<PAGE>   1



                                    FORM 10-Q
                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

     (MARK ONE)

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

    FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998

                                       OR

    ( )      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
             EXCHANGE ACT OF 1934

    FOR THE TRANSITION PERIOD FROM                  TO
                                   ----------------    -----------------

    COMMISSION FILE NUMBER 0-26964

                              CARNEGIE GROUP, INC.
    DELAWARE                                               25-1435252
    (State or other Jurisdiction of                    (I.R.S Employer
    Incorporation or Organization)                   Identification Number)

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

                                 (412) 642-6900
              (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

         Indicate by check mark whether the registrant (1) has filed all reports
    required to be filed by Section 13 or 15(d) of the Securities Exchange Act
    of 1934 during the preceding 12 months (or such shorter period that the
    registrant was required to files such reports), and (2) has been subject to
    such filing requirements for the past 90 days.

                                                   Yes   X        No

    Indicate the number of shares outstanding of each of the issuer's classes of
Common Stock as of the latest practicable date:

               CLASS                         OUTSTANDING AT JULY 31, 1998
               -----                         ----------------------------
     Common Stock, $.01 par value                     6,553,624




<PAGE>   2



                                    FORM 10-Q

                              CARNEGIE GROUP, INC.

                                TABLE OF CONTENTS


<TABLE>
<CAPTION>
                                                                                                                PAGE
                                                                                                               NUMBER
                                                                                                               ------
<S>                                                                                                             <C>
   PART 1 FINANCIAL INFORMATION

         Item 1.  Financial Statements
                  Carnegie Group, Inc. and Subsidiaries                                                            3
                  Consolidated Statements of Operations for
                  the three months and six months ended June 30, 1998 and 1997

                  Carnegie Group, Inc. and Subsidiaries                                                            4
                  Consolidated Balance Sheets at June 30, 1998 and December 31, 1997

                  Carnegie Group, Inc. and Subsidiaries                                                            5
                  Consolidated Statements of Cash Flows for the six months ended June 30, 1998 and 1997

                  Notes to Unaudited Consolidated Financial Statements                                             6

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

          Item 3. Quantitative and Qualitative Disclosures about                                                  15
                  Market Risks

   PART 2 OTHER INFORMATION

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

         Signatures                                                                                               17

         Exhibit Index                                                                                            18
</TABLE>



                                       2
<PAGE>   3



                         PART I - FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

                      CARNEGIE GROUP, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                                           THREE MONTHS ENDED                SIX MONTHS ENDED
                                                                       ---------------------------------------------------------
                                                                          JUNE            JUNE             JUNE             JUNE
                                                                           30,             30,              30,              30,
                                                                          1998            1997             1998             1997
                                                                       ---------------------------------------------------------
<S>                                                                   <C>             <C>              <C>             <C>
                  Revenue
                        Software services--Unrelated parties           $4,858,684      $6,078,572       $ 8,693,518     $11,578,304
                        Software services--Related parties              3,483,209       1,681,074         6,892,174       2,688,182
                                                                       ----------      ----------       -----------     -----------
                              Total software services                   8,341,893       7,759,646        15,585,692      14,266,486
                        Software licenses                                 214,828          98,361           574,458         723,439
                                                                       ----------      ----------       -----------     -----------
                              Total revenue                             8,556,721       7,858,007        16,160,150      14,989,925
                                                                       ----------      ----------       -----------     -----------

                  Costs and expenses:
                        Cost of revenue - Unrelated parties             3,459,181       3,785,525         6,360,486       7,623,025
                        Cost of revenue - Related parties               2,346,750         924,949         4,625,847       1,506,694
                                                                       ----------      ----------       -----------     -----------
                              Total cost of revenue                     5,805,931       4,710,474        10,986,333       9,129,719
                        Research and development                          366,141         392,864           560,776         750,546
                        Selling, general and administrative             2,153,967       2,061,187         4,257,878       3,938,023
                        Write-off of purchased in-process research
                          and development                                      --              --         2,425,000              --
                                                                       ----------      ----------       -----------     -----------
                              Total costs and expenses                  8,326,039       7,164,525        18,229,987      13,818,288
                                                                       ----------      ----------       -----------     -----------

