 and 1997,
     respectively.

     SFAS No. 109, "Accounting for Income Taxes," requires a valuation allowance
     when it is "more likely than not" that some portion or all of the deferred
     tax assets will not be realized. The ultimate realization of the deferred
     income tax asset depends on the Company's ability to generate sufficient
     taxable income in the future. The Company weighed the positive evidence of
     profitability over the last four years and future income expectations
     against the negative evidence of dependence upon a limited number of
     customers and other uncertainties and concluded that retaining a valuation
     allowance related to net operating losses was not necessary at December 31,
     1996 and continues to be unnecessary at December 31, 1997. The remaining
     valuation allowance at December 31, 1996 and 1997 relates to general
     business credits which expire sooner than net operating loss carryforwards
     and realization is limited to years not subject to the alternative minimum
     tax.

     Significant changes in circumstances or in enacted tax laws which affect
     the valuation allowance are recorded when they occur. The Company's annual
     strategic business planning process takes place in the fourth quarter of
     the year, and the valuation allowance is adjusted for future years' income
     expectations resulting from that process. When preparing subsequent interim
     and annual financial statements, the Company reevaluates whether there has
     been any significant change in the assumptions underlying its plan and
     adjusts the valuation allowance as necessary. In the event the estimated
     results are not achieved, an adjustment to the recorded deferred tax asset
     could result and such adjustment could be material.

     The changes in the valuation allowance at December 31, 1995 and 1996
     resulted primarily from current year utilization of net operating loss
     carryforwards in excess of amounts estimated at the respective preceding
     year ends together with changes in the Company's estimate of the portion of
     the deferred tax asset more likely than not to be realized in the future in
     light of the factors described above.

                                       37
<PAGE>   39
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

     At December 31, 1997, the net operating loss carryforwards for federal tax
     purposes available to offset future income are as follows:

<TABLE>
<CAPTION>
   YEAR                                                     FEDERAL       YEAR OF
ORIGINATED                                                   AMOUNT      EXPIRATION
----------                                                   ------      ----------
<S>                                                        <C>           <C>
  1986...................................................      35,000       2001
  1987...................................................   1,124,900       2002
  1988...................................................   2,463,600       2003
  1989...................................................   2,898,300       2004
  1992...................................................     423,800       2007
  1993...................................................   1,329,200       2008
  1997...................................................     363,100       2012
                                                           ----------
                                                           $8,637,900
</TABLE>

     Additionally, at December 31, 1997, the Company has net operating loss
     carryforwards for Pennsylvania income tax purposes of $1,513,800 available
     to offset taxable income in the years 1998 through 2000.

     At December 31, 1997, Carnegie Group had investment, research and minimum
     tax credit carryforwards available totaling $96,162, $475,279 and $119,283,
     respectively. Investment credit carryforwards have been reduced 35 percent
     under the provisions of the Tax Reform Act of 1986. The investment tax
     credit carryforwards expire by the year 2000, the research tax credit
     carryforward expires by the year 2003 and the minimum tax credit has an
     indefinite carryforward.

     If certain substantial changes in the Company's ownership were to occur,
     there would be an annual limitation on the amount of carryforwards that
     could be utilized for federal income tax purposes.

14.  ACQUISITION OF ADVANTAGE kbs, INC.

     On March 19, 1998, Carnegie Group acquired all of the outstanding stock of
     Advantage kbs, Inc. (Advantage) for a purchase price of $5 million cash,
     plus an additional contingent payment of up to $2.5 million, which is
     dependent on revenue and earnings of Advantage for the year ending December
     31, 1998. Advantage provides problem resolution software and professional
     services for automating customer support. The transaction will be accounted
     for as a purchase.

     Supplemental Pro Forma Results of Operations (Unaudited)--Supplemental pro
     forma results of operations for the acquisition of Advantage have not been
     presented as the relative fair values of the net assets acquired have not
     yet been determined. Carnegie Group anticipates it will write off a
     significant portion of the purchase price as "in-process research and
     development" in the first quarter of 1998.

15. CURRENT ACCOUNTING PRONOUNCEMENTS

     In 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income",
     and SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
     Information." SFAS No. 130 establishes standards for the reporting and
     display of comprehensive income and its components. The Company is required
     to adopt the provisions of SFAS No. 130 beginning with its consolidated
     financial statements for the three months ended March 31, 1998. SFAS No.
     131 requires certain disclosures about segment information in interim and
     annual financial statements and related information about products and
     services, geographic areas and major customers. The Company must adopt the
     provisions of SFAS No. 131 for its consolidated financial statements for
     the year ending December 31, 1998. The adoptions of SFAS Nos. 130 and 131
     are not expected to have a material effect on the Company's financial
     position, results of operations or cash flows.

