<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 MARCH 31, 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 APRIL 30, 1998
              -----                            -----------------------------
  Common Stock, $.01 par value                           6,539,866


<PAGE>   2




                                    FORM 10-Q

                              CARNEGIE GROUP, INC.

                                TABLE OF CONTENTS

                                                                          PAGE
                                                                         NUMBER
                                                                         ------
PART 1 FINANCIAL INFORMATION

       Item 1.  Financial Statements
                Carnegie Group, Inc. and Subsidiaries                       3
                Consolidated Statements of Operations for
                the three months ended March 31, 1998 and 1997

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

                Carnegie Group, Inc. and Subsidiaries                       5
                Consolidated Statements of Cash Flows for the three
                months ended March 31, 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



                                      -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
                                                                              ------------------
                                                                            MARCH              MARCH
                                                                             31,                 31,
                                                                            1998                1997
                                                                            ----                ----
<S>                                                                     <C>                 <C>        
Revenue
      Software services--Unrelated parties                              $ 3,834,834         $ 5,499,732
      Software services--Related parties                                  3,408,965           1,007,108
                                                                        -----------         -----------
            Total software services                                       7,243,799           6,506,840
      Software licenses                                                     359,630             625,078
                                                                        -----------         -----------
            Total revenue                                                 7,603,429           7,131,918
                                                                        -----------         -----------

Costs and expenses:
      Cost of revenue - Unrelated parties                                 2,901,305           3,837,500
      Cost of revenue - Related parties                                   2,279,097             581,745
                                                                        -----------         -----------
            Total cost of revenue                                         5,180,402           4,419,245
      Research and development                                              194,635             357,682
      Selling, general and administrative                                 2,103,911           1,876,836
      Write-off of purchased in-process research and development          2,425,000                  --
                                                                        -----------         -----------
            Total costs and expenses                                      9,903,948           6,653,763
                                                                        -----------         -----------

Income (loss) from operations                                            (2,300,519)            478,155
Other income (expense):
      Interest income                                                       198,363             163,898
      Other income                                                            6,099               6,199
      Interest expense                                                      (12,403)             (3,645)
                                                                        -----------         -----------
      Total other income                                                    192,059             166,452
                                                                        -----------         -----------
Income (loss) before income taxes                                        (2,108,460)            644,607
Income tax provision                                                       (123,721)           (256,360)
                                                                        -----------         -----------
      Net income (loss)                                                 $(2,232,181)        $   388,247
                                                                        -----------         -----------
Basic earnings (loss) per share                                         $     (0.34)        $      0.06
                                                                        ===========         ===========
Diluted earnings (loss) per share                                       $     (0.34)        $      0.06
                                                                        ===========         ===========

</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)
                                                                 MARCH 31,          DECEMBER 31,
                                                                   1998                 1997
                                                                   ----                 ----
<S>                                                              <C>                 <C>
                              ASSETS
CURRENT ASSETS:
Cash and cash equivalents                                        $7,246,188          $13,483,284
Accounts receivable                                               2,454,979            2,955,241
Accounts receivable from related parties                          2,112,673            3,396,859
Accounts receivable--unbilled                                     3,042,125            1,390,650
Accounts receivable related parties--unbilled                     1,115,774              211,885
Deferred income taxes                                             1,961,893            2,005,855
Other current assets                                                844,030              871,931
                                                                -----------          -----------
         Total current assets                                    18,777,662           24,315,705
                                                                -----------          -----------

Property and equipment, net of accumulated
  depreciation and amortization                                   2,734,548            2,568,758
Deferred income taxes                                             1,846,758            1,910,760
Long term notes receivable--from officers                           794,170              784,984
Goodwill and other intangible assets                              3,073,546                   --
Other assets                                                          8,289               10,597
                                                                -----------          -----------
         Total assets                                           $27,234,973          $29,590,804
                                                                ===========          ===========

               LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
Trade accounts payable                                            $ 896,907          $   663,667
Payables to related parties                                         194,755              182,145
Accrued compensation                                                930,395              933,004
Advance billings and deferred revenue                             1,866,853            2,388,660
Accrued rent                                                        330,470              330,981
Accrued restructuring                                               277,324              598,723
Other accrued liabilities                                           666,755              423,544
Obligations under capital leases--current portion                   167,927                  --
                                                                -----------          -----------
         Total current liabilities                                5,331,386            5,520,724
                                                                -----------          -----------