                  Income (loss) from operations                           230,682         693,482        (2,069,837)      1,171,637
                  Other income (expense):
                        Interest income                                    88,844         168,978           287,207         332,876
                        Other income                                        2,033           6,399             8,132          12,598
                        Interest expense                                        0          (3,408)          (12,403)         (7,053)
                                                                       ----------      ----------       -----------     -----------
                        Total other income                                 90,877         171,969           282,936         338,421
                                                                       ----------      ----------       -----------     -----------
                  Income (loss) before income taxes                       321,559         865,451        (1,786,901)      1,510,058
                  Income tax provision                                   (149,757)       (343,942)         (273,478)       (600,302)
                                                                       ----------      ----------       -----------     -----------
                        Net income (loss)                              $  171,802      $  521,509       $(2,060,379)    $   909,756
                                                                       ----------      ----------       -----------     -----------
                  Basic earnings (loss) per share                      $     0.03      $     0.08       $     (0.32)    $      0.14
                                                                       ==========      ==========       ===========     ===========
                  Diluted earnings (loss) per share                    $     0.03      $     0.08       $     (0.32)    $      0.13
                                                                       ==========      ==========       ===========     ===========
</TABLE>



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





                                       3
<PAGE>   4



                      CARNEGIE GROUP, INC. AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                            (UNAUDITED)
                                                                             JUNE 30,                  DECEMBER 31,
                                                                               1998                        1997
                                                                           ------------                ------------
<S>                                                                       <C>                         <C>
                                         ASSETS
           CURRENT ASSETS:
           Cash and cash equivalents                                       $ 5,812,171                 $13,483,284
           Accounts receivable                                               4,048,633                   2,955,241
           Accounts receivable from related parties                          1,786,399                   3,396,859
           Accounts receivable--unbilled                                     3,141,758                   1,390,650
           Accounts receivable related parties--unbilled                     1,363,627                     211,885
           Deferred income taxes                                             1,908,639                   2,005,855
           Other current assets                                              1,028,088                     871,931
                                                                           -----------                 -----------
                    Total current assets                                    19,089,315                  24,315,705
                                                                           -----------                 -----------

           Property and equipment, net of accumulated
             depreciation and amortization                                   2,717,148                   2,568,758
           Deferred income taxes                                             1,769,228                   1,910,760
           Long term notes receivable--from officers                           803,356                     784,984
           Goodwill and other intangible assets                              3,028,639                          --
           Other assets                                                          3,982                      10,597
                                                                           -----------                 -----------
                    Total assets                                            27,411,668                  29,590,804
                                                                           -----------                 -----------

                          LIABILITIES AND STOCKHOLDERS' EQUITY

           CURRENT LIABILITIES:
           Trade accounts payable                                          $ 1,194,419                 $   663,667
           Payables to related parties                                         111,171                     182,145
           Accrued compensation                                                998,955                     933,004
           Advance billings and deferred revenue                             1,865,987                   2,388,660
           Accrued rent                                                        328,586                     330,981
           Accrued restructuring                                               162,882                     598,723
           Other accrued liabilities                                           547,821                     423,544
           Obligations under capital leases--current portion                   167,927                          --
                                                                           -----------                 -----------
                    Total current liabilities                                5,377,748                   5,520,724
                                                                           -----------                 -----------

           Obligations under capital leases-noncurrent portion                  77,565                          --
                                                                           -----------                 -----------
                    Total liabilities                                        5,455,313                   5,520,724
                                                                           -----------                 -----------

           STOCKHOLDERS' EQUITY:
           Common stock, $.01 par value; 20,000,000
             shares authorized, 6,775,704 and
             6,707,934 shares issued at June 30,
             1998 and December 31, 1997 respectively                            67,757                      67,079
           Capital in excess of par value                                   31,807,444                  31,704,241
           Accumulated deficit                                              (9,286,614)                 (7,226,240)
           Treasury stock, 242,400 and 190,000 shares (at cost)               (632,232)                   (475,000)
                                                                           -----------                 -----------
                    Total stockholders' equity                              21,956,355                  24,070,080
                                                                           -----------                 -----------
                    Total liabilities and stockholders' equity             $27,411,668                 $29,590,804
                                                                           ===========                 ===========
</TABLE>


