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                     U.S. SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                   FORM 10-KSB

                Annual Report Pursuant to Section 13 or 15(d) of
                       the Securities Exchange Act of 1934
                   For the fiscal year ended December 31, 1998
                         Commission file number 1-12337

                                 QC OPTICS, INC.
                 (Name of Small Business Issuer in Its Charter)

             DELAWARE
---------------------------------                                04-2916548
(State or Other Jurisdiction                                -------------------
 of Incorporation or Organization)                           (I.R.S. Employer
                                                            Identification No.)

46 Jonspin Road, Wilmington, Massachusetts                             01887
------------------------------------------                          ----------
(Address of Principal Executive Offices)                            (Zip Code)

                                 (978) 657-7007
                (Issuer's Telephone Number, Including Area Code)

         Securities registered under Section 12(b) of the Exchange Act:

                                                            Name of Exchange on
        Title of each class                                   Which Registered
        -------------------                                 -------------------
        Common Stock, $.01 par value per share          American Stock Exchange
        Redeemable Warrants                             American Stock Exchange

       Securities registered under Section 12(g) of the Exchange Act: None

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

                           Yes  X                     No
                              -----                     -----
         Indicate by check mark if disclosure of delinquent  filers  pursuant to
Item 405 of Regulation S-B is not contained  herein,  and will not be contained,
to the best of the  registrant's  knowledge,  in definitive proxy or information
statements  incorporated  by  reference  in Part III of this Form  10-KSB or any
amendment to this Form 10-KSB [X].

         The issuer's net sales for the fiscal year ended December 31, 1998 were
$9,909,876.

         The aggregate  market value of the voting stock held by  non-affiliates
based upon the closing  price for such stock on March 1, 1999 was  approximately
$1,515,159.  As of March 1, 1999,  3,242,500  shares of Common  Stock,  $.01 par
value per share,  and 1,092,500  Redeemable  Warrants,  of the  registrant  were
issued and outstanding.

                       DOCUMENTS INCORPORATED BY REFERENCE

         Portions of the  Definitive  Proxy  Statement for the Annual Meeting of
Stockholders  for the fiscal year ended  December 31, 1998, to be filed pursuant
to Regulation 14A (the "Proxy Statement"), are incorporated by reference in Part
III of this Form 10-KSB.


         Transitional Small Business Disclosure Format (check one):

                           Yes                    No  X
                              -----                 -----

<PAGE>



                                     PART I

ITEM 1.  DESCRIPTION OF BUSINESS.

         This report contains  forward-looking  statements regarding anticipated
increases in revenues,  marketing of products and proposed products,  liquidity,
downturns in the  semiconductor  and computer  hard disk  industries,  Year 2000
compliance  issues,   product   performance,   patents,   patent   applications,
competition,  adequacy of the  Company's  facilities  and other  matters.  These
statements,  in  addition  to  statements  made in  conjunction  with the  words
"anticipate,"  "expect,"  "intend,"  "believe,"  "seek,"  "estimate" and similar
expressions  are  forward-looking  statements that involve a number of risks and
uncertainties.  Such statements are based on management's  current  expectations
and are subject to a number of factors and uncertainties that could cause actual
results  to  differ  materially  from  those  described  in the  forward-looking
statements.  Such factors and uncertainties  include, but are not limited to the
following: business conditions and growth in certain market segments and general
economy;  the  cyclical  nature  of the  semiconductor  and  computer  hard disk
industries;  the  uncertainties  concerning  the Asian  markets,  an increase in
competition;  increased or continued market acceptance of the Company's products
and proposed products;  the loss of the services of one or more of the Company's
key employees,  which could have a material  adverse effect on the Company;  the
uncertainty  that existing  patents will be valid,  if challenged,  and that any
additional  patents  will be issued or that the scope of any  patent  protection
will exclude competitors; the Company's ability to effectively address Year 2000
issues;  dependence on few customers;  the availability of additional capital to
fund expansion on acceptable terms, if at all; and other risks and uncertainties
indicated  from time to time in the Company's  filings with the  Securities  and
Exchange Commission. See also "Factors That May Affect Future Results."

         GENERAL

         QC Optics,  Inc. (the  "Company" or "QCO")  designs,  manufactures  and
markets laser based defect  detection  systems for the  semiconductor,  computer
hard  disk and flat  panel  display  markets.  QCO uses its  patented  and other
proprietary  technology in lasers and optical  systems that scan a computer hard
disk,  photomask  or flat  panel  display  for  defects  or  contamination.  The
Company's systems combine automatic handling, clean room capability and computer
control with reliable laser based  technology.  The Company  believes that these
features  enable the Company to maintain a leading market position in the United
States  in  the  semiconductor,  computer  hard  disk  and  flat  panel  display
inspection  industries where high quality inspection  capabilities are required.
The  Company's   customers   include  many  of  the  world's   largest   leading
semiconductor and computer hard disk manufacturers.  Currently, QCO has over 300
systems installed in 16 countries.

         In the fourth quarter of 1997, the Company shipped the DISKAN-9000(TM),
which  is  targeted  to  provide  computer  hard  disk  manufacturers  with  the
capability to inspect 100% of their production volume. Compared to the Company's
previous equipment, the DISKAN-9000(TM) provides more than 70% higher throughput
and a 30% reduction in footprint.  Over 50 of these systems were sold during its
first year on the market.

         In the first quarter of 1998, the Company released the DISKAN-FA-2(TM),
a   failure   analysis   tool  that   complements   the   DISKAN-9000(TM).   The
DISKAN-FA-2(TM) offers full failure analysis  capabilities,  including automatic
microscope  review of defects,  which  allows  customers to identify and correct
process problems.


                                       -2-
<PAGE>


         The Company's  systems,  such as its QCO-4000(TM) and  DISKAN-9000(TM),
are designed to fit into its customers'  production  line virtually  eliminating
the need for special handling or special production  procedures while performing
100%  inspection  throughout  the process.  In addition,  these systems sort out
fatal   defects  on  disks  and   pelliclized   photomasks   before  they  cause
manufacturing yield or other quality problems. As more manufacturers of computer
hard disks move toward total inspection  protocols versus statistical  sampling,
demand during the past year for the Company's products that can inspect computer
hard  disks  has  increased.  The  Company  is  also  working  on  research  and
development for a new photomask  inspection system,  which it expects to release
as a product during 1999.

         QCO was formed in 1986 as a Delaware  corporation to acquire the assets
of a division of GCA  Corporation.  The Company  funded its product  development
primarily  with equity  investments  and debt financing from Kobe Steel Ltd. and
its   subsidiaries   including  Kobe  Steel  USA  Holdings,   Inc.,  a  Delaware
corporation,  and Kobe Steel USA  International,  Inc.,  a Delaware  corporation
(collectively, "Kobe Steel"). From 1986 to 1990, the Company focused its efforts
in developing inspection systems for computer hard disk inspection. Applying the
Company's patented and proprietary information, the Company expanded its efforts
to use this  technology  for inspection of photomasks  used to image  integrated
circuit patterns onto  semiconductor  wafers.  In early 1996,  management of the
Company  exercised an option granted in 1995 to acquire a 62.2% equity  interest
through  a  management  buyout  with bank  supplied  debt  financing  personally
guaranteed by QCO's senior  management.  In October 1996, the Company  completed
its initial  public  offering  through the sale of Common  Stock and  Redeemable
Warrants and received net proceeds of approximately $5,000,000.

         QCO's  principal  offices  and  manufacturing  facilities  are based in
Wilmington,  Massachusetts. The Company also maintains regional sales or service
personnel  in Florida,  New Mexico and  California.  The Company  currently  has
approximately 46 employees and has a manufacturer's representative in Europe and
manufacturer's representatives and distributors in Asia.

MARKETS

         The Company currently serves three markets with its inspection systems:
semiconductors,  computer hard disks and flat panel displays.  In addition,  the
Company plans to continue to develop additional products, based on the Company's
existing patented and proprietary  technologies,  to further develop laser based
inspection systems.

         The  Company's  core  technology  inspects  by  illuminating   critical
surfaces and then examining and analyzing light reflected from the surface. This
analysis  allows the end user to analyze and determine the type of defect on the
surface.  Lasers are used to provide the  stable,  high-intensity  light  source
needed for these inspection processes. Certain ultraviolet light lasers are used
to detect smaller  defects.  The angular  distribution  and the intensity of the
reflected and scattered light from the surface  provide a  "fingerprint"  of the
surface and defects.  This information  passes through analog and digital signal
processes and is then analyzed using the Company's proprietary software.

SEMICONDUCTOR PHOTOMASK INSPECTION SYSTEMS

         In the  manufacture  of  semiconductors,  photomasks  are used to image
integrated  circuit  patterns onto silicon wafers.  Semiconductor  manufacturing
begins with the creation of a photomask,  in which the circuit design is written
onto the photomask, one layer at a time. A wafer stepper uses the photomask like
a  photographic  negative  to rapidly  make  numerous  repetitive  images of the
circuit pattern on the wafer. The stepper  transfers light through the photomask
onto  photoresist  that is spread over the surface of the wafer.  Those areas of
the  photoresist  that have been  exposed  to light are  dissolved  by  chemical




                                       -3-

<PAGE>


developers, and the exposed areas of the layer under the resist are then etched.
A different  photomask  is required  for each layer of the  integrated  circuit.
Successive  steps of  deposition,  lithography  and etch  build  the  layers  of
patterns that make up a single integrated circuit.

         In the  1990's,  a number of  advancements  in  photomask  design  have
allowed  manufacturers  to  manufacture  integrated  circuits with  increasingly
smaller  linewidths.  These  linewidths are now as low as 0.18  micrometers  and
less.  In the late  1980's  and early  1990's,  the  development  of a number of
technologies  allowed  photomasks to be used much more efficiently.  During this
period,  the  demand  for  photomask  inspection  equipment  was  less  than the
increased demand for  semiconductors  as more advanced  photomask  technologies,
such as  computer-automated  design  equipment  and  pellicles,  were  utilized.
Pellicles are a thin transparent  membrane  suspended over the photomask surface
on a frame  mounted  to the  photomask.  The  pellicle  increases  semiconductor
manufacturing  yields by  preventing  airborne  particles  from falling onto the
surface of the  photomask  and  printing  as defects on the wafer.  Since  their
introduction in the early 1980s,  pellicles have significantly  reduced the need
to clean photomasks during production,  thus substantially extending the life of
a photomask.  Accordingly,  the introduction of pellicles  significantly reduced
the  number  of  photomasks  required  in  high  volume   semiconductor   device
manufacturing.

         Management  believes  that the increased  complexity  in  semiconductor
devices will contribute to high demand for complex  photomasks and for increased
sophistication in photomask inspection equipment.  As semiconductors become more
and more  complex,  the  potential  for  defects in  photomasks  has  increased.
Similarly,  demand  for  inspection  of  photomasks  has  increased  to  improve
manufacturing  yields by identifying  defects or contaminations in photomasks as
early as possible.  Quickly attaining and then maintaining high yields is one of
the most important determinants of profitability in the semiconductor  industry.
The Company believes that its customers  typically  experience rapid paybacks on
their investments in the Company's inspection systems.  Semiconductor  factories
are increasingly  expensive to build and equip.  Yield management and monitoring
systems,  which typically  represent a small  percentage of the total investment
required to build and equip a fabrication  facility,  enable integrated  circuit
manufacturers  to leverage these expensive  facilities and improve their returns
on investment. In addition to utilizing state-of-the-art inspection systems on a
statistical basis to improve manufacturing yields,  semiconductor  manufacturers
increasingly  demand the ability to inspect  photomasks during the manufacturing
process to provide real time inspection  capability.  In-process inspection is a
critical yield enhancement and cost reduction technique because it allows defect
detection in real-time rather than waiting until after final test results become
available to discover problems that have a significant negative impact on yield.