Obligations under capital leases-noncurrent portion                 101,872                   --
                                                                -----------          -----------
         Total liabilities                                        5,433,258            5,520,724
                                                                -----------          -----------

STOCKHOLDERS' EQUITY:
Common stock, $.01 par value; 20,000,000
  shares authorized, 6,772,685 and
  6,707,934 shares issued at March 31,
  1998 and December 31, 1997 respectively                            67,726               67,079
Capital in excess of par value                                   31,796,596           31,704,241
Accumulated deficit                                              (9,458,417)          (7,226,240)
Treasury stock, 223,000 and 190,000 shares (at cost)               (604,190)            (475,000)
                                                                -----------          -----------
         Total stockholders' equity                              21,801,715           24,070,080
                                                                -----------          -----------
         Total liabilities and stockholders' equity             $27,234,973          $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>
                                                                                               THREE MONTHS ENDED
                                                                                               ------------------
                                                                                         MARCH 31,              MARCH 31,
                                                                                           1998                   1997
                                                                                           ----                   ----

<S>                                                                                    <C>                     <C>
Cash flows from operating activities:
     Net income                                                                        $ (2,232,181)           $ 388,247
     Adjustments to reconcile net income
     to net cash (used in) provided
     by operating activities:
         Depreciation and amortization                                                      362,656              283,841
         Deferred income taxes                                                               74,898              228,160
         Write-off of purchased in-process research and development                       2,425,000
         Changes in working capital components, net of acquisition of business:
         Accounts receivable                                                               (815,446)            (137,071)
         Accounts receivable - related parties                                              380,297               (1,953)
         Other assets                                                                        42,186              (74,540)
         Trade accounts payable                                                            (140,192)             397,988
         Payables to related parties                                                         12,610             (597,461)
         Accrued compensation                                                               (98,650)            (106,686)
         Accrued rent                                                                          (511)             (92,517)
         Interest receivable                                                                 (9,186)                  --
         Accrued restructuring                                                             (321,399)                  --
         Other accrued liabilities                                                          284,365               40,667
         Advance billings and deferred revenue                                             (802,370)              30,768
                                                                                        ------------         -----------
              Net cash (used in) provided by
                operating activities                                                       (837,923)             359,443

Cash flows from investing activities:
     Capital expenditures                                                                  (272,643)            (651,259)
     Acquisition of business                                                             (5,090,341)                   -
                                                                                         -----------           ---------
              Net cash used in investing activities                                      (5,362,984)            (651,259)
                                                                                        -----------           ----------
Cash flows from financing activities:
         Principal payments under capital
           lease obligations                                                                     --              (14,615)
         Purchase of treasury stock                                                        (129,190)                  --
         Proceeds from sales of common stock, net                                            93,001               10,697
                                                                                         ----------           ----------
              Net cash used in financing activities                                         (36,189)              (3,918)
                                                                                         -----------          -----------
Net change in cash and cash equivalents                                                  (6,237,096)            (295,734)
Cash and cash equivalents:
     Beginning of period                                                                 13,483,284           14,691,765
     End of period                                                                       $7,246,188          $14,396,031
                                                                                         ==========          ===========

</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
period ended March 31, 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.

<TABLE>
<CAPTION>
                                                   March 31,       December 31,
                                                     1998             1997
                                                     ----             ----
<S>                                               <C>             <C>
Sales                                             $ 8,439,414     $ 32,589,000
Net loss                                             (18,118)        (381,145)
Basic earnings (loss) per share                         $0.00          $(0.06)
Diluted earnings (loss) per share                       $0.00          $(0.06)
</TABLE>

EARNINGS PER COMMON SHARE

The computation of basic and diluted earnings per common share for the periods
ended March 31, 1998 and 1997 is performed as follows:

<TABLE>
<CAPTION>
                                                     1998              1997
                                                     ----              ----
<S>                                              <C>                  <C>     
Net Income (loss)                                $(2,232,181)         $388,247
                                                 ============         ========
Weighted average common shares
   outstanding                                      6,497,584        6,278,594
Effect of dilutive options                            308,107          674,220
                                                    ---------        ---------
Dilutive shares outstanding                         6,805,691        6,952,814
                                                    =========        =========
Earnings (loss) per common share
   Basic                                              $(0.34)            $0.06
                                                      =======            =====
   Diluted                                            $(0.34)            $0.06
                                                      =======            =====
</TABLE>


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 


                                      -6-
<PAGE>   7

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 March 31, 1998
was $15.0 million, compared to $17.3 million at March 31, 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 QUARTERS ENDED MARCH 31, 1998 AND MARCH 31, 1997.