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




                                       4
<PAGE>   5



                      CARNEGIE GROUP, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                                 SIX MONTHS ENDED
                                                                                          ----------------------------
                                                                                            JUNE 30,         JUNE 30,
                                                                                              1998             1997
                                                                                          ------------     -----------
<S>                                                                                      <C>              <C>        
           Cash flows from operating activities:
                Net income                                                                $(2,060,379)     $   909,756
                Adjustments to reconcile net income
                to net cash (used in) provided
                by operating activities:
                    Depreciation and amortization                                             791,562          602,433
                    Deferred income taxes                                                     205,682          528,522
                    Write-off of purchased in-process research and development              2,425,000               --
                    Changes in working capital components, net of acquisition 
                      of business:
                    Accounts receivable                                                    (2,042,939)        (383,673)
                    Accounts receivable - related parties                                     458,718       (1,183,253)
                    Other assets                                                              (92,520)        (226,140)
                    Trade accounts payable                                                    333,458          677,002
                    Payables to related parties                                               (70,974)        (741,731)
                    Accrued compensation                                                       65,951           91,578
                    Accrued rent                                                               (2,395)        (135,726)
                    Interest receivable                                                       (18,372)              --
                    Accrued restructuring                                                    (435,842)              --
                    Other accrued liabilities                                                  72,942              720
                    Advance billings and deferred revenue                                    (803,238)       1,084,068
                                                                                          -----------      -----------
                         Net cash (used in) provided by
                           operating activities                                            (1,173,346)       1,223,556
           Cash flows from investing activities:
                Capital expenditures                                                         (609,713)      (1,159,726)
                Acquisition of business                                                    (5,834,703)              --
                                                                                          -----------      -----------
                         Net cash used in investing activities                             (6,444,416)      (1,159,726)
                                                                                          -----------      -----------
           Cash flows from financing activities:
                    Principal payments under capital
                      lease obligations                                                            --          (27,899)
                    Purchase of treasury stock                                               (157,232)              --
                    Proceeds from sales of common stock, net                                  103,881           91,762
                                                                                          -----------      -----------
                         Net cash (used in) provided by financing activities                  (53,351)          63,863
                                                                                          -----------      -----------
           Net change in cash and cash equivalents                                         (7,671,113)         127,693
           Cash and cash equivalents:
                Beginning of period                                                        13,483,284       14,691,765
                End of period                                                             $ 5,812,171      $14,819,458
                                                                                          ===========      ===========
</TABLE>


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





                                       5
<PAGE>   6



              NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

   BASIS OF PRESENTATION

         In the opinion of the management of Carnegie Group, Inc. (the
   "Company"), these unaudited interim consolidated financial statements include
   all adjustments, consisting only of normal recurring adjustments, considered
   necessary for a fair presentation of operating results for the three month
   and six month periods ended June 30, 1998. Results for the interim periods
   are not necessarily indicative of results for the full year. The accompanying
   statements have been prepared in accordance with generally accepted
   accounting principles for interim financial information and pursuant to the
   rules and regulations of the Securities and Exchange Commission and therefore
   do not include all information and footnotes required by generally accepted
   accounting principles for complete financial statements. Accordingly, the
   information contained in this Form 10-Q should be read in conjunction with
   the financial statements and notes thereto contained in the Company's Form
   10-K for the year ended December 31, 1997 as filed with the Securities and
   Exchange Commission.

   ACQUISITION

         The Company acquired the capital stock of Advantage kbs, Inc.
   (Advantage kbs) on March 19, 1998. The initial consideration paid was
   $5,000,000 in cash, with terms of the transaction providing for additional
   consideration of up to $2,500,000 in cash, which is dependent on revenue and
   earnings of Advantage kbs for the year ending December 31, 1998. Financing
   for the initial consideration was obtained from available cash remaining from
   the proceeds of a public offering by the Company in December of 1995. The
   additional consideration, if incurred, will also be paid from the remaining
   proceeds of the December 1995 public offering. Advantage kbs, based in
   Edison, New Jersey, provides problem resolution software and professional
   services for automating customer support. The acquisition was treated as a
   purchase for financial accounting purposes, and accordingly the Company's
   results of operations include the results of Advantage kbs since the
   acquisition date. The purchase price was allocated to the net assets acquired
   based upon their estimated fair market values and $2,425,000 was written off
   as purchased in-process research and development. The excess of the purchase
   price over the fair market value of net assets acquired (related to
   capitalized software, goodwill and other intangible assets) amounted to
   approximately $3.1 million and is being amortized over periods ranging from 5
   to 15 years using the straight line method. This allocation was based on
   preliminary estimates and may be revised as the year proceeds. The following
   unaudited proforma summary presents the Company's results of operations as if
   the acquisition had occurred at the beginning of the periods presented and
   does not purport to be indicative of what would have occurred had the
   acquisition been made as of those dates or of results which may occur in the
   future.