         The overall  semiconductor  industry has been and could  continue to be
cyclical  with  periods of  oversupply.  The current  downturn in the demand for
semiconductors  has  reduced  the demand for  photomasks  as well as reduced the
demand for photomask  inspection  and has placed  pricing  pressure on photomask
inspection  equipment  vendors.  The  Company's  ability to reduce  expenses  in
response to any such downturn is limited by its needs for continued research and
development expenses and in customer service and support.  Previous downturns in
capital  investment by the  semiconductor  fabrication  industry have materially
affected  the  operating  results of the  Company  and other  businesses  in the
semiconductor  capital equipment  industry and future downturns may have similar
adverse effects.

COMPUTER HARD DISK INSPECTION

         Computer hard disk manufacturers use advanced  deposition  processes to
produce thin film disks.  Typically,  an aluminum substrate is nickel plated and
then  precision  polished  to provide  the  extremely  smooth  and flat  surface
required for the recording head to "fly" over the disk in the disk drive.  Other




                                       -4-

<PAGE>


substrates,  such as glass, are gaining market share, and the DISKAN(TM) product
series is generally compatible with these alternative  substrate materials.  The
substrate  is then  commonly  textured  (portions  of the disk are  modified  to
slightly roughen the surface, to prevent the recording head from sticking to the
surface of the disk). Thin films of magnetic material and a protective  overcoat
are then deposited onto the surface of the disk. Prior to shipment the disks are
checked for quality,  most commonly by visual and electronic  tests.  QC Optics'
computer hard disk  inspection  systems have been utilized for over 14 years for
inspecting disks  throughout the  manufacturing  process to identify  conditions
outside set control ranges by inspecting a small sample of the total  production
volume.  Any  defect  or  contaminant  on  the  disk  increases  the  risk  that
information cannot be properly stored. As storage densities have increased,  the
size of defects that affect data storage has  decreased,  and computer hard disk
manufacturers  have begun to find it cost  effective  to move from  inspecting a
sample of their production volume to inspecting close to 100% of their products.
This transition to 100% inspection  increases the potential  market for computer
hard disk  inspection  equipment  and resulted in the increase in the  Company's
DISKAN-9000 product sales in 1997 and 1998.

         The  overall  computer  hard  disk  drive  industry  has been and could
continue to be cyclical with periods of oversupply.  The current downturn in the
demand for computer  hard disk drives has reduced the demand for  computer  hard
disks as well as reduced the demand for computer  hard disk  inspection  and has
placed pricing pressure on computer hard disk inspection  equipment vendors. The
Company's ability to reduce expenses in response to any such downturn is limited
by its needs for  continued  research and  development  expenses and in customer
service and support.  Previous  downturns in capital  investment by the computer
hard disk industry have materially affected the operating results of the Company
and other businesses in the computer hard disk industry and future downturns may
have similar adverse effects.

FLAT PANEL DISPLAYS

         Over time,  the use of flat panel  displays  ("FPDs")  is  expected  to
significantly  replace  vacuum tube  monitors used in  televisions  and computer
monitors,  providing  users  with  quality  images on less bulky  displays.  The
manufacture  of these  devices is still in the very early  stages of  commercial
development in the United States and manufacturing capacity expansion has slowed
during 1998  primarily due to the rapid  decrease in the price of finished FPDs.
FPDs are currently being designed to include electronic  substrates that undergo
a lithography  process  similar to  semiconductors  as well as glass  substrates
which require inspection prior to the lithography process.

         The market for FPDs has grown significantly in recent years as a result
of the increasing  popularity of portable computers and other electronic devices
that  utilize  screens and other types of  displays  to provide  information  in
digital  format and  graphical  displays to the end user.  The weight and narrow
form factor of FPDs are enabling new display  applications  where the previously
predominant monitor technology,  cathode ray tubes ("CRTs"),  did not allow such
use. Laptop and notebook computers, personal digital assistants,  portable video
games,  digital phones and a variety of devices for the  automotive,  technical,
medical and military markets are examples of electronic products in fast growing
markets which cannot be served by CRT  technology.  The Company expects that FPD
manufacturers will eventually  increase their purchases of inspection  equipment
in  response to both the growth in the FPD market as well as the shift to larger
and higher resolution displays.

STRATEGY

         The  Company's  goal  is to  maintain  a  leadership  position  in  the
photomask and computer hard disk inspection  system markets and use its patented
and proprietary  technology to pursue other  opportunities  in high  performance
inspection  systems.  The  Company  intends to  achieve  this goal  through



                                       -5-

<PAGE>

the implementation of the following strategies:

         *        EXPAND  MARKETING  EFFORTS FOR  EXISTING  PRODUCTS.  Since its
                  introduction  of photomask and computer  hard disk  inspection
                  systems,  the  Company's  objective  has  been to  expand  its
                  leadership  position in these fields. The Company has extended
                  its sales,  service and  marketing  activities  outside of the
                  United States into Europe and Asia, where the Company believes
                  long term market demand exists for state-of-the-art inspection
                  systems  in  both  photomasks  and  computer  hard  disks.  In
                  addition,  in the  computer  hard  disk  market,  the  Company
                  intends  to  continue  to  market  its   computer   hard  disk
                  inspection  systems for 100% production line inspection versus
                  statistical sampling inspection.

         *        MAINTAIN TECHNOLOGY LEADERSHIP POSITION.  Since its formation,
                  the  Company's  objective  has been to  maintain a  leadership
                  position  in  inspection   technology  in  the  photomask  and
                  computer  hard disk  inspection  system  markets.  To maintain
                  technology leadership, the Company intends to continue to work
                  closely  with major  customers,  several of which are  leading
                  suppliers of  semiconductors  and computer hard disks in their
                  respective industries.

         *        BROADEN PRODUCT OFFERINGS THROUGH  ACQUISITIONS.   Although no
                  acquisition is currently planned and no assurance can be given
                  that the Company will complete any  acquisition,  QCO plans to
                  expand its activities in related inspection  markets,  such as
                  the  expected  market for flat panel  displays.  In  addition,
                  there  are a number of  smaller  companies  in the  inspection
                  market  that  have   technology  and  market  links  with  the
                  Company's existing businesses, including material handling and
                  stocking equipment, cleaning equipment, and related products.

         *        PROVIDE  BROAD RANGE OF PHOTOMASK  INSPECTION  SOLUTIONS.  The
                  Company's  strategy is to provide a broad  range of  technical
                  solutions,  leveraged  off  of  existing  technologies,   with
                  different   performance   characteristics.   Certain   of  the
                  Company's  inspection  systems  currently address less complex
                  photomask   designs   while   new   products,   such   as  the
                  QCO-4000(TM),  are designed to address the most  sophisticated
                  photomasks currently used. The Company is currently working on
                  research  and  development  for  a  new  photomask  inspection
                  system,  which it expects to release as a new  product  during
                  1999.

         *        PROVIDE   BROAD  RANGE  OF  COMPUTER   HARD  DISK   INSPECTION
                  SOLUTIONS. The Company's strategy is to expand and improve its
                  product offerings by strengthening its current technologies to
                  provide 100% inspection tools such as the  DISKAN-9000(TM)  as
                  well as failure  analysis tools,  such as the  DISKAN-FA-1(TM)
                  introduced   in  the   third   quarter   of   1997,   and  the
                  DISKAN-FA-2(TM) introduced in the first quarter of 1998.

         *        LEVERAGE INSTALLED BASE. In marketing new products to existing
                  customers,  the  Company  intends  to  leverage  its  existing
                  customer  base  to  upgrade  the  over  300  Company   systems
                  currently in the field with new product offerings. Many of the
                  Company's  products  are built with  modular  systems that are
                  designed to  facilitate  future  enhancements,  as well as new
                  system software.

         *        EXPAND  CUSTOMER  SUPPORT  SERVICES.   The  Company  currently
                  provides local support and service with  personnel  located in
                  California,   New  Mexico  and  Florida  in  addition  to  its
                  principal    engineering    services   at   its    Wilmington,
                  Massachusetts  headquarters.  The  Company  also  has  factory
                  trained  service  representatives  in the UK,  France,  Japan,

                                       -6-
<PAGE>


                  Korea, Taiwan,  Malaysia and Thailand.  The Company intends to
                  expand the number of customer support sites in both the United
                  States and  overseas to help  facilitate  customer  support as
                  well as support future sales opportunities.

PRODUCTS AND SERVICES

         QCO's current  products  consist of  photomask,  computer hard disk and
flat panel display  inspection  systems.  The Company's  systems are designed to
provide  a low cost of  ownership  through  high  performance,  reliability  and
integration  into the  manufacturing  process.  The Company utilizes a number of
different forms of lasers in its laser based inspection systems,  allowing it to
cover a broad range of technical  requirements  and cost  sensitivities  for its
customers.

         Many of QCO's  newer  systems  are  designed  to fit into its  customer
production  lines,  virtually  eliminating  the need  for  special  handling  or
production  procedures while performing 100% inspection  throughout the process.
QCO's systems sort out fatal defects on disks and pelliclized  photomasks before
they become manufacturing yield or other quality problems.  All of QCO's systems
have the  sensitivity to detect defects or  contamination  down to less than 0.5
micrometers.  In  the  fourth  quarter  of  1997,  the  Company  introduced  the
DISKAN-9000(TM),  which  provides  computer  hard  disk  manufacturers  with the
capability to inspect 100% of their production volume. Compared to the Company's
previous equipment, the DISKAN-9000(TM) provides more than 70% higher throughput
and a 30% reduction in footprint.  Over 50 of these systems were sold during its
first  year  on the  market.  The  Company  is  also  working  on  research  and
development for a new photomask  inspection system,  which it expects to release
as a product during 1999.

         Specific Company products include the following:

         QCO-4000(TM):  The QCO-4000(TM) represents what the Company believes is
a state-of-the-art  breakthrough for inspecting pelliclized photomasks.  Defects
on  complex,  small  featured  photomasks  are  non-destructively  detected  and
characterized  with a  sensitivity  down to .25  micrometers,  using the  latest
technologies  in  ultraviolet  argon  ion laser  optics  and  innovative  signal
processing. The QCO-4000(TM) is capable of inspecting all four critical surfaces
of the photomask,  which are the front and back pellicles and the front and back
of the  photomask.  The  QCO-4000(TM)  also  provides for  inspection  both on a
sampling  basis  as well as 100%  inspection.  This  allows  this  system  to be
extremely  versatile  for needs  ranging from  incoming  inspection  to complete
process  characterization and documentation.  Utilizing advanced systems control
technology,  the operator has complete  control over all system  operations  and
decisions. Computers incorporated in the product and several communication ports
allow the QCO-4000(TM) to be easily integrated into the  manufacturing  process,
manufacturing resource planning ("MRP") and similar systems. The average selling
price for this system is approximately $900,000 to $1,300,000,  although various
options can increase or reduce the price of a specific system.

         API-3000/5(TM):  This automatic pelliclized photomask inspection system
has a  sensitivity  of  0.5  micrometers  and is  compatible  with  many  of the
photomasks most commonly used in today's semiconductor  manufacturing processes.
This product is used by  semiconductor  manufacturers  to qualify the  photomask
just  prior  to  its  use on  lithography  equipment  as  well  as for  incoming
inspection.  Photomask  manufacturers utilize the system for final inspection as
well  as  process  control.  The  average  selling  price  for  this  system  is
approximately  $500,000 to $750,000,  although  various  options can increase or
reduce the price of a specific system.

         API-1100(TM):  This equipment is a photomask  blank  inspection  system
with full automatic  handling capable of detecting  pinholes and particulates as
small as 0.3 micrometers.  This product is



                                       -7-

<PAGE>


utilized by photomask blank  substrate  manufacturers  for final  inspection and
transfers the finished product directly into a shipping  cassette from a process
cassette.  Quartz  and glass  manufacturers  also use this  equipment  for final
inspection.  The average selling price for this system is approximately $400,000
to  $600,000,  although  various  options can  increase or reduce the price of a
specific system.