         Revenue. Total revenue for the quarter ended March 31, 1998 was $7.6
compared to $7.1 million in the first quarter of 1997, an increase of $.5
million or 7%.

         Total software services revenue was $7.2 million in the first quarter
of 1998 compared to $6.5 million in the first quarter of 1997, an increase of
$.7 million or 11%. Revenue from software services-unrelated parties was $3.8
million in the first quarter of 1998 compared to $5.5 million in the first
quarter of 1997, a decrease of $1.7 million or 31%. This decrease was the result
of the Company being engaged in a large fixed-price contract in the first
quarter of 1997 that did not exist in the first quarter of 1998. Revenue from
software services-related parties was $3.4 million in the first quarter of 1998
compared to $1.0 million in the first quarter of 1997, an increase of $2.4
million or 240%. This increase was the result of an increase in the number of
customer contact engagements for a telecommunications industry client.


                                      -8-
<PAGE>   9

         Revenue from software licenses was $360,000 in the first quarter of
1998 compared to $625,000 in the first quarter of 1997, a decrease of $265,000
or 42%. 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. Total cost of revenue was $5.2 million in the
first quarter of 1998, compared to $4.4 million in the first quarter of 1997, an
increase of $.8 million or 18%. Cost of revenue-unrelated parties was $2.9
million in the first quarter of 1998 compared to $3.8 million in 1997, a
decrease of $.9 million or 24%. Cost of revenue-related parties was $2.3 million
in the first quarter of 1998 compared to $.6 million in 1997, an increase of
$1.7 million or 283%. This increase was the result of an increase in the number
of customer contact engagements for a telecommunications industry client.

         Research and Development. Research and development expenses were
$195,000 in the first quarter of 1998 compared to $358,000 in the first quarter
of 1997, a decrease of $163,000 or 46%.

         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 $2.1 million in the first quarter of 1998 compared
to $1.9 million in the first quarter of 1997, an increase of $.2 million or 11%.
This increase was due primarily to an increase in corporate services
administration costs. 

         Write-off of Purchased In Process Research and Development. During the
first quarter 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) was $192,000 in the
first quarter of 1998 compared to $166,000 in the first quarter of 1997, an
increase of $26,000 or 16%. This income is primarily 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 $124,000 was recorded
in the first quarter of 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.

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 quarter of 1998 the Company used $838,000 in cash for
operating activities. Overall, the Company had a net use of cash amounting to
$6,237,096. Approximately $5,000,000 was used in the acquisition of Advantage
kbs.


                                      -9-
<PAGE>   10


         The Company's net accounts receivable increased by $435,000 in the
first quarter of 1998, which reflects increases in revenue. 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 $522,000 in the first
quarter of 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 March 31, 1998 and December 31, 1997. This
agreement was amended on June 30, 1997 by extending the expiration date to June
29, 1998. No borrowings were outstanding against the line of credit at March 31,
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 remaining $80,000, some of which will be capitalized or
expensed as incurred during 1998, is not expected to 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 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


                                      -10-
<PAGE>   11

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 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.

         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 


                                      -11-

<PAGE>   12

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 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 


                                      -12-

<PAGE>   13

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 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 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 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 


                                      -13-
<PAGE>   14


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

       11.1             Statement regarding computation of per share earnings

        27.             Financial Data Schedule

(b) Reports on Form 8-K

         The registrant filed a report on Form 8-K on March 30, 1998 in
         connection with the acquisition of Advantage kbs.


                                      -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: May  15, 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

                                                                SEQUENTIAL
EXHIBIT NO.                   DESCRIPTION                       PAGE NUMBER
-----------                   -----------                       -----------

11.1                  Statement Regarding Computation
                      of Per Share Earnings

27                    Financial Data Schedule



                                      -18-