                                              JUNE 30,      DECEMBER 31,
                                                1998            1997
                                             -----------    ------------
            Sales                            $16,996,135    $32,589,000
            Net income (loss)                    165,219       (622,211)
            Basic earnings (loss) 
              per share                      $      0.03    $     (0.10)
            Diluted earnings (loss) 
              per share                      $      0.02    $     (0.10)

EARNINGS PER COMMON SHARE

The computation of basic and diluted earnings per common share is performed as
follows:

<TABLE>
<CAPTION>
                                                   6 months ended                 3 months ended
                                                       June 30,                       June 30,
                                             --------------------------      -------------------------
                                                 1998             1997          1998             1997
                                                 ----             ----          ----             ----
<S>                                          <C>            <C>             <C>            <C>
            Net Income (loss)                $(2,060,379)    $  909,756      $  171,802     $  521,509
                                             ===========     ==========      ==========     ==========
            Weighted average common shares
               outstanding                     6,512,252      6,287,407       6,528,036      6,296,648
            Effect of dilutive options           309,564        642,635         310,593        608,700
                                                 -------        -------         -------        -------
            Dilutive shares outstanding        6,821,816      6,930,042       6,838,629      6,905,348
                                             ===========     ==========      ==========     ==========
            Earnings (loss) per common share
               Basic                              $(0.32)         $0.14          $ 0.03          $0.08
                                                  ======          =====          ======          =====
               Diluted                            $(0.32)         $0.13          $ 0.03          $0.08
                                                  ======          =====          ======          =====
</TABLE>

RECENT ACCOUNTING PRONOUNCEMENTS

         In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments
of an Enterprise and Related Information."



                                       6
<PAGE>   7



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 adoption of SFAS No. 131 is not expected to
have a material effect on the measurement of the Company's financial position,
results of operations or cash flows; the Company is reviewing possible changes
in disclosures that may be called for.

         In March 1998, the American Institute of Certified Public Accountants
issued Statement of Position 98-1 (SOP 98-1), "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use." SOP 98-1 establishes
standards for accounting for costs incurred in developing or procuring computer
software for internal use. The Company will be required to adopt this standard
effective January 1, 1999. The adoption of this standard is not expected to have
a material effect on the Company's financial position, results of operations or
cash flows.




                                       7
<PAGE>   8



ITEM 2

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

GENERAL

         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 phase, is followed by an Implementation phase, and ends with a
Deployment phase.

         On March 19, 1998, the Company acquired all the outstanding stock of
Advantage kbs for a purchase price of $5 million, plus an additional contingent
payment of up to $2.5 million which is dependent upon revenue and earnings of
Advantage kbs for the year ending December 31, 1998. Based in Edison, New
Jersey, Advantage kbs provides problem resolution software and professional
services for automating customer support. The Company believes that the
acquisition of Advantage kbs 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 kbs
is subject to certain risks. The possible business and financial advantages of
the acquisition may not be achieved unless the operations of Advantage kbs are
successfully integrated with the Company in a timely manner.

         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,
the U. S. Army, Diebold, BellSouth Telecommunications, Inc., First USA Bank,
Highmark Blue Cross Blue Shield and Philips Medical Systems.

         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 at June 30, 1998 was
$10.4 million, compared to $12.4 million at June 30, 1997 and $8.7 million at
December 31, 1997. As most of the contracts in backlog are terminable by the
Company or the client upon short notice, there can be no assurance that
contracts reflected in backlog are a reliable measure of future revenue.

COMPARISON OF QUARTER AND SIX MONTHS ENDED JUNE 30, 1998 AND JUNE 30, 1997.