         DISKAN(TM) SERIES: These are computer hard disk inspection systems that
are equipped with integrated  automatic  handling or external  handling systems.
The Company's newest product, the DISKAN-9000(TM)  which was introduced in 1997,
is  configured to provide the customer with the ability to inspect 100% of their
production and has 70% higher  throughput with a 30% smaller  footprint than the
Company's previous systems.  Over 50 of these systems were sold during its first
year on the market. During 1998, the Company experienced  increasing demand from
customers  to provide a system for 100%  inspection.  In  addition,  the Company
offers the  DISKAN-FA-1(TM),  which incorporates  multiple  cassette-to-cassette
automatic  handling,  and is used to  inspect a sample of the  customer's  total
production for process control. The DISKAN-FA-2(TM), where disks are loaded from
a  single  cassette  into the  system,  is used for  failure  analysis,  process
development and process control.  The average selling price for these systems is
approximately  $100,000 to $450,000,  although  various  options can increase or
reduce the price of a specific system.

         API-1100FP(TM):  The API-1100FP(TM) is a Company product that addresses
the inspection  demands for flat panel display  substrates  inspection  systems,
including systems with automatic handling  capability.  This product is utilized
for process control by flat panel display  manufacturers,  as well as flat panel
display glass substrate manufacturers. The average selling price for this system
is approximately $300,000 to $600,000,  although various options can increase or
reduce the price of a specific system.

PRODUCTS UNDER DEVELOPMENT

         The  Company's  product  development  strategy  is to  make  continuous
improvements   to  its  existing   product  line  relying  on  its   proprietary
technologies and to expand prior development efforts in applications  related to
the markets it serves.  The Company  currently  has an  engineering  and product
development  staff of 14  individuals  who assist  the  Company's  customers  in
integrating the Company's  products into the customer's work  environment.  This
work  provides  the  Company  an  opportunity  to  keep  abreast  of new  market
opportunities for the Company's technologies.

         Currently  the Company is working on product  enhancements  to both its
QCO photomask and DISKAN(TM) product lines.  During 1998, the Company introduced
the new disk failure analysis tool, the  DISKAN-FA-2(TM),  with  capabilities to
inspect   computer  hard  disks  that  target  new  inspection   points  in  the
manufacturing  process.  If the new inspection  points prove to be  economically
justified for 100%  inspection,  it would further  increase the market potential
for  the  DISKAN(TM)   product   series.   This  system   provides  even  higher
sensitivities in measurements  and higher  throughput.  Management  expects that
these new  systems  will  significantly  improve the cost  effectiveness  of the
equipment for 100%  inspection of the customers'  production.  In addition,  the
Company  continues  its efforts in the flat panel  display  market to modify its
existing  products for research and  development in the inspection of flat panel
displays.  The  technology  used in flat panel  displays will continue to evolve
significantly  and as a result,  the Company expects that it will be required to
continue  to  expend  significant   efforts  in  improving  and  developing  new
technologies for the flat panel display markets.

         The  Company's  success in  developing  and  selling  new and  enhanced
products  depends upon a variety of factors,  including  accurate  prediction of
future  customer  requirements,   introduction  of  new  products  on  schedule,
cost-effective manufacturing and product performance in the field. The Company's



                                       -8-

<PAGE>


new product decisions and development  commitments must anticipate the equipment
needed to satisfy the requirements for inspection processes one or more years in
advance of sales. Any failure to accurately predict customer requirements and to
develop new  generations  of products  to meet those  requirements  would have a
sustained material adverse effect on the Company's business, financial condition
and results of operations.  New product transitions could adversely affect sales
of existing  systems,  and product  introductions  could contribute to quarterly
fluctuations in operating results as orders for new products commence and orders
for existing products or enhancements of existing products fluctuate.

CUSTOMER SERVICE AND SUPPORT

         In addition to selling and installing  standard  products and providing
support services, the Company provides  individualized  engineering services for
customers as well as technical  support  worldwide.  The  Company's  service and
support  personnel also advise  customers  about product  applications,  provide
customer  training,   coordinate  upgrades,   manage  spare  parts  and  provide
preventative maintenance.

         The Company's  warranty  obligations for its systems  generally cover a
12-month period.  However, many customers request service and support beyond the
warranty period.  Generally,  the Company has historically derived less than 10%
of its revenues from annual  service and  maintenance  for its installed base of
systems.  Some of the  Company's  systems are currently  serviced  under service
contracts and other customers  purchase  repairs on a labor and materials basis.
Service revenues for the fiscal year ended December 31, 1998 and the fiscal year
ended   December   31,  1997  were   $879,874  and   $1,135,094,   respectively.
Historically,   warranty   expenses  have  been  consistent   with   established
allowances.

CUSTOMERS

         The  Company's   customers  include   semiconductor  and  other  device
fabricators,  photomask  fabricators  and their  suppliers,  computer  hard disk
manufacturers and customers interested in developing flat panel displays. Repeat
sales to existing  customers  represent a  significant  portion of the Company's
product  revenues,  and the Company believes that its installed base of over 300
systems  represents a significant  competitive  advantage,  particularly  in the
United States.

         Historically,  the Company  has sold a  significant  proportion  of its
systems  to a limited  number  of  customers  as the  markets  that the  Company
participates in are primarily dominated by a few major companies.  Approximately
95% of net  sales  in  Fiscal  1998  and  Fiscal  1997  were to the ten  largest
customers  in each fiscal  year.  Sales to the largest  customer  accounted  for
approximately  55% of net sales during Fiscal 1998. The failure to replace sales
with  sales to other  customers  in  succeeding  periods  would  have a material
adverse  effect on the Company's  business,  financial  condition and results of
operations.  The Company  expects that sales to relatively  few  customers  will
continue  to account  for a high  percentage  of the  Company's  revenues in any
accounting period in the foreseeable future. A reduction in orders from any such
customer  or the  cancellation  of any  significant  order could have a material
adverse  effect on the Company's  business,  financial  condition and results of
operations.  None  of the  Company's  customers  has  entered  into a  long-term
agreement requiring it to purchase the Company's products.

         In addition,  due to the  substantial  purchase price for the Company's
products and systems, revenues and operating results may vary significantly from
quarter to quarter depending upon the timing of orders and shipments.



                                       -9-

<PAGE>


SALES AND MARKETING

         QCO markets and distributes its products directly in the United States.
The Company maintains sales and service offices in Wilmington, Massachusetts and
Santa  Clara,  California,  and  service  or sales  personnel  in New Mexico and
Florida.  The  Company  also  sells  through   manufacturer's   representatives,
distributors and directly to certain customers internationally.

         Due to the significant  involvement  required to purchase QCO's systems
and their highly technical nature, the sales process is often complex, requiring
interaction  with several  levels of the customer's  organization  and extensive
technical exchanges,  product demonstrations and commercial  negotiations.  As a
result,  the  sales  cycle  can  often be quite  long.  Purchase  decisions  are
typically made at a high level within the customer's  organization and the sales
process  often  requires  broad  participation   across  the  QCO  organization.
Accordingly,  the Company's  systems typically have a lengthy sales cycle during
which the Company may expend  substantial  funds and management  time and effort
with no assurance that a sale will result.

ENGINEERING AND PRODUCT DEVELOPMENT

         The Company  directs its engineering and design efforts at products for
which the Company  believes there is growing market demand.  In particular,  the
Company seeks to meet the  requirements  of its customers for products  aimed at
emerging  applications in the  semiconductor,  computer hard disk and flat panel
display inspection  markets by applying the latest available  technology and the
design and engineering  know-how gained from the Company's focus on this market.
For many of its customers,  the Company provides  engineering and design support
to help  integrate  the  Company's  products into  production  environments.  By
working  closely  with  these  customers,  the  Company is exposed to new market
opportunities for its products.

         The Company  employed 13 individuals in engineering  and development as
of  December  31,  1998.  During  Fiscal  1998 and Fiscal  1997,  the  Company's
engineering expenses totaled approximately $1,196,000 and $1,316,000, or 12% and
13% of net sales,  respectively.  The Company expenses all software  development
costs as incurred.

         The  Company's  business  strategy  includes  investing in or acquiring
companies which offer the Company access to  complementary  technologies and new
markets within the Company's target industries.

COMPETITION

         The markets in which the Company  competes are highly  competitive  and
are characterized by rapid  technological  change,  evolving industry standards,
rapid  product  obsolescence  and  intense   competition.   Competitors  in  the
semiconductor   photomask   inspection  market  include  Hitachi,   Horiba,  KLA
Instruments and Nikon. In the computer hard disk inspection  market  competitors
include DPI Technology Systems,  Hitachi,  Phase Metrics and System Seiko. Based
on the number of installations, the Company believes it is a leading supplier of
semiconductor  photomask soft defect  inspection  systems and computer hard disk
inspection  systems in the United  States.  The  Company  competes  based on its
installed base of customers,  engineering and service  capabilities,  breadth of
products,  patents  and  proprietary  information  and  reputation.  Many of the
Company's   competitors  and  potential   competitors  have  greater  financial,
marketing  and  technological  resources  than  the  Company.  There  can  be no
assurance that companies with  complementary  technologies and greater financial
resources will not enter




                                      -10-


<PAGE>


these  industries  and  develop  products  that are  superior  to the  Company's
products or achieve market acceptance.

         A  substantial  investment  is  required  by  customers  to install and
integrate  capital  equipment  into  a  production  line.  As a  result,  once a
manufacturer has selected a particular  vendor's capital  equipment,  management
believes  that the  manufacturer  generally  relies upon that  equipment for the
specific  production line application and frequently will attempt to consolidate
its other capital equipment requirements with the same vendor. Accordingly, if a
particular  customer  selects a  competitor's  capital  equipment,  the  Company
expects to  experience  difficulty in selling to that customer for a significant
period of time.

         The Company expects competition to continue in the future from existing
competitors  and from other  companies that may enter the Company's  existing or
future markets with similar or alternative  solutions that may be less costly or
provide  additional  features.  The Company believes that its ability to compete
successfully  depends on a number of factors,  which include product quality and
performance, order turnaround, the provision of competitive design capabilities,
success  in  developing  new  applications,   adequate  manufacturing  capacity,
efficiency of production,  timing of new product  introductions  by the Company,
its  customers  and its  competitors,  the number  and  nature of the  Company's
competitors in a given market, price and general market and economic conditions.
In  addition,  increased  competitive  pressure  may lead to  intensified  price
competition, resulting in lower prices and gross margins, which could materially
adversely affect the Company's business and results of operations.  No assurance
can be given that the Company will compete successfully in the future or that it
will be able to make the technological advances necessary to remain competitive.

         Changes in manufacturing processes could also have a materially adverse
effect on the Company's business, financial condition and results of operations.
The Company anticipates  continued changes in semiconductor,  computer hard disk
and flat panel display  technologies  and  processes.  No assurance can be given
that the Company will be able to develop,  manufacture  and sell  products  that
respond adequately to such changes.

BACKLOG

         The  Company's  backlog for products  and  services  was  approximately
$258,000 at December 31, 1998, compared to approximately  $6,370,000 at December
31, 1997 and $740,000 at December 31, 1996.  As of March 1, 1999,  the Company's
backlog for  products and services  was  approximately  $3,429,000.  QCO defines
backlog to include only those systems,  accessories and upgrades with respect to
which a  purchase  order has been  received  and a  delivery  schedule  has been
specified  for shipment  over the next twelve (12)  months,  and  contracts  for
services to be provided  for longer  periods up to 36 months.  Cancellations  of
product purchase orders are sometimes subject to cancellation charges.  Although
a  significant  indicator  of  business  levels,   backlog  is  not  necessarily
representative of future sales.



                                      -11-

<PAGE>


MANUFACTURING

         The Company's  manufacturing  activities  consist of final  assembly of
subassemblies,  which are then integrated  into finished  systems and tested for
compliance with customer requirements. The Company believes that production lead
time, product quality and customer response are key elements to its success.