                                       38
<PAGE>   40
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

16.  QUARTERLY RESULTS (UNAUDITED)

<TABLE>
<CAPTION>
                                            FIRST    SECOND     THIRD    FOURTH
                                           QUARTER   QUARTER   QUARTER   QUARTER    YEAR
                                           -------   -------   -------   -------    ----
                                             ($ IN THOUSANDS EXCEPT EARNINGS PER SHARE)
<S>                                        <C>       <C>       <C>       <C>       <C>
1997:
  Revenue...............................   $7,132    $7,858    $7,944    $6,472    $29,406
  Revenue less cost of revenue..........    2,713     3,147     2,966     1,494     10,320
  Income (loss) from operations.........      478       693       352    (2,071)      (548)
  Net income (loss).....................      388       522       322    (1,122)       110
  Basic earnings (loss) per common
     share..............................     0.06      0.08      0.05     (0.17)      0.02
Diluted earnings (loss) per common
  share.................................     0.06      0.08      0.05     (0.17)      0.02
1996:
  Revenue...............................   $8,323    $6,664    $6,509    $6,913    $28,409
  Revenue less cost of revenue..........    3,258     2,344     2,547     2,501     10,650
  Income from operations................      944        40       529       788      2,301
  Net income............................      683       121       410     2,146      3,360
  Basic earnings per common share.......     0.11      0.02      0.07      0.34       0.54
  Diluted earnings per common share.....     0.10      0.02      0.06      0.31       0.47
</TABLE>

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE.

     Not applicable.

                                       39
<PAGE>   41

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

     The information set forth under the caption "Executive Officers of the
Registrant" in Part I of this Annual Report on Form 10-K and the information set
forth under the captions "Election of Directors" and "Section 16(a) Beneficial
Ownership Reporting Compliance" in the Proxy Statement is incorporated herein by
reference in response to this Item 10.

     In addition to Messrs. Yablonsky and Manzetti, the principal occupations
and employments of whom are set forth under the caption "Executive Officers of
the Registrant" in Part I of this Annual Report on Form 10-K, the following
persons are directors of the Company:

     Dr. Reddy is a co-founder of the Company and has served as a director since
the Company's inception. Dr. Reddy serves as a consultant in a scientific or
engineering capacity from time to time on projects for the Company. Dr. Reddy
has served as Chairman of the Board since February 1988. Dr. Reddy is Dean of
the School of Computer Science and the Herbert A. Simon University Professor of
Computer Science and Robotics at Carnegie Mellon University. Dr. Reddy joined
Carnegie Mellon's Department of Computer Science in September 1969 and served as
Director of the Robotics Institute from September 1979 to September 1992. Dr.
Reddy is a member of the Board of Directors of Telxon Corporation, Director and
Chairman of the Board of SEEC, Inc., and a member of the Technical Advisory
Board of Microsoft Corporation.

     Dr. Carbonell is a co-founder of the Company and has served as a director
since the Company's inception. Dr. Carbonell serves as a consultant in a
scientific or engineering capacity from time to time on projects for the
Company. Dr. Carbonell has been affiliated with Carnegie Mellon University since
January 1979. He has been a Professor of Computer Science since July 1983 and
the Director, Center for Machine Translation since July 1986 at Carnegie
Mellon's School of Computer Science. Dr. Carbonell is Director, Wisdom
Technologies Corporation.

     Mr. Chatfield has served as a director of the Company since May 1992. Mr.
Chatfield was President of Chatfield Enterprises from April 1990 to November
1992, and has been President of Optimum Power Technology, Inc. since December
1992, Chairman of Emprise Technologies, Inc. since December 1992, and General
Partner of CEO Venture Fund since January 1986. He was a founder of Duquesne
Systems, Inc., a predecessor of LEGENT Corporation.

     Dr. Fox is a co-founder of the Company and has served as a director since
the Company's inception. Dr. Fox serves as a consultant in a scientific or
engineering capacity from time to time on projects for the Company. Dr. Fox has
been Professor of Industrial Engineering with cross appointments in the
Department of Computer Science and Faculty of Management at the University of
Toronto since August 1991. Dr. Fox is founder, President and Chief Executive
Officer of Fox-Novator Systems Ltd., a provider of electronic commerce software
for the Internet/World Wide Web. Prior to August 1991, Dr. Fox was an Associate
Professor of Computer Science and Robotics and Director of the Center for
Integrated Manufacturing Systems at Carnegie Mellon University.