         Revenue. Total revenue for the quarter ended June 30, 1998 was $8.6
million compared to $7.9 million for the quarter ended June 30, 1997, an
increase of $.7 million or 9%. For the six months ended June 30, 1998 revenue
was $16.1 million compared to $15.0 million for the period ended June 30, 1997,
an increase of $1.1 million or 7%.

         Total software services revenue for the quarter ended June 30, 1998 was
$8.3 million compared to $7.8 million for the quarter ended June 30, 1997, an
increase of $.5 million or 6%. This increase was the result of the inclusion of
Advantage Kbs. Software service revenue for the six month period ended June 30,
1998 was $15.6 million compared to $14.3 million for the six month period ended
June 30, 1997, an increase of $1.3 million or 9%. This increase was primarily
due to the inclusion of Advantage Kbs along with an increase in the number of
customer contact engagements. 



                                       8
<PAGE>   9



         Revenue from software licenses was $215,000 for the quarter ended June
30, 1998 compared to $98,000 for the quarter ended June 30, 1997, an increase of
$117,000 or 119%. Revenue from software licenses was $574,000 for the six month
period ended June 30, 1998 compared to $723,000 for the six month period ended
June 30, 1997, a decrease of $149,000 or 21%. This decrease was attributable to
the decreased sales of reusable software templates.

         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 expenses. For the quarter ended June 30, 1998 total cost
of revenue was $5.8 million compared to $4.7 million for the quarter ended June
30, 1997, an increase of $1.1 million or 23%. For the six month period ended
June 30, 1998 total cost of revenue was $11.0 million compared to $9.1 million
for the six month period ended June 30, 1997, an increase of $1.9 million or
21%. Cost of revenue-related parties was $4.6 million for the six month period
ended June 30, 1998 compared to $1.5 million for the six month period ended June
30, 1997, an increase of $3.1 million or 207%. This increase in cost of revenue
was primarily attributed to the acquisition or Advantage Kbs.

         Research and Development. Research and development expenses for the
quarter ended June 30, 1998 were $366,000 compared to $393,000 for the quarter
ended June 30, 1997, a decrease of $27,000 or 7%. For the six month period ended
June 30, 1998 research and development expenses were $561,000 compared to
$751,000 for the six month ended June 30, 1997, a decrease of $190,000 or 25%.

         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 $4.3 million for the six month period ended June
30, 1998 compared to $3.9 million for the six month period ended June 30, 1997,
an increase of $.4 million or 10%. This increase was due primarily to the
acquisition of Advantage Kbs.

         Write-off of Purchased In Process Research and Development. During the
first six months of 1998, $2.4 million of purchased in process research and
development was written off related to the acquisition of Advantage kbs.

         Other Income (Expense). Other income (expense) for the quarter ended
June 30, 1998 was $91,000 compared to $172,000 for the quarter ended June 30,
1997, a decrease of $81,000 or 47%. Other income for the 6 month period ended
June 30, 1998 was $283,000 compared to $338,000 for the 6 month period ended
June 30, 1997, a decrease of $55,000 or 16%. This income is primarily interest
income earned on the company's cash reserves.

         Income Tax Provision. An income tax provision of $150,000 was recorded
in the second quarter ended June 30, 1998 and $273,000 for the six months ended
June 30, 1998 based on the Company's estimate of the effective tax rate for the
year.

         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 sustained 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.

         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 forth 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.



                                       9
<PAGE>   10



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, and in part by
borrowing under available lines of credit. The Company has also funded its
operations through the net proceeds of the initial public offering of its Common
Stock consummated in December 1995.

         During the first six months of 1998 the Company used $1,173,000 in cash
for operating activities. Overall, the Company had a net use of cash amounting
to $7,671,113. Approximately $5,000,000 was used in the acquisition of Advantage
kbs.

         The Company's net accounts receivable increased by $1,584,221 in the
six months ended June 30, 1998. Invoicing of amounts to clients generally occurs
within 45 days of time and materials cost incurrence, unless a specific schedule
is agreed upon, and payment follows invoicing in accordance with customary
terms. The Company has not experienced any significant write-offs of
receivables, nor does the Company expect that payments are doubtful;
accordingly, the Company has not made any allowance for doubtful accounts.