         Although the Company manufactures some of the subassemblies used in its
systems, most are purchased from unaffiliated  subcontractors,  typically to the
Company's  specifications.  None of the  Company's  suppliers  is  obligated  to
provide the Company with any specific  quantity of components  or  subassemblies
over any specific period.  Certain of the components and subassemblies  included
in the Company's  products are obtained  from a limited  group of suppliers.  In
addition,  because the Company  believes that  subsystem  vendors have increased
their  manufacturing  expertise,  the  Company  expects  to  continue  to obtain
virtually all of its components and subassemblies from third parties in order to
devote its resources  toward systems  design,  software  development and systems
integration,  its  primary  areas of  competence.  The  Company's  reliance on a
limited  group of suppliers  involves  several  risks,  including  the potential
inability to obtain an adequate  supply of components  and reduced  control over
pricing and  delivery  time.  To date,  the Company has  generally  been able to
obtain  adequate and timely delivery of critical  subassemblies  and components,
although it has experienced  occasional delays. Because the manufacture of these
components and  subassemblies  is very complex and requires long lead times, and
although  alternative  sources are  available,  such  sources may not be readily
available.  As a result,  no  assurance  can be given that  delays or  shortages
caused  by  suppliers  will  not  occur in the  future.  Any  disruption  of the
Company's  supply of critical  components  and  subassemblies  could prevent the
Company  from   meeting  its   manufacturing   schedules,   which  could  damage
relationships  with customers and would have a materially  adverse effect on the
Company's business, financial condition and results of operations.

         The  Company's  ability  to  increase  its  manufacturing  capacity  in
response  to an  increase  in demand is  limited  given  the  complexity  of the
manufacturing  process,  the lengthy  lead times  necessary  to obtain  critical
components and the need for highly skilled personnel. The failure of the Company
to keep pace with customer  demand would lead to further  extensions of delivery
times,  which could deter customers from placing  additional  orders,  and could
adversely  affect  product  quality.  No assurance can be given that the Company
will be successful in increasing its manufacturing capacity.

GOVERNMENTAL REGULATIONS AND INDUSTRY STANDARDS

         The Company's products and worldwide operations are subject to numerous
governmental  regulations designed to protect the health and safety of operators
of manufacturing equipment. In particular,  the European Union ("EU") has issued
regulations  relating  to  electromagnetic  fields,  electrical  power and human
exposure  to laser  radiation.  In  addition,  numerous  domestic  semiconductor
manufacturers  including certain of the Company's customers,  have subscribed to
voluntary  health and safety  standards  and decline to purchase  equipment  not
meeting such standards.  The Company believes that its products currently comply
with  all  applicable  material  governmental  health  and  safety  regulations,
including those of the EU, and with the voluntary industry  standards  currently
in effect.

PROTECTION OF  PROPRIETARY  INFORMATION

         The  Company  holds 14 United  States  patents.  Several  of the issued
patents  are also  issued in Japan,  Europe  and Canada and there is one or more
patent  applications  pending in Europe and  Japan.  Most of the issued  patents
relate to advanced inspection measurement  techniques.  The issued United



                                      -12-

<PAGE>


States patents  expire from 2000 to 2015. The Company also has three  registered
trademarks in the United States that are due for renewal in 2008 and 2009.


         The  Company's  products  require  technical  know-how to engineer  and
manufacture and are based, in part, upon proprietary  technology.  To the extent
proprietary  technology  is  involved,  the Company  relies on patents and trade
secrets that it seeks to protect, in part, through  confidentiality  agreements.
No assurance can be given that such  agreements  will not be breached,  that the
Company will have adequate  remedies for any breach, or that the Company's trade
secrets will not  otherwise  become  known to, or  independently  developed  by,
existing or potential  competitors  of the Company.  The Company may be involved
from time to time in  litigation  to  determine  the  enforceability,  scope and
validity  of its  rights.  In  addition,  no  assurance  can be  given  that the
Company's  products  will not infringe any patents of others.  Litigation  could
result  in  substantial  cost to the  Company  and  diversion  of  effort by the
Company's management and technical personnel.

EMPLOYEES

         As of December 31, 1998,  the Company had 46  full-time  employees,  of
whom 12 were in sales, marketing and service, 13 were in engineering and product
development, 6 were in administration and 15 were in manufacturing.

         None of the Company's  employees are represented by a labor union.  The
Company considers its relationships  with its employees to be satisfactory.  The
Company's  financial  performance will depend  significantly  upon the continued
contributions of its officers and key management,  technical,  sales and support
personnel,  many of whom would be difficult to replace. In addition, the Company
believes  that certain of its former  employees  currently  provide  services or
technical support to the Company's customers or competitors. No assurance can be
given that the Company will be successful  in attracting or retaining  qualified
personnel.

ITEM  2.  FACILITIES

         The Company  maintains its principal  executive  offices,  research and
development, and manufacturing operations in approximately 25,000 square feet of
a facility in Wilmington,  Massachusetts  subleased from Caprius, Inc. (formerly
Advanced NMR Systems,  Inc.). The Company currently pays base rent in the amount
of  approximately  $16,270 per month plus  utility  charges  with respect to the
facility, pursuant to a sublease that expires on May 1, 2001.

            The Company also maintains a technical center and sales office in an
approximately 1,500 square foot facility in Santa Clara, California, leased from
Koll/Intereal Bay Area. The Company currently pays base rent of $2,652 per month
plus certain expenses related to the facility,  pursuant to a lease that expires
on  November  30,  2001 . The  Company  believes  that  its  facilities  for its
technical center and sales office are adequate for its current needs.

         Although no assurance can be given,  the Company believes that adequate
facilities  for  expansion,  if required,  are available at  competitive  rates.
Although  the Company has no present  plans to acquire  additional  research and
development,  manufacturing or shipping facilities, it may in the future seek to
establish  additional  research  and  development,   manufacturing  or  shipping
facilities as a result of its anticipated growth or acquisitions.




                                      -13-

<PAGE>


ITEM 3.           LEGAL PROCEEDINGS.

         On  August  6,  1998,  K.  Andrew   Bernal,   a  beneficial   owner  of
approximately  9.7% of the issued and  outstanding  Common Stock of the Company,
filed a civil lawsuit against the Company and Eric T. Chase, individually,  as a
director of the Company  and as the trustee of the QC Optics  Voting  Trust (the
"Voting  Trust").  The suit alleges  violations of federal and state  securities
laws, breach of contract, fraud and other claims relating to Mr. Bernal's shares
of Common Stock held in the Voting  Trust.  Mr. Bernal is seeking the release of
his shares from the Voting Trust as well as monetary and punitive  damages.  The
Company  believes  that Mr.  Bernal's  claims  are  without  merit,  intends  to
vigorously defend the suit and has filed a motion to dismiss the claims.

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

         The Company did not submit any matter during the fourth  quarter of the
fiscal year covered by this report to a vote of the Company's  security holders,
through the solicitation of proxies or otherwise.



                                      -14-

<PAGE>

                                     PART II

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

         The  Company's  Common Stock is traded on the American  Stock  Exchange
("AMEX")  under the symbol  "OPC." On March 1, 1999,  the  closing  price of the
Company's  Common  Stock  as  reported  on the  AMEX was  $1.39.  The  Company's
Redeemable  Warrants  are traded on AMEX  under the  symbol  "OPC+." On March 1,
1999, the closing price of the Company's  Redeemable Warrants as reported on the
AMEX was $.375.

         As of March 1, 1999,  there were  approximately 27 holders of record of
the  Company's  Common  Stock  and  approximately  22  holders  of record of the
Company's  Redeemable  Warrants.  Management  believes  that  there are over 500
beneficial  owners of the Company's Common Stock and over 500 beneficial  owners
of the Company's Redeemable Warrants.

         For the periods  indicated,  the following table set forth the range of
high and low sale prices for the Company's Common Stock and Redeemable  Warrants
as reported by AMEX.


<TABLE>
<CAPTION>

                                                                                           REDEEMABLE
                                                              COMMON STOCK                  WARRANTS
                                                              ------------                 ----------
                                                              HIGH         LOW          HIGH         LOW
                                                              ----         ---          ----         ---
         1997
         ----
        <S>                                                  <C>           <C>         <C>          <C>

         First Quarter                                        $5.875       $3.75        $1.50        $.50
         Second Quarter                                       $3.75        $2.375       $ .75        $.3125
         Third Quarter                                        $5.25        $3.25        $1.1875      $.4375
         Fourth Quarter                                       $5.00        $3.25        $1.1875      $.4375

         1998
         ----

         First Quarter                                        $5.125       $3.375       $1.00        $.375
         Second Quarter                                       $4.875       $2.375       $.938        $.25
         Third Quarter                                        $2.625       $1.50        $.50         $.25
         Fourth Quarter                                       $1.875       $1.188       $.313        $.125

         1999
         ----

         First Quarter (through March 1, 1999)                $2.25        $1.25        $.563        $.125

</TABLE>




         The Company has not paid cash  dividends  on its Common Stock since its
inception and does not anticipate  paying any cash dividends on its Common Stock
in the foreseeable  future.  The Company currently intends to reinvest earnings,
if  any,  in  the  development  and  expansion  of  its  business.   Any  future
determination  with respect to the payment of  dividends  will be subject to the
discretion  of the  Company's  Board  of  Directors  and  will  depend  upon the
earnings,  capital requirements,  and financial position of the Company, general
economic  conditions,  and other pertinent factors.  In addition,  the Company's
agreement  with its primary  bank  lender  prohibits  the  payment of  dividends
without the bank's prior written consent.

                                      -15-

<PAGE>



ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.

         The following  discussion  and analysis  should be read in  conjunction
with the financial statements and notes thereto appearing elsewhere herein.

RESULTS OF OPERATIONS

YEAR ENDED DECEMBER 31, 1998 ("FISCAL 1998") COMPARED TO YEAR ENDED DECEMBER 31,
1997 ("FISCAL 1997").

         The  Company  has been  adversely  affected  by a general  slowdown  in
capital  equipment  spending  in  the  semiconductor  and  computer  disk  drive
industries as evidenced by the low $258,000  customer  order backlog at December
31,  1998.  Backlog  at  March  1,  1999  improved  to  $3,429,000.  Although  a
significant   indicator  of  business   levels,   backlog  is  not   necessarily
representative of future sales. Additionally,  the current financial instability
in certain Asian countries adversely affects the Company.

         Net sales for  Fiscal  1998 were  $9,909,876  compared  to net sales of
$10,091,834 for Fiscal 1997, a decrease of 1.8%.  Historically,  the Company has
experienced significant  fluctuations in operating results due to the relatively
small number of high dollar volume sales in any year.  Management  expects these
fluctuations  to  continue.  As a  result  of  the  steep  declines  in  capital
expenditures in the semiconductor and computer hard disk industries, the Company
expects that (i) it will have lower revenue levels for the first quarter of 1999
as compared  to the  preceding  quarters  of 1998,  and (ii) it will not achieve
break-even results for such quarter.

         Cost of sales for Fiscal 1998 was  $5,248,844 as compared to $4,786,110
for Fiscal  1997.  Gross  profit for Fiscal  1998 was  $4,661,032  (47.0% of net
sales) as  contrasted  to  $5,305,724  (52.6% of net  sales) in Fiscal  1997,  a
decrease  of 12.2%.  The  decrease  in gross  profit  was due  primarily  to the
decreased margins on certain newly introduced products.

         Selling,  general and  administrative  expenses decreased to $3,315,869
for Fiscal 1998 as compared to $3,785,536 in Fiscal 1997. This decrease of 12.4%
was due  primarily  to  decreased  professional  fees  and  commissions,  offset
partially by increases in staffing costs and certain field service expenses.

         Engineering  expenses  in Fiscal  1998  decreased  to  $1,196,393  from
$1,316,469 in Fiscal 1997.  The decrease  resulted  primarily  from decreases in
staffing,  materials and travel expenses.  Research and development costs, which
are  included  in  engineering   expenses,   remained   relatively  constant  at
approximately $415,000 for Fiscal 1998 and $440,000 for Fiscal 1997.

         Income  before  provision for income taxes was $329,883 for Fiscal 1998
as compared to $392,196 in Fiscal 1997.  The  decrease  reflects the decrease in
gross profit offset somewhat by smaller decreases in operating expenses.

         The  provision  for  income  taxes for  Fiscal  1998 was  $118,800  (an
effective rate of 36.0%) compared to $146,900 (an effective rate of 37.5%).  The
higher 1997 effective tax rate relates primarily to the effect of state taxes.

         Net income was  $211,083  for Fiscal 1998 as  compared to $245,296  for
Fiscal 1997.