     Ms. Muesing has served as a director of the Company since August 1995. Ms.
Muesing has been Vice President of Network and Technology Services for U S WEST
Communications, Inc., a wholly owned subsidiary of U S WEST, Inc., since
September 1995. Prior to that time, Ms. Muesing was Vice President of
Transformation Systems for U S West Communications, Inc. from August 1994 to
September 1995, Vice President of Information Application Development for U S
WEST Technologies from June 1992 to August 1994 and Vice President of Quality, U
S WEST, Inc. from October 1990 to June 1992.

ITEM 11.  EXECUTIVE COMPENSATION.

     The information set forth under the caption "Executive Compensation" in the
Proxy Statement is incorporated herein by reference in response to this Item 11.

                                       40
<PAGE>   42

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

     The information set forth under the caption "Security Ownership of Certain
Beneficial Owners and Management" in the Proxy Statement is incorporated herein
by reference in response to this Item 12.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

     The information set forth under the subcaption "Certain Transactions" in
the Proxy Statement is incorporated herein by reference to this Item 13.

                                       41
<PAGE>   43

                                    PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.

     (a) Documents filed as part of this Report:

     1. FINANCIAL STATEMENTS. The following consolidated financial statements of
the Company are filed as part of this Annual Report on Form 10-K:

<TABLE>
<CAPTION>
                                                              PAGE NO.
                                                              --------
<S>                                                           <C>
Report of Independent Accountants...........................     22
Consolidated Balance Sheets at December 31, 1995, 1996 and
  1997......................................................     23
Consolidated Statements of Operations for the years ended
  December 31, 1995, 1996 and 1997..........................     24
Consolidated Statements of Stockholders' Equity for the
  years ended December 31, 1995, 1996 and 1997..............     25
Consolidated Statements of Cash Flows for the years ended
  December 31, 1995, 1996 and 1997..........................     26
Notes to Consolidated Financial Statements..................     27
</TABLE>

     2. FINANCIAL STATEMENT SCHEDULES.

     Financial statement schedules have been omitted because they are
inapplicable, are not required under applicable provisions of Regulation S-X, or
the information that would otherwise be included in such schedules is contained
in the registrant's consolidated financial statements or accompanying notes.

     3. EXHIBITS. The Exhibits listed below are filed or incorporated by
reference as part of this Annual Report on Form 10-K.

<TABLE>
<CAPTION>
EXHIBIT NO.                           DESCRIPTION
-----------                           -----------
<S>           <C>
 3.01         Restated Certificate of Incorporation of Carnegie Group,
              Inc. (1)
 3.02         Amended and Restated By-Laws of Carnegie Group, Inc. (1)
10.01         Carnegie Group, Inc. 1989 Stock Option Plan. (1)(2)
10.02         Carnegie Group, Inc. Long-Term Incentive Plan. (1)(2)
10.03         Carnegie Group, Inc. 1995 Stock Option Plan. (1)(2)
10.04         Carnegie Group, Inc. 1995 Employee Stock Purchase Plan.
              (1)(2)
10.05         Employment Agreement, dated August 11, 1987, between
              Carnegie Group, Inc. and Dennis Yablonsky. (1)(2)
10.06         Signing Bonus Stock Option Agreement, dated August 11, 1987,
              between Carnegie Group, Inc. and Dennis Yablonsky. (1)(2)
10.07(a)      Severance Agreement, dated May 28, 1993, between Carnegie
              Group, Inc. and Dennis Yablonsky. (1)(2)
10.07(b)      Severance Agreement, dated May 28, 1993, between Carnegie
              Group, Inc. and Bruce D. Russell. (1)(2)
10.07(c)      Severance Agreement, dated May 17, 1993, between Carnegie
              Group, Inc. and John W. Manzetti. (1)(2)
10.08(a)      General License Agreement, dated December 17, 1992, among U
              S WEST Advanced Technologies, Inc., U S WEST Communications,
              Inc. and Carnegie Group, Inc. (1)
10.08(b)      Development Agreement, dated as of January 2, 1996. (3)
10.08(c)      Development Agreement, dated as of March 1, 1996. (3)
10.08(d)      Development Agreement, dated as of July 1, 1996. (4)
10.08(e)      Development Agreement, dated as of October 15, 1996
</TABLE>

                                       42
<PAGE>   44

<TABLE>
<CAPTION>
EXHIBIT NO.                           DESCRIPTION
-----------                           -----------
<S>           <C>
10.08(g)      Development Agreement, dated as of January 24, 1997, by and
              between U S West Advanced Technologies, Inc., U S West
              Communications, Inc., and Carnegie Group, Inc. (5)