         Advance billings and deferred revenue decreased $803,000 in the six
months ended June 30, 1998. Advanced billings and deferred revenue balances will
normally change from period to period. Any increase reflects 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 currently has a committed line of credit agreement in the
amount of $3.5 million in place with PNC Bank, N.A. (the "Bank"). 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 that line of credit. The Bank's
prime interest rate was 8.50% at June 30, 1998 and December 31, 1997. This
agreement was amended on June 30, 1998 by extending the expiration date to July
30, 1998, and is pending further extension to June 29, 1999. No borrowings were
outstanding against the line of credit at June 30, 1998 or December 31, 1997.

         The Company believes that the current cash balances, together with cash
generated from operations and borrowing available under its line 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 financing. 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.

IMPACT OF YEAR 2000 ISSUE

         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 by 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 Company believes the remaining $80,000, some of which
will be capitalized or expensed as incurred during 1998, will not have a
material effect on the results of operations. To date, the Company has
capitalized or expensed approximately $540,000 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 




                                       10
<PAGE>   11



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.

RECENT ACCOUNTING PRONOUNCEMENTS

         In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments
of an Enterprise and Related Information." 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
adoption of SFAS No. 131 is not expected to have a material effect on the
measurement of the Company's financial position, results of operations or cash
flows; the Company is reviewing possible changes in disclosures that may be
called for.

         In March 1998, the American Institute of Certified Public Accountants
issued Statement of Position 98-1 (SOP 98-1), "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use." SOP 98-1 establishes
standards for accounting for costs incurred in developing or procuring computer
software for internal use. The Company will be required to adopt this standard
effective January 1, 1999. The adoption of this standard is not expected to have
a material effect on the Company's financial position, results of operations or
cash flows.

MATERIAL FACTORS AFFECTING THE COMPANY'S BUSINESS

         The Company's business is subject to a number of risks and
uncertainties that could materially affect future results. To the extent that
any of the statements made in this report on Form 10-Q (including, without
limitation, statements with respect to growth in the Company's business and
client engagements) may be deemed to be forward-looking statements, or to the
extent that the Company or its representatives may in the future be deemed to
make oral forward-looking statements, the following is a list of important
factors, among others, that could cause actual results to differ materially from
those expressed in 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.

         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.



                                       11
<PAGE>   12



         Risks Associated with the Integration of Advantage kbs. On March 19,
1998, the Company acquired all the outstanding capital stock of Advantage kbs
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 kbs 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 kbs be successfully integrated with
those of the Company in a timely manner. The successful integration of the
Company and Advantage kbs 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 kbs.

         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 assessments of its ability to
realize its deferred tax asset through future taxable income reflects this. The
Company's interim and annual financial statements included 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 any 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




                                       12
<PAGE>   13



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 and 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 Five" 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 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 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 




                                       13
<PAGE>   14



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 1997 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.

         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.




                                       14
<PAGE>   15



ITEM 3

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable















                                       15
<PAGE>   16



                           PART II - OTHER INFORMATION

ITEM 6 EXHIBITS AND REPORTS ON FORM 8-K

(a)    EXHIBITS                       DESCRIPTION

       The exhibits listed below are filed or incorporated by reference as part
       of this quarterly report on Form 10-Q.

       10.01   Letter Agreement, effective as of January 1, 1998, to amend
               Schedule Number 34-001-97, effective as of October 10, 1997, to
               Agreement No. 970050785 between US WEST Business Resources, Inc.,
               as agent for various US WEST companies and Carnegie Group, Inc.
               (confidential treatment with respect to certain information in
               this exhibit has been requested of the Commission pursuant to
               Rule 24b-2 under the Securities Exchange Act of 1934, as
               amended).

       10.02   Schedule Number 29-001-98, effective as of January 1, 1998, to
               Agreement No. 9700050785 between US WEST Business Resources,
               Inc., as agent for various US WEST Companies and Carnegie Group,
               Inc. (confidential treatment with respect to certain information
               in this exhibit has been requested of the Commission pursuant to
               Rule 24b-2 under the Securities Exchange Act of 1934, as
               amended).

       10.03   Schedule Number 38-002-98, effective as of January 1, 1998, to
               Agreement No. 9700050785 between US WEST Business Resources,
               Inc., as agent for various US WEST Companies and Carnegie Group,
               Inc. (confidential treatment with respect to certain information
               in this exhibit has been requested of the Commission pursuant to
               Rule 24b-2 under the Securities Exchange Act of 1934, as
               amended).