                                      -16-

<PAGE>



LIQUIDITY AND CAPITAL RESOURCES

         At December  31,  1998,  the Company had cash and cash  equivalents  of
$3,313,889, a decrease of $452,645 from $3,766,534 at December 31, 1997. Working
capital was  $8,023,392  at December  31,  1998 as  compared  to  $7,607,447  at
December 31, 1997,  an increase of $415,945.  Cash used by operating  activities
was $421,793 in 1998 compared to $1,074,204 in 1997.

         The Company has a revolving  line of credit with State  Street Bank and
Trust Company.  The revolving  line of credit  agreement was amended on June 29,
1998 and allows for  maximum  borrowings  of  $2,000,000  and  requires  monthly
payment of interest  on the  outstanding  balance to maturity on June 30,  2000.
Borrowings  under the revolving  line of credit  agreement are limited to 80% of
qualifying accounts receivable.  Borrowings under the agreement bear interest at
the bank's  prime  rate  (7.75% at  December  31,  1998).  The terms of the loan
agreement  provide for the  maintenance of certain  specified  financial  ratios
including the quick ratio and debt to equity,  minimum  earnings tests and other
negative and affirmative  covenants and restricts certain  transactions  without
the bank's prior written  consent.  As of December 31, 1998,  the Company was in
default of the minimum  earnings  covenant,  but obtained a waiver of compliance
from its bank. At December 31, 1998,  the Company had no borrowings  outstanding
under the revolving credit agreement and availability of approximately $411,000.

         Based on its current cash balances,  current bank credit facilities and
anticipated  results of  operations,  management  believes  that the Company has
sufficient  funds to meet its working capital  requirements  for the next twelve
months.  Thereafter,  the  Company  anticipates  that it could  need  additional
financing to meet its current plans for expansion.  No assurance can be given of
the Company's  ability to obtain financing on favorable terms, if at all. If the
Company  is unable to  obtain  additional  financing,  its  ability  to meet its
current plan for expansion could be materially adversely affected.

INFLATION

         To date,  inflation  has not had a  material  effect  on the  Company's
business.

YEAR 2000 DISCLOSURE

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

         The Company uses computer software programs in its internal operations,
such as for performing  administrative and financial functions.  The Company has
tested  its  key  internal  systems  and  implemented  remedial  measures  where
necessary. The Company is also contacting its significant suppliers to determine
those  whose  failure to be Year 2000  compliant  could  seriously  disrupt  the
Company's  business  operations.  The Company expects to complete this review by
the second quarter of 1999.

         Based on the Company's on-going review of its equipment in operation at
customer sites,  the Company  believes that a number of its systems are not Year
2000 compliant.  The Company has been and will continue to contact its customers
and offer  modifications  to make such systems Year 2000 compliant.  The Company
estimates  that the costs  incurred to remediate  Year 2000 problems  related to
noncompliant




                                      -17-

<PAGE>



products  will not  materially  adversely  affect its  operations  or  financial
condition.

         At this time,  the Company  cannot give any  assurance  that it will be
successful in completing its planned actions to become Year 2000 compliant on or
before the Year 2000. Additionally,  no assurance can be given that instances of
noncompliance  which  could  have a  material  adverse  effect on the  Company's
operations or financial condition will be identified;  that the systems of other
companies  with which the Company  transacts  business  will be  corrected  on a
timely basis;  that a failure by such entities to correct a Year 2000 problem or
a conversion which is incompatible  with the Company's  systems would not have a
material adverse effect on the Company's operations or financial  condition;  or
that even if all planned actions are completed,  the Company will not experience
some adverse effects from Year 2000 related issues.

                     FACTORS THAT MAY AFFECT FUTURE RESULTS
                     --------------------------------------

         As  previously  discussed,  information  provided  by  the  Company  or
statements made by its employees from time to time may contain "forward-looking"
information which involves risks and  uncertainties.  In particular,  statements
contained in this report that are not historical facts may be  "forward-looking"
statements.  The Company's actual future results may differ  significantly  from
those  stated in any  forward-looking  statements.  Factors  that may cause such
differences include, but are not limited to, the factors discussed below.

         CYCLICAL NATURE OF THE SEMICONDUCTOR, COMPUTER HARD DISK AND FLAT PANEL
DISPLAY   INDUSTRIES.   The  Company's   operating  results  depend  on  capital
expenditures  by  semiconductor,  computer  hard  disk  and flat  panel  display
manufacturers.  The semiconductor and computer hard disk industries are cyclical
and have historically  experienced  periodic downturns,  which have had a severe
effect on the demand for capital  equipment.  Prior  semiconductor  and computer
hard disk industry downturns and construction of excess capacity by the industry
have adversely affected the Company's revenues,  gross margin and net income and
have also  adversely  affected the market price for the Company's  Common Stock.
Moreover, the overall computer industry has been and is likely to continue to be
cyclical with periods of oversupply.  Recently, such industries have experienced
excess capacity and poor operating results and, as a result, the Company's sales
to semiconductor  customers were substantially  weaker in 1998 than in 1997. The
Company's ability to reduce expenses in response to any such downturn is limited
by its need for continued investment in research and development and in customer
service and support. A downturn in demand for semiconductor,  computer hard disk
and flat panel display  manufacturing  equipment  would have a material  adverse
effect on the Company's business, financial condition and results of operations.

         FLUCTUATIONS  IN  OPERATING  RESULTS.  The Company  derives most of its
annual revenues from a relatively small number of sales of products, systems and
upgrades.  As a result,  any delay in the  recognition  of  revenue  for  single
products,  systems  or  upgrades  would have a  material  adverse  effect on the
Company's results of operations for a given accounting period. In addition, some
of the  Company's  net  sales  have  been  realized  near the end of a  quarter.
Accordingly,  a  delay  in a  shipment  scheduled  to  occur  near  the end of a
particular  quarter could materially  adversely affect the Company's  results of
operations for that quarter.

         The  Company's  operating  results  have  historically  been subject to
significant  quarterly and annual  fluctuations.  The Company  believes that its
operating results will continue to fluctuate on a quarterly and annual basis due
to a variety of factors, including but not limited to the cyclical nature of the
industries  served by the  Company's  inspection  products,  patterns of capital
spending by customers, the timing of significant orders, order cancellations and
shipment rescheduling, market acceptance of the Company's products, fluctuations
in the grant and funding of development  contracts,  consolidation of



                                      -18-

<PAGE>

customers,  unanticipated  delays in design,  engineering  or  production  or in
customer  acceptance of product shipments,  changes in pricing by the Company or
its  competitors,  the timing of product  announcements  or introductions by the
Company or its competitors, the mix of systems sold, the relative proportions of
product  revenues  and  service  revenues,  the  timing  of  payments  of  sales
commissions,  the  availability  of  components  and  subassemblies,  changes in
product  development costs,  expenses  associated with acquisitions and exchange
rate  fluctuations.  Over the last three years,  the Company's  gross margin has
fluctuated  and the Company  anticipates  that its gross margin will continue to
fluctuate.  The Company  cannot predict the impact of these and other factors on
its financial performance in any future period.

         CONCENTRATION  OF  CUSTOMERS.  Historically,  the  Company  has  sold a
significant  proportion of its systems to a limited number of customers as a few
major   companies   primarily   dominate   the  markets  in  which  the  Company
participates.  Sales  to the  Company's  ten  largest  customers  accounted  for
approximately 95% of net sales for each of the years ended December 31, 1997 and
December 31, 1998. Sales to the largest customer accounted for approximately 49%
and 55% of net sales for the years  ended  December  31, 1997 and  December  31,
1998,  respectively.  The failure to replace sales with sales to other customers
in  succeeding  periods  would have a material  adverse  effect on the Company's
business,  financial  condition and results of operations.  The Company  expects
that sales to  relatively  few  customers  will  continue  to account for a high
percentage of the Company's revenues in any accounting period in the foreseeable
future.  A reduction in orders from any such customer or the cancellation of any
significant  order  could  have a  material  adverse  effect  on  the  Company's
business,  financial condition and results of operations.  None of the Company's
customers  has entered into a long-term  agreement  requiring it to purchase the
Company's products.

         RAPID TECHNOLOGICAL CHANGE AND DEPENDENCE ON PRODUCT  DEVELOPMENT.  The
semiconductor, computer hard disk and flat panel display industries, in general,
are   characterized  by  rapid   technological   advances,   changing   customer
requirements, evolving industry standards and frequent new product introductions
and enhancements. As a result, the Company must continue to enhance its existing
products and develop and  manufacture  new products and upgrades  with  improved
capabilities,  which has  required  and will  continue  to  require  substantial
investments  in research and  development  by the Company to advance a number of
state-of-  the-art   technologies.   Continuous   investments  in  research  and
development   will  also  be  required  to  respond  to  the  emergence  of  new
technologies. The failure to develop, manufacture and market new products, or to
enhance existing products, would have a material adverse effect on the Company's
business,  financial  condition  and  results of  operation.  In  addition,  the
Company's  competitors  can be expected to continue to develop and introduce new
and enhanced  products,  any of which could cause a decline in market acceptance
of the Company's products or a reduction in the Company's margins as a result of
intensified price competition.

         The  Company's  success in  developing  and  selling  new and  enhanced
products  depends upon a variety of factors,  including  accurate  prediction of
future  customer  requirements,   introduction  of  new  products  on  schedule,
cost-effective manufacturing and product performance in the field. The Company's
new product decisions and development  commitments must anticipate the equipment
needed to satisfy  requirements  for  inspection  processes  one year or more in
advance of sales. Any failure to predict accurately customer requirements and to
develop new  generations  of products  to meet those  requirements  would have a
sustained material adverse effect on the Company's business, financial condition
and results of operations.  New product transitions could adversely affect sales
of existing systems, as customers may defer ordering products from the Company's
existing  product lines.  Product  introductions  could  contribute to quarterly
fluctuations in operating results as orders for new products commence and orders
for existing  products or enhancements of existing  products  fluctuate.  If new
products have  reliability  or quality  problems,  then reduced  orders,  higher
manufacturing  costs,  delays in collecting  accounts  receivable and additional
service and  warranty  expense may result.  There can be no  assurance  that the


                                      -19-

<PAGE>


Company  will  successfully  develop and  manufacture  new  products or that any
product  enhancements or new products  developed by the Company will gain market
acceptance.  There can be no assurance  that the Company will be able to develop
enhancements  and new products  successfully or in time to meet emerging demand,
or that enhancements and new products  developed by the Company will be accepted
by the Company's customers.

         COMPETITION.  The  markets  in which the  Company  competes  are highly
competitive  and are  characterized  by  rapid  technological  change,  evolving
industry  standards,   rapid  product   obsolescence  and  intense  competition.
Competitors in the  semiconductor  photomask  inspection market include Hitachi,
Horiba,  KLA Instruments and Nikon. In the computer hard disk inspection  market
competitors  include DPI Technology Systems,  Hitachi,  Phase Metrics and System
Seiko.  Based on the  number of  installations,  the  Company  believes  it is a
leading supplier of semiconductor  photomask soft defect inspection  systems and
computer hard disk inspection systems in the United States. The Company competes
based on its installed base of customers,  engineering and service capabilities,
breadth of products, patents and proprietary information,  and reputation.  Many
of the Company's  competitors and potential  competitors have greater financial,
marketing  and  technological  resources  than  the  Company.  There  can  be no
assurance that companies with  complementary  technologies and greater financial
resources will not enter these industries and develop products that are superior
to the Company's products or achieve market acceptance.

         A  substantial  investment  is  required  by  customers  to install and
integrate  capital  equipment  into  a  production  line.  As a  result,  once a
manufacturer has selected a particular  vendor's capital  equipment,  management
believes  that the  manufacturer  generally  relies upon that  equipment for the
specific  production line application and frequently will attempt to consolidate
its other capital equipment requirements with the same vendor. Accordingly, if a
particular  customer  selects a  competitor's  capital  equipment,  the  Company
expects to  experience  difficulty in selling to that customer for a significant
period of time.