10.08(h)      Development Agreement, dated April 28, 1997, by and between
              an affiliate of U S West Communications Group, Inc., and
              Carnegie Group, Inc. (6)

10.08(i)      Letter Agreement, dated May 20, 1997, to amend Development
              Agreement, dated as of January 24, 1997, as previously
              amended by Letter Agreement, dated March 6, 1997, by and
              between U S West Business Resources, Inc., as agent for U S
              West Advanced Technologies, Inc., U S West Communications,
              Inc., and Carnegie Group, Inc. (6)

10.08(j)      Letter Agreement, dated as of March 25, 1997, by and between
              U S West Business Resources, Inc., as agent for U S West
              Advanced Technologies, Inc., U S West Communications, Inc.,
              and Carnegie Group, Inc. (6)

10.08(k)      Letter Agreement, dated as of March 6, 1997, by and between
              U S West Business Resources, Inc., as agent for U S West
              Advanced Technologies, Inc., U S West Communications, Inc.,
              and Carnegie Group, Inc. (6)

10.08(l)      Agreement No. 9700050785, effective as of July 1, 1997,
              between US West Business Resources, Inc., as agent for
              various U S West Companies, and Carnegie Group, Inc. (7)

10.08(m)      Schedule Number 230397, effective as of July 21, 1997, to
              Agreement No. 9700050785, effective as of July 1, 1997,
              between U S West Business Resources, Inc., as agent for
              various U S West Companies, and Carnegie Group, Inc. (7)

10.08(n)      Schedule Number 230597, effective as of August 18, 1997, to
              Agreement No. 9700050785, effective as of July 1, 1997,
              between U S West Business Resources, Inc., as agent for
              various U S West Companies, and Carnegie Group, Inc. (7)

10.08(o)      Schedule Number "35-002-97"/Agreement No. 9700050785,
              effective September 2, 1997, issued pursuant to the General
              terms and Conditions of Agreement No. 9700050785 dated June
              30, 1997 between U S West and Carnegie Group, Inc.
              (confidential treatment with respect to certain information
              contained in this exhibit has been requested of the
              Securities and Exchange Commission pursuant to Rule 24b-2
              under the Securities Exchange Act of 1934, as amended)

10.08(p)      Schedule No. 230997 effective August 11, 1997 pursuant to
              the General Terms and Conditions of Agreement No. 9700050785
              dated June 30, 1997 between U S West and Carnegie Group,
              Inc. (confidential treatment with respect to certain
              information contained in this exhibit has been requested of
              the Securities and Exchange Commission pursuant to Rule
              24b-2 under the Securities Exchange Act of 1934 as amended)

10.08(q)      Schedule No. "14-001-07 effective September 29, 1997, issued
              pursuant to the General Terms and Conditions of Agreement
              No. 9700050785 dated June 30, 1997 between U S West and
              Carnegie Group, Inc. (confidential treatment with respect to
              certain information contained in this exhibit has been
              requested of the Securities and Exchange Commission pursuant
              to Rule 24b-2 under the Securities Exchange Act of 1934, as
              amended)

10.08(r)      Letter Agreement dated October 1, 1997 to Amend Development
              Agreement No. 35-001-97 (Amendment No. 35-001-97-B)
              (confidential treatment with respect to certain information
              contained in this exhibit has been requested of the
              Securities and Exchange Commission pursuant to Rule 24b-2
              under the Securities Exchange Act of 1934, as amended)

10.08(s)      Letter Agreement dated October 30, 1997 to Amend Development
              Agreement No. 37-001-97 (Amendment No. 37-001-97-C)
              (confidential treatment with respect to certain information
              contained in this exhibit has been requested of the
              Securities and Exchange Commission pursuant to Rule 24b-2
              under the Securities Exchange Act of 1934, as amended)
</TABLE>

                                       43
<PAGE>   45

<TABLE>
<CAPTION>
EXHIBIT NO.                           DESCRIPTION
-----------                           -----------
<S>           <C>
10.08(t)      Schedule Number "X34-001-97" effective October 10, 1997
              issued pursuant to the General terms and Conditions of
              Agreement No. 9700050785 dated June 30, 1997 between U S
              West and Carnegie Group, Inc. (confidential treatment with
              respect to certain information contained in this exhibit has
              been requested of the Securities and Exchange Commission
              pursuant to Rule 24b-2 under the Securities Exchange Act of
              1934, as amended)

10.08(u)      Schedule No. "23-07-97" effective November 17, 1997 pursuant
              to the General Terms and Conditions of Agreement No.
              9700050785 dated June 30, 1997 between U S West and Carnegie
              Group, Inc. (confidential treatment with respect to certain
              information contained in this exhibit has been requested of
              the Securities and Exchange Commission pursuant to Rule
              24b-2 under the Securities Exchange Act of 1934, as amended)