       10.04   Schedule Number 34-002-98, effective as of March 13, 1998, to 
               Agreement No. 9700050785 between US WEST Business Resources,
               Inc., as agent for various US WEST Companies and Carnegie Group,
               Inc. (confidential treatment with respect to certain information
               in this exhibit has been requested of the Commission pursuant to
               Rule 24b-2 under the Securities Exchange Act of 1934, as
               amended).

       10.05   Letter Agreement, dated May 7, 1998, to amend Schedule Number
               23-07-97, effective as of December 1, 1997, to Agreement No.
               9700050785 between US WEST Business Resources, Inc., as agent for
               various US WEST Companies and Carnegie Group, Inc. (confidential
               treatment with respect to certain information in this exhibit has
               been requested of the Commission pursuant to Rule 24b-2 under the
               Securities Exchange Act of 1934, as amended).


       11.1    Statement regarding computation of per share earnings

       27.     Financial Data Schedule

(b)    Reports on Form 8-K

       The Company did not file any reports on Form 8-K during the quarter ended
       June 30, 1998.











                                       16
<PAGE>   17



                                   SIGNATURES

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

Date: August  14, 1998                 CARNEGIE GROUP, INC.

                                           /s/ DENNIS YABLONSKY
                                           --------------------
                                           Dennis Yablonsky
                                           President, and
                                           Chief Executive Officer

                                           /s/ JOHN W. MANZETTI
                                           --------------------
                                           John W. Manzetti
                                           Executive Vice President,
                                           Chief Financial Officer
                                           and Treasurer










                                       17
<PAGE>   18


EXHIBIT INDEX

<TABLE>
<CAPTION>
                                                                                        SEQUENTIAL
EXHIBIT NO.                           DESCRIPTION                                       PAGE NUMBER
-----------                           -----------                                       -----------
<S>     <C>                                                                             <C>
10.01   Letter Agreement, effective as of January 1, 1998, to amend
        Schedule Number 34-001-97, effective as of October 10, 1997, to
        Agreement No. 970050785 between US WEST Business Resources, Inc.,
        as agent for various US WEST companies and Carnegie Group, Inc.
        (confidential treatment with respect to certain information in
        this exhibit has been requested of the Commission pursuant to
        Rule 24b-2 under the Securities Exchange Act of 1934, as
        amended).

10.02   Schedule Number 29-001-98, effective as of January 1, 1998, to
        Agreement No. 9700050785 between US WEST Business Resources,
        Inc., as agent for various US WEST Companies and Carnegie Group,
        Inc. (confidential treatment with respect to certain information
        in this exhibit has been requested of the Commission pursuant to
        Rule 24b-2 under the Securities Exchange Act of 1934, as
        amended).

10.03   Schedule Number 38-002-98, effective as of January 1, 1998, to
        Agreement No. 9700050785 between US WEST Business Resources,
        Inc., as agent for various US WEST Companies and Carnegie Group,
        Inc. (confidential treatment with respect to certain information
        in this exhibit has been requested of the Commission pursuant to
        Rule 24b-2 under the Securities Exchange Act of 1934, as
        amended).

10.04   Schedule Number 34-002-98, effective as of March 13, 1998, to 
        Agreement No. 9700050785 between US WEST Business Resources,
        Inc., as agent for various US WEST Companies and Carnegie Group,
        Inc. (confidential treatment with respect to certain information
        in this exhibit has been requested of the Commission pursuant to
        Rule 24b-2 under the Securities Exchange Act of 1934, as
        amended).

10.05   Letter Agreement, dated May 7, 1998, to amend Schedule Number
        23-07-97, effective as of December 1, 1997, to Agreement No.
        9700050785 between US WEST Business Resources, Inc., as agent for
        various US WEST Companies and Carnegie Group, Inc. (confidential
        treatment with respect to certain information in this exhibit has
        been requested of the Commission pursuant to Rule 24b-2 under the
        Securities Exchange Act of 1934, as amended).

11.1    Statement Regarding Computation of Per Share Earnings

27      Financial Data Schedule
</TABLE>









                                       18