         The Company expects competition to continue in the future from existing
competitors  and from other  companies that may enter the Company's  existing or
future markets with similar or alternative  solutions that may be less costly or
provide  additional  features.  The Company believes that its ability to compete
successfully  depends on a number of factors,  which include product quality and
performance, order turnaround, the provision of competitive design capabilities,
success  in  developing  new  applications,   adequate  manufacturing  capacity,
efficiency of production,  timing of new product  introductions  by the Company,
its  customers  and its  competitors,  the number  and  nature of the  Company's
competitors in a given market, price and general market and economic conditions.
In  addition,  increased  competitive  pressure  may lead to  intensified  price
competition, resulting in lower prices and gross margins, which could materially
adversely affect the Company's business and results of operations.  No assurance
can be given that the Company will compete successfully in the future.

         Changes in manufacturing processes could also have a materially adverse
effect on the Company's business, financial condition and results of operations.
The Company anticipates  continued changes in semiconductor,  computer hard disk
and flat panel display  technologies  and  processes.  No assurance can be given
that the Company will be able to develop,  manufacture  and sell  products  that
respond adequately to such changes.


         ASIAN ECONOMIES.  Asian countries are having economic difficulties that
are causing  economic  slowdowns or recessions in those  countries.  The current
trend in foreign exchange rates raises the cost of equipment manufactured in the
United States to Asian companies.  Furthermore,  it makes equipment



                                      -20-

<PAGE>

manufactured  in Asia  more  price  competitive  to  local  customers  than  the
equipment of the Company. The region does not appear to be responding to efforts
to stimulate its economies.  Asia has historically  been an important region for
the  semiconductor,  computer hard disk and flat panel display capital equipment
industry.  If these economies do not recover in the near future, the recovery in
the capital equipment  industry may be extended in time or reduced in scale. The
economic  difficulties  of these  countries could also have a negative impact on
the economies of the U.S. and Europe,  leading to further declines in demand for
the Company's products.

         YEAR 2000. The Year 2000 issue is the result of computer programs using
two digits rather than four to define the applicable  year. Any of the Company's
computer  programs  or  hardware  or other  equipment  that have  date-sensitive
software  or  embedded  chips may  recognize  a date using "00" as the year 1900
rather  than  the  year  2000.   This  could  result  in  a  system  failure  or
miscalculations  causing  disruptions  of  operations,  including,  among  other
things, a temporary inability to process  transactions,  send invoices or engage
in similar normal business activities.

         The Company uses computer software programs in its internal operations,
such as for performing  administrative and financial functions.  The Company has
tested  its  key  internal  systems  and  implemented  remedial  measures  where
necessary. The Company is also contacting its significant suppliers to determine
those  whose  failure to be Year 2000  compliant  could  seriously  disrupt  the
Company's  business  operations.  The Company expects to complete this review by
the second quarter of 1999.

         Based on the Company's on-going review of its equipment in operation at
customer sites,  the Company  believes that a number of its systems are not Year
2000 compliant.  The Company has been and will continue to contact its customers
and offer  modifications  to make such systems Year 2000 compliant.  The Company
estimates  that the costs  incurred to remediate  Year 2000 problems  related to
noncompliant  products will not  materially  adversely  affect its operations or
financial condition.

         At this time,  the Company  cannot give any  assurance  that it will be
successful in completing its planned actions to become Year 2000 compliant on or
before the Year 2000. Additionally,  no assurance can be given that instances of
noncompliance  which  could  have a  material  adverse  effect on the  Company's
operations or financial condition will be identified;  that the systems of other
companies  with which the Company  transacts  business  will be  corrected  on a
timely basis;  that a failure by such entities to correct a Year 2000 problem or
a conversion which is incompatible  with the Company's  systems would not have a
material adverse effect on the Company's operations or financial  condition;  or
that even if all planned actions are completed,  the Company will not experience
some adverse effects from Year 2000 related issues.

         PATENTS AND  PROPRIETARY  INFORMATION.  The Company's  patent and trade
secret rights are of material importance to the Company and its future prospects
because the Company  relies on these rights to protect  proprietary  technology.
The Company  attempts to protect its  proprietary  technology  through  patents,
copyrights,  trademarks and trade  secrets.  No assurance can be given as to the
issuance of additional patents or, if so issued, as to their scope and validity.
Patents granted may not provide meaningful protection from competitors.  Even if
a competitor's  products were to infringe patents owned by the Company, it would
be costly for the  Company to  enforce it rights in an  infringement  action and
would  divert  funds and  other  resources  from the  Company's  operations.  In
addition,  effective  patent,  copyright  and  trade  secret  protection  may be
unavailable or limited in certain foreign  countries.  No assurance can be given
that the Company'  products or processes  will not infringe any patents or other
intellectual  property  rights of third  parties.  If the Company's  products or
processes do infringe  the rights of third  parties,  no assurance  can be given
that the Company can obtain a license from the  intellectual  property  owner on
commercially reasonable terms or at all.


                                      -21-

<PAGE>



         Some  customers  using certain  products of the Company have received a
notice of  infringement  from the Lemelson  Foundation,  alleging that equipment
used in the manufacture of semiconductor  products  infringes  patents issued to
Mr. Jerome H. Lemelson  relating to "computer image analysis" or "digital signal
generation and analysis."  Certain of these  customers have notified the Company
that they may seek indemnification from the Company for any damages and expenses
resulting from this matter. Neither the Company nor any of its products has been
identified by the Lemelson Foundation as infringing its patents. There can be no
assurance, however, that the Lemelson Foundation would not bring a claim against
the  Company for  infringement  or that the  Company  would  prevail in any such
action.  If the  Lemelson  Foundation  were to prevail in any such  action,  the
Company  might be required to pay license fees or  royalties to the  Foundation,
which could have an adverse impact on the Company' s profitability.

         The Company relies on trade secrets that it seeks to protect,  in part,
through, confidentiality agreement with employees, consultants and its customers
and potential  customers.  No assurance can be given that these  agreements will
not be breached,  that the Company will have adequate remedies for any breach or
that  the  Company's  trade  secrets  will  not  otherwise  become  known  to or
independently  developed by  competitors.  As the Company intends to enforce its
patents,  trademarks and  copyrights  and protect its trade  secrets,  it may be
involved from time to time in litigation to determine the enforceability,  scope
and validity of these rights.  Any such  litigation  could result in substantial
cost to the Company and  diversion  of effort by the  Company's  management  and
technical personnel.

         DEPENDENCE  ON  SUPPLIERS.  The Company does not maintain any long-term
supply  agreements  with any of its  suppliers  and the majority of the critical
components  and  subassemblies  included in the Company's  products are obtained
from a limited group of suppliers.  The  manufacture  of certain  components and
subassemblies  is very  complex and requires  long lead times and the  Company's
systems cannot be produced  without certain critical  components.  Additionally,
alternative suppliers for many of these components may not be readily available,
and  no  substantial  increase  in  the  number  of  alternative   suppliers  is
anticipated.  The  Company  intends to  continue  to rely on  outside  suppliers
because of their  specialized  expertise in component  fabrication and subsystem
assembly.  The  Company's  reliance  on a limited  group of  suppliers  involves
several risks, including the potential inability to obtain an adequate supply of
components  and reduced  control over pricing and delivery  time.  To date,  the
Company  has  generally  been able to obtain  adequate  and timely  delivery  of
critical  subassemblies and components,  although it has experienced  occasional
delays.  There can be no assurance that delays or shortages  caused by suppliers
will  not  occur  in the  future.  Any  inability  to  obtain  adequate,  timely
deliveries  of  subassemblies  and  components  could  prevent the Company  from
meeting scheduled shipment dates, which would damage  relationships with current
and  prospective   customers  and  materially  adversely  affect  the  Company's
business, financial condition and results of operations.

         RISKS  OF  ACQUISITIONS.   The  Company's  business  strategy  includes
expanding its product lines and markets  through  internal  product  development
and/or acquisitions.  Although no acquisitions are currently contemplated by the
Company,  any acquisition may result in potentially dilutive issuances of equity
securities, the incurrence of debt and contingent liabilities,  and amortization
expense related to intangible  assets  acquired,  any of which could  materially
adversely affect the Company's financial condition and results of operations. In
addition,   acquired  businesses  may  be  experiencing  operating  losses.  Any
acquisition  will  involve  numerous  risks,   including   difficulties  in  the
assimilation of the




                                      -22-

<PAGE>

acquired  Company's  operations  and  products,  the  diversion of  management's
attention from other business concerns,  uncertainties associated with operating
in new markets and working with new  customers,  and the  potential  loss of the
acquired company's key employees.  To date, the Company has had no experience in
acquisitions.  There  can be no  assurance  that  any such  integration  will be
accomplished smoothly or successfully.  The difficulties of such integration may
be increased by the necessity of coordinating organizations, which are separated
geographically.  The  inability of  management  to  successfully  integrate  the
operations of such acquired  businesses  could have a material adverse effect on
the business and results of operations of the Company.

         VOLATILITY  OF STOCK PRICE.  The stock market in general and the market
for shares of technology  companies in particular have experienced extreme price
fluctuations,  which have often been  unrelated to the operating  performance of
the affected  companies.  Many companies in the  semiconductor and computer hard
disk industries,  including the Company have experienced  dramatic volatility in
the market prices of their common stock.  The Company believes that factors such
as  announcements  of  developments  related to the  Company's  business  or its
competitors' or customers'  businesses,  fluctuations in the Company's financial
results, general conditions or developments in the semiconductor,  computer hard
disk drive and flat panel display industries and the worldwide economy, sales of
the Common Stock into the market,  announcements of technological innovations or
new or  enhanced  products  by the Company or its  competitors,  a shortfall  in
revenue,  gross  margin,  earnings  or other  financial  results  or  changes in
research  analysts'  expectations,  the limited number of shares of Common Stock
traded on a daily basis,  or a variety of factors  beyond the Company's  control
could  cause the  price of the  Company's  Common  Stock to  fluctuate,  perhaps
substantially.  There can be no assurance that the market price of the Company's
Common  Stock  will  not  experience  significant  fluctuations  in the  future,
including fluctuations that are material, adverse and unrelated to the Company's
performance.

         CONTROL BY EXISTING STOCKHOLDERS.  The QC Optics, Inc. Voting Trust and
Kobe  Steel  USA  Holdings,  Inc.  beneficially  own  approximately  69%  of the
Company's  outstanding shares of Common Stock.  Accordingly,  these stockholders
acting  together have the ability to control all matters  requiring  approval by
the  stockholders  of the Company,  including  the election of  directors.  This
concentration  of ownership may also have the effect of delaying or preventing a
change of control of the Company.

         RISKS ASSOCIATED WITH INTERNATIONAL SALES AND OPERATIONS.  Based on the
location to which  products  were shipped or services  were  rendered,  sales to
customers in countries  other than the United States  accounted for 53%, and 66%
of net  sales  in  Fiscal  1997  and  Fiscal  1998,  respectively.  The  Company
anticipates that the international shipments, principally to Japan, Thailand and
Malaysia,  will continue to account for a  significant  portion of net sales for
the foreseeable  future.  Sales and operations  outside of the United States are
subject to certain inherent risks, including fluctuations in the value of the U.
S.  dollar  relative to foreign  currencies,  tariffs,  quotas,  taxes and other
market barriers, political and economic instability,  restrictions on the export
or import of technology,  potentially limited intellectual  property protection,
difficulties in staffing and managing  international  operations and potentially
adverse tax  consequences.  There can be no assurance  that any of these factors
will not have a material  adverse  effect on the Company's  business,  financial
condition  or  results in  operations.  In  particular  although  the  Company's
international  sales  are  primarily  denominated  in U.  S.  dollars,  currency
exchange  fluctuations  in  countries  where the  Company  does  business  could
materially  adversely  affect the Company's  business,  financial  condition and
results of  operations  by  rendering  the Company less  price-competitive  than
foreign manufacturers.

         LENGTHY SALES CYCLE.  Installing and integrating  inspection  equipment
requires a substantial  investment by a customer.  In addition,  customers often
require a significant  number of product  presentations and  demonstrations,  as
well as substantial  interaction  with the Company's senior


                                      -23-

<PAGE>


management,  before  reaching a sufficient  level of  confidence in the system's
performance   characteristics  and  compatibility  with  the  customer's  target
applications.  Accordingly, the Company's systems typically have a lengthy sales
cycle during which the Company may expend  substantial funds and management time
and effort with no assurance that a sale will result.