10.08(v)      Schedule No. "23-09-97" effective November 21, 1997 pursuant
              to the General Terms and Conditions of Agreement No.
              9700050785 dated June 30, 1997 between U S West and Carnegie
              Group, Inc. (confidential treatment with respect to certain
              information contained in this exhibit has been requested of
              the Securities and Exchange Commission pursuant to Rule
              24b-2 under the Securities Exchange Act of 1934, as amended)

10.08(w)      Letter Agreement dated December 1, 1997 with respect to
              Schedule No. "230397"/ Agreement No. 9700050785
              (confidential treatment with respect to certain information
              contained in this exhibit has been requested of the
              Securities and Exchange Commission pursuant to Rule 24b-2
              under the Securities Exchange Act of 1934, as amended)

10.09         CCA Marketing Agreement, dated January 19, 1995, between U S
              WEST Communications, Inc. and Carnegie Group, Inc. (1)

10.10(a)      Lease, dated December 12, 1986, between Glass Plaza
              Associates and Carnegie Group, Inc. (1)

10.10(b)      Amendment, dated as of September 2, 1987. (1)

10.10(c)      Amendment, dated as of December 15, 1987. (1)

10.10(d)      Amendment, dated as of February 4, 1991. (1)

10.10(e)      Amendment, dated as of October 1, 1991. (1)

10.10(f)      Amendment, dated as of November 23, 1993. (1)

10.10(g)      Amendment, dated as of March 14, 1995. (1)

10.10(h)      Lease, dated as of October 18, 1995, between Glass Plaza
              Associates and Carnegie Group, Inc. (8)

10.11(a)      Loan Agreement, dated as of September 11, 1997, between
              Dennis Yablonsky and Carnegie Group, Inc. (2)(7)

10.11(b)      Loan Agreement, dated as of September 11, 1997, between John
              Manzetti and Carnegie Group, Inc. (2)

21.01         Subsidiaries of the Registrant

23.01         Consent of Price Waterhouse LLP

27            Financial Data Schedule
</TABLE>

---------

(1) Incorporated by reference from the Company's Registration Statement on Form
    S-1, File No. 33-97118.

(2) Management contract or compensatory plan or arrangement.

(3) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the fiscal quarter ended March 31, 1996 as amended.

(4) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the fiscal quarter ended September 30, 1996, as amended.

                                       44
<PAGE>   46

(5) Incorporated by reference from the Company's Quarterly Report on Form 10-Q/A
    for the fiscal quarter ended March 31, 1997

(6) Incorporated by reference from the Company's Quarterly Report on Form 10-Q/A
    for the fiscal quarter ended June 30, 1997.

(7) Incorporated by reference from the Company's Quarterly Report on Form 10-Q/A
    for the fiscal quarter ended September 30, 1997.

(8) Incorporated by reference from the Company's Annual Report on Form 10-K for
    the fiscal year ended December 31, 1995.

     (b) Reports on Form 8-K:

     The Company did not file any Reports on Form 8-K during the year ended
December 31, 1997.

                                       45
<PAGE>   47

                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities Act
of 1934, the registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.

                                            CARNEGIE GROUP, INC.

March 27, 1996
                                            By: /s/ DENNIS YABLONSKY
                                            ------------------------------------

                                              Dennis Yablonsky
                                              President and Chief
                                                Executive Officer

     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
              SIGNATURE                                     CAPACITY                            DATE
              ---------                                     --------                            ----
<S>                                         <C>                                            <C>

/s/ DENNIS YABLONSKY                        President and Chief Executive Officer          March 27, 1997
------------------------------------        (Principal Executive Officer) and
Dennis Yablonsky                            Director

/s/ JOHN W. MANZETTI                        Executive Vice President and                   March 27, 1997
------------------------------------        Chief Financial Officer
John W. Manzetti                            (Principle Financial and Accounting
                                            Officer) and Director

/s/ RAJ REDDY                               Chairman of the Board and Director             March 27, 1997
------------------------------------
Raj Reddy

/s/ JAIME G. CARBONELL                      Director                                       March 27, 1997
------------------------------------
Jaime G. Carbonell

/s/ GLEN F. CHATFIELD                       Director                                       March 27, 1997
------------------------------------
Glen F. Chatfield

/s/ MARK S. FOX                             Director                                       March 27, 1997
------------------------------------
Mark S. Fox

/s/ TRACIE A. MUESING                       Director                                       March 27, 1997
------------------------------------
Tracie A. Muesing
</TABLE>

                                       46