         HEALTH AND SAFETY REGULATIONS AND STANDARDS. The Company's products and
worldwide operation are subject to numerous governmental regulations designed to
protect  the health and  safety of  operators  of  manufacturing  equipment.  In
particular,  the European Union ("EU")  regulations  relating to electromagnetic
fields,  electrical  power  and  human  exposure  to laser  radiation  have been
implemented.  In  addition,   numerous  domestic  semiconductor   manufacturers,
including  certain of the  Company's  customers,  have  subscribed  to voluntary
health and safety  standards and decline to purchase  equipment not meeting such
standards.  The Company  believes  that its products  currently  comply with all
applicable  material  governmental  health and safety regulations and standards,
including those of the EU, and with the voluntary industry  standards  currently
in effect.  In part because the future scope of these and other  regulations and
standards  cannot be predicted,  there can be no assurance that the Company will
be able to comply with any future regulation or industry standard. Noncompliance
could result in  governmental  restrictions  on sales or  reductions in customer
acceptance of the Company's  products.  Compliance may also require  significant
product  modifications;  potentially  resulting in increased  costs and impaired
product performance.

         DEPENDENCE  ON KEY  PERSONNEL  AND  POSSIBLE  LACK OF  AVAILABILITY  OF
QUALIFIED  PERSONNEL.  The  Company  is  dependent  to a  large  degree  on  the
experience and abilities of its Chief Executive Officer, President and Chairman,
Eric T. Chase, and its Vice President of Technology,  Jay L. Ormsby. The loss of
the services of either of these individuals could have a material adverse effect
on the Company. The Company has entered into employment  agreements,  containing
noncompetition restrictions,  with each of Messrs. Chase and Ormsby. The Company
is the sole  beneficiary  of key person  life  insurance  policies,  each in the
amount of $1,000,000, on the lives of Messrs. Chase and Ormsby.

         The Company's  future success and growth  strategy will depend in large
part upon its ability to attract and retain highly skilled managerial, technical
and  marketing  personnel.  Competition  for  such  personnel  in the  Company's
industry  is  intense.  No  assurance  can be  given  that the  Company  will be
successful in attracting or retaining the qualified  personnel necessary for its
business  and  anticipated  growth,  and the  failure to attract or retain  such
personnel  could  have a  material  adverse  effect on the  Company's  business,
financial conditions and results of operations.



                                      -24-

<PAGE>



ITEM 7.           FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

         The following financial statements are filed as part of this report:

PAGE

Report of Independent Public Accountants   ...............................   F-2
Balance Sheets as of December 31, 1997 and December 31, 1998..............   F-3
Statements of Operations for the years ended December 31, 1997 and
   December 31, 1998......................................................   F-4
Statements of Stockholders' Equity for the years ended
   December 31, 1997 and December 31, 1998................................   F-5
Statements of Cash Flows for the years ended December 31, 1997
   and December 31, 1998..................................................   F-6
Notes to Financial Statements.............................................   F-7


ITEM 8. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
        DISCLOSURE.

         During the two most recent fiscal years of the Company, there have been
no changes in the Company's  independent  public  accountants  or  disagreements
between the Company and its independent public accountants.

                                    PART III


ITEM 9.  DIRECTORS,  EXECUTIVE  OFFICERS AND CONTROL  PERSONS;  COMPLIANCE  WITH
         SECTION 16(A) OF THE EXCHANGE ACT.

         The Company  intends to file a Definitive  Proxy  Statement  within 120
days of the completion of the Company's fiscal year ended December 31, 1998. The
information  required by this item is  incorporated  by reference from the Proxy
Statement.

ITEM 10. EXECUTIVE COMPENSATION.

         The information required by this Item is incorporated by reference from
the Proxy  Statement,  to be filed with the  Commission  not later than 120 days
after the close of the Company's fiscal year ended December 31, 1998.

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

         The information required by this Item is incorporated by reference from
the Proxy  Statement,  to be filed with the  Commission  not later than 120 days
after the close of the Company's fiscal year ended December 31, 1998.



                                      -25-

<PAGE>


ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

       The  information  required by this Item is incorporated by reference from
the Proxy  Statement,  to be filed with the  Commission  not later than 120 days
after the close of the Company's fiscal year ended December 31, 1998.

13.      EXHIBITS AND REPORTS ON FORM 8-K.

         (A)      EXHIBITS.

                  (1)      The following exhibits are filed herewith:

Exhibit
  No.                      Title
------                     -----
  23              Consent of Arthur Andersen LLP.

  27              Financial Data Schedule.


                  (2) The following exhibits were filed as part of the Company's
Quarterly  Report on Form  10-QSB for the  quarter  ended June 30,  1998 and are
incorporated herein by reference:


Exhibit
  No.                               Title
-------                             -----
10h               Allonge to Promissory Note of the Company to State Street Bank
                  and Trust Company ("State Street"), dated June 29, 1998.

10j               Amended  and  Restated  Credit  Agreement  by and  between the
                  Company and State Street, dated June 29, 1998.


                  (3) The following exhibits were filed as part of the Company's
Annual  Report on Form  10-KSB  for the year  ended  December  31,  1997 and are
incorporated herein by reference:

Exhibit
  No.                               Title
-------                             -----
10a               Sublease  Agreement  between  the  Company  and  Advanced  NMR
                  Systems  (now known as Caprius,  Inc.),  dated as of April 15,
                  1997.

                  (4) The following exhibits were filed as part of the Company's
Registration  Statement on Form SB-2 (No. 333-07683),  declared effective by the
Commission on October 24, 1996 and are incorporated herein by reference:

Exhibit
  No.                               Title
-------                             -----
  3a              Certificate of Incorporation, as amended.

  3b              Bylaws, as amended.




                                      -26-

<PAGE>



  4a              Sections of Bylaws and Certificate of  Incorporation  defining
                  the rights of security  holders  (contained in Exhibits 3a and
                  3b).

  4b              Specimen Common Stock Certificate.

  4c              Form of Representative's Warrant Agreement (revised).

  4e              Specimen Warrant Certificate.

  4f              Form of Warrant  Agreement between the Company and the Warrant
                  Agent.

  9               QC Optics  Voting  Trust u/d/t dated as of October 27, 1995 by
                  and among Eric T. Chase, as trustee,  and Eric T. Chase,  Karl
                  Andrew Bernal, Jay L. Ormsby, John R. Freeman, Albert E. Tobey
                  and Abdu Boudour.

  10p             1996 Stock Option Plan.

  10q             1996 Director Formula Stock Option Plan.

  10r             Form of  Employment  Agreements  effective  as of July 1, 1996
                  entered into by and between the Company and Eric T. Chase, Jay
                  L. Ormsby, Albert E. Tobey and Abdu Boudour.

          (B)     REPORTS ON FORM 8-K.

         No reports on Form 8-K have been filed by the  Company  during the last
quarter of the period covered by this report.




                                      -27-

<PAGE>




                                   SIGNATURES

         In accordance  with Section 13 or 15(d) of the Securities  Exchange Act
of 1934,  as  amended,  the  registrant  caused  this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

                                         QC OPTICS, INC.
                                         ---------------


                                         By:/s/ Eric T. Chase
                                           -------------------------------------
                                           Eric T. Chase
                                           President and Chief Executive Officer


         In accordance  with the Exchange Act, this report has been signed below
by the following  persons on behalf of the  registrant and in the capacities and
on the dates indicated.

<TABLE>
<CAPTION>

         Name                                        Capacity                           Date
         ----                                        --------                           ----

<S>                                        <C>                                         <C> 
/s/ Eric T. Chase                           President, Chief Executive Officer,         March 22, 1999
----------------------------------          and Chairman of the Board of
Eric T. Chase                               Directors (Principal Executive
                                            Officer)

/s/ Richard C. Allard                       Vice President of Finance and               March 22, 1999
----------------------------------          Treasurer (Principal Financial
Richard C. Allard                           and Principal Accounting Officer)


/s/ Allan Berman                            Director                                    March 22, 1999
---------------------------------
Allan Berman

/s/ John M. Tarrh                           Director                                    March 22, 1999
---------------------------------
John M. Tarrh

</TABLE>



                                      -28-

<PAGE>


                                 QC OPTICS, INC.

                                      INDEX

<TABLE>
<CAPTION>

                                                                                                                 PAGE
                                                                                                                 ----
<S>                                                                                                             <C>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS                                                                         F-2

BALANCE SHEETS AS OF DECEMBER 31, 1997 AND 1998                                                                  F-3

STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1998                                          F-4

STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31,
1997 AND 1998                                                                                                    F-5

STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1998                                          F-6

NOTES TO FINANCIAL STATEMENTS                                                                                    F-7

</TABLE>


                                      F-1
<PAGE>


                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS



To QC Optics, Inc.:

We have audited the accompanying  balance sheets of QC Optics,  Inc. (a Delaware
corporation)  as of December 31, 1997 and 1998,  and the related  statements  of
operations, stockholders' equity and cash flows for the years ended December 31,
1997  and  1998.  These  financial  statements  are  the  responsibility  of the
Company's  management.  Our  responsibility  is to  express  an opinion on these
financial statements based on our audits.

We  conducted  our  audits  in  accordance  with  generally   accepted  auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion,  the financial  statements  referred to above present fairly, in
all material respects,  the financial position of QC Optics, Inc. as of December
31, 1997 and 1998,  and the results of its operations and its cash flows for the
years ended December 31, 1997 and 1998, in conformity  with  generally  accepted
accounting principles.




                                                            ARTHUR ANDERSEN LLP




Boston, Massachusetts
February 12, 1999


                                      F-2

<PAGE>


                                 QC OPTICS, INC.

                   BALANCE SHEETS--DECEMBER 31, 1997 AND 1998

                                     ASSETS
<TABLE>
<CAPTION>

                                                                                          1997              1998
                                                                                          ----              ----
<S>                                                                                       <C>              <C>
CURRENT ASSETS:
   Cash and cash equivalents                                                           $   3,766,534    $   3,313,889
   Accounts receivable, less allowance of $50,000 at December 31, 1997 and 1998            2,509,002        1,897,564
   Inventory                                                                               4,025,428        3,732,134
   Prepaid expenses                                                                           76,974           68,001
                                                                                     ---------------  ---------------

         Total current assets                                                             10,377,938        9,011,588
                                                                                     ---------------  ---------------

PROPERTY AND EQUIPMENT, AT COST:
   Furniture and fixtures                                                                    189,350          217,024
   Machinery and equipment                                                                   342,609          345,787
   Leasehold improvements                                                                     76,714           76,714
   Motor vehicles                                                                             21,574           21,574
                                                                                     ---------------  ---------------

                                                                                             630,247          661,099

   Less--Accumulated depreciation                                                            402,528          484,974
                                                                                     ---------------  ---------------

         Property and equipment, net                                                         227,719          176,125
                                                                                     ---------------  ---------------

DEFERRED TAX ASSETS                                                                          349,500          243,500
                                                                                     ---------------  ---------------

OTHER ASSETS                                                                                  82,924           35,656
                                                                                     ---------------  ---------------

         Total assets                                                                  $  11,038,081    $   9,466,869
                                                                                       =============    =============

                                         LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
   Accounts payable                                                                    $     742,563    $     119,414
   Accrued payroll and related expenses                                                      457,505          271,244
   Accrued commissions                                                                        59,894            9,615
   Accrued income taxes                                                                      221,789                -
   Accrued expenses                                                                          642,923          455,491
   Customer deposits                                                                         645,817          132,432
                                                                                     ---------------  ---------------

         Total current liabilities                                                         2,770,491          988,196
                                                                                     ---------------  ---------------

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY:
   Preferred stock, $.01 par value-
     Authorized--1,000,000 shares
     Issued and outstanding--No shares at December 31, 1997 and 1998                                -                -
   Common stock, $.01 par value-
     Authorized--10,000,000 shares
     Issued and outstanding--3,242,500 shares at December 31, 1997 and 1998                   32,425           32,425
   Additional paid-in capital                                                              9,902,886        9,902,886
   Accumulated deficit                                                                    (1,667,721)      (1,456,638)
                                                                                     ---------------  ---------------

         Total stockholders' equity                                                        8,267,590        8,478,673
                                                                                     ---------------  ---------------

         Total liabilities and stockholders' equity                                    $  11,038,081    $   9,466,869
                                                                                       =============    =============

</TABLE>

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


                                      F-3

<PAGE>


                                 QC OPTICS, INC.

                            STATEMENTS OF OPERATIONS
                 FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1998

<TABLE>
<CAPTION>

                                                                                          1997              1998
                                                                                          ----              ----
<S>                                                                                     <C>               <C>
NET SALES                                                                            $   10,091,834   $    9,909,876

COST OF SALES                                                                             4,786,110        5,248,844
                                                                                     --------------   --------------

         Gross profit                                                                     5,305,724        4,661,032
                                                                                     --------------   --------------

OPERATING EXPENSES:
   Selling, general and administrative expenses                                           3,785,536        3,315,869
   Engineering expenses                                                                   1,316,469        1,196,393
                                                                                     --------------   --------------

         Total operating expenses                                                         5,102,005        4,512,262
                                                                                     --------------   --------------

         Operating income                                                                   203,719          148,770

INTEREST INCOME                                                                             202,434          190,074

INTEREST EXPENSE                                                                            (13,957)          (8,961)
                                                                                     --------------   --------------

         Income before provision for income taxes                                           392,196          329,883

PROVISION FOR INCOME TAXES                                                                  146,900          118,800
                                                                                     --------------   --------------

         Net income                                                                  $      245,296   $      211,083
                                                                                     ==============   ==============

BASIC AND DILUTED NET INCOME PER COMMON AND COMMON EQUIVALENT SHARE                          $ 0.08           $ 0.06
                                                                                             ======           ======

BASIC WEIGHTED AVERAGE COMMON SHARES OUTSTANDING                                          3,242,500        3,242,500
                                                                                     ==============   ==============

DILUTED WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT SHARES OUTSTANDING                  3,245,478        3,251,465
                                                                                     ==============   ==============
</TABLE>

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


                                      F-4

<PAGE>


                                 QC OPTICS, INC.

                       STATEMENTS OF STOCKHOLDERS' EQUITY
                 FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1998
<TABLE>
<CAPTION>

                              PREFERRED STOCK              COMMON STOCK
                                                                                     ADDITIONAL                           TOTAL
                              NUMBER OF   PAR       NUMBER OF                         PAID-IN         ACCUMULATED      STOCKHOLDERS'
                               SHARES    VALUE       SHARES           PAR VALUE       CAPITAL           DEFICIT           EQUITY
<S>                               <C>   <C>        <C>          <C>               <C>              <C>               <C>
BALANCE, DECEMBER 31, 1996          -    $   -      3,242,500    $       32,425    $    9,902,886   $   (1,913,017)   $    8,022,294

   Net income                       -        -              -                 -                 -          245,296           245,296
                                -----    -----   ------------    --------------    --------------   --------------    --------------

BALANCE, DECEMBER 31, 1997          -        -      3,242,500            32,425         9,902,886       (1,667,721)        8,267,590

   Net income                       -        -              -                 -                 -          211,083           211,083
                                -----    -----   ------------    --------------    --------------   --------------    --------------

BALANCE, DECEMBER 31, 1998          -    $   -      3,242,500    $       32,425    $    9,902,886   $   (1,456,638)   $    8,478,673
                                =====    =====   ============    ==============    ==============   ==============    ==============
</TABLE>




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


                                      F-5


<PAGE>


                                 QC OPTICS, INC.

                            STATEMENTS OF CASH FLOWS
                 FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1998
<TABLE>
<CAPTION>

                                                                                          1997              1998
<S>                                                                                 <C>              <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net income                                                                        $       245,296  $       211,083
                                                                                     ---------------  ---------------
   Adjustments to reconcile net income to net cash used in operating activities-
     Depreciation and amortization                                                            74,169           82,446
     (Increase) decrease in deferred taxes, net                                             (141,500)         106,000
     Changes in operating assets and liabilities-
       Accounts receivable                                                                  (624,308)         611,438
       Inventory                                                                            (642,368)         293,294
       Prepaid expenses and other assets                                                     (65,358)          56,241
       Accounts payable                                                                       58,716         (623,149)
       Accrued expenses                                                                     (467,106)        (645,761)
       Customer deposits                                                                     488,255         (513,385)
                                                                                     ---------------  ---------------

              Total adjustments                                                           (1,319,500)        (632,876)
                                                                                     ---------------  ---------------

              Net cash used in operating activities                                       (1,074,204)        (421,793)
                                                                                     ---------------  ---------------

CASH FLOWS FROM INVESTING ACTIVITIES:
   Purchase of property and equipment                                                       (182,034)         (30,852)
                                                                                     ---------------  ---------------

              Net cash used in investing activities                                         (182,034)         (30,852)
                                                                                     ---------------  ---------------

CASH FLOWS FROM FINANCING ACTIVITIES:                                                              -                -
                                                                                     ---------------  ---------------

NET DECREASE IN CASH AND CASH EQUIVALENTS                                                 (1,256,238)        (452,645)

CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR                                               5,022,772        3,766,534
                                                                                     ---------------  ---------------

CASH AND CASH EQUIVALENTS, END OF YEAR                                               $     3,766,534  $     3,313,889
                                                                                     ===============  ===============

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
   Cash paid for-
     Interest                                                                        $        14,422  $         9,177
                                                                                     ===============  ===============

     Income taxes                                                                    $       535,811  $       242,450
                                                                                     ===============  ===============


</TABLE>

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


                                      F-6

<PAGE>


                                 QC OPTICS, INC.

                          NOTES TO FINANCIAL STATEMENTS
                                DECEMBER 31, 1998




(1)    DESCRIPTION OF BUSINESS

       QC  Optics,  Inc.  (the  Company)  was  formed  in 1986 and  manufactures
       high-end   critical   surface   inspection   systems  for  sales  to  the
       semiconductor, flat panel display and computer hard disk industries.

(2)    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

       Revenue Recognition

       Revenues from product sales and the sale of spare parts are recognized at
       the time  equipment is shipped.  Revenues  from  service and  maintenance
       agreements  are  recognized  ratably  over  the  period  covered  by  the
       agreement. Net sales of the Company by products,  spares and service were
       as follows:

                                               FOR THE YEARS ENDED
                                              1997             1998

          Products                      $    8,350,828    $    8,479,725
          Spares and service                 1,741,006         1,430,151
                                        --------------    --------------

          Total sales                   $   10,091,834    $    9,909,876
                                        ==============    ==============

       The Company derives most of its annual  revenues from a relatively  small
       number of sales of products, systems and upgrades. As a result, any delay
       in the  recognition  of revenue for a single  product,  system or upgrade
       could  have a  material  adverse  effect  on  the  Company's  results  of
       operations  for a  given  accounting  period.  In  addition,  some of the
       Company's  net  sales  have  been  realized  near  the end of a  quarter.
       Accordingly,  a delay in a shipment  scheduled to occur near the end of a
       particular  quarter could have a material adverse affect on the Company's
       results of operations for that quarter.

       The  Company's  operating  results  have  historically  been  subject  to
       significant quarterly and annual fluctuations.  The Company believes that
       its  operating  results will  continue to  fluctuate  on a quarterly  and
       annual basis due to a variety of factors,  including the  cyclicality  of
       the industries served by the Company's inspection  products;  patterns of
       capital spending by customers;  the timing of significant  orders;  order
       cancellations  and  shipment  rescheduling;   market  acceptance  of  the
       Company's products;  consolidation of customers;  unanticipated delays in
       design,  engineering or production,  or in customer acceptance of product
       shipments;  changes in pricing by the Company or its competitors; the mix
       of systems sold; the relative proportions of product revenues and service
       revenues; the timing of payment of sales commissions;  changes in product
       development  costs;  expenses  associated with  acquisitions and exchange
       rate fluctuations and the availability of components and subassemblies.


                                      F-7
<PAGE>


                                 QC OPTICS, INC.

                          NOTES TO FINANCIAL STATEMENTS
                                DECEMBER 31, 1998

                                   (Continued)


       Warranty Costs

       The Company  accrues  warranty costs in the period the related revenue is
       recognized.

       RESEARCH AND DEVELOPMENT COSTS

       Research and development  costs are expensed as incurred and are included
       in  engineering  expenses in the  accompanying  statements of operations.
       Research and development  costs for the years ended December 31, 1997 and
       1998 amounted to approximately $440,000 and $415,000, respectively.

       CASH AND CASH EQUIVALENTS

       Cash and cash equivalents include highly liquid investments with original
       maturities of three months or less.

       INVENTORY

       Inventory is stated at the lower of cost (first-in,  first-out) or market
       and consists of the following:

                                                         DECEMBER 31,
                                                     1997             1998

        Raw materials and finished parts       $    1,931,130    $    1,815,183
        Work-in-process                             2,094,298         1,189,882
        Finished goods                                      -           727,069
                                               --------------    --------------

                                               $    4,025,428    $    3,732,134
                                               ==============    ==============

       Work-in-process  and finished goods inventories  include material,  labor
       and manufacturing overhead.

       PROPERTY AND EQUIPMENT

       Property and equipment are stated at cost.  Maintenance  and repair items
       are  charged to expense  when  incurred;  renewals  and  betterments  are
       capitalized. When property and equipment are retired or sold, their costs
       and related accumulated  depreciation are removed from the accounts,  and
       any resulting gain or loss is included in income.  Leasehold improvements
       are depreciated  over the life of the lease or useful life,  whichever is
       shorter.


                                      F-8
<PAGE>

                                 QC OPTICS, INC.

                          NOTES TO FINANCIAL STATEMENTS
                                DECEMBER 31, 1998

                                   (Continued)


       The Company provides for depreciation  using the straight-line  method to
       amortize  the cost of plant and  equipment  over their  estimated  useful
       lives, which are generally as follows:

            ASSET CLASSIFICATION                         ESTIMATED
                                                        USEFUL LIFE

            Furniture and fixtures                       3-8 years
            Machinery and equipment                      3-8 years
            Motor vehicles                               3-5 years

       INCOME TAXES

       The Company utilizes the liability method of accounting for income taxes,
       as set forth in Statement of Financial  Accounting  Standards  (SFAS) No.
       109,  Accounting for Income Taxes.  SFAS No. 109 requires the recognition
       of deferred  tax assets and  liabilities  for the  temporary  differences
       between the tax and financial  statement  carrying  amounts of assets and
       liabilities.  Deferred  tax assets are  recognized  net of any  valuation
       allowance.

       CONCENTRATION OF CREDIT RISK/SIGNIFICANT CUSTOMERS

       Financial   instruments  that   potentially   expose  the  Company  to  a
       concentration  of credit risk include  accounts  receivable  and cash and
       cash equivalents.

       The  Company  sells its  products  primarily  to a small  number of large
       corporate  customers  in  the  semiconductor,  flat  panel  displays  and
       computer hard disk drive industries and performs  ongoing  evaluations of
       its customers'  financial  conditions.  Concentration of credit risk with
       respect to sales and trade  receivables is significant  and summarized as
       follows:

<TABLE>
<CAPTION>

                                  NET SALES FOR THE              ACCOUNTS RECEIVABLE AS OF
                          YEARS ENDED DECEMBER 31,                     DECEMBER 31,
                               1997              1998             1997              1998
       <S>                  <C>               <C>              <C>              <C>
        Company A            $  4,956,000      $ 5,400,000      $  1,615,000     $  1,447,000
        Company B               1,043,000           10,000           224,000            2,000
        Company C                       -        1,693,000                 -            2,000

</TABLE>

       The  Company  maintains  its  cash  and  cash  equivalents  at  financial
       institutions in Massachusetts. Accounts at these institutions are insured
       by the Federal Deposit  Insurance  Corporation up to $100,000.  Uninsured
       cash  and  cash  equivalent  bank  balances   amounted  to  approximately
       $3,775,000 and $2,991,000 at December 31, 1997 and 1998, respectively.


                                      F-9
<PAGE>

                                 QC OPTICS, INC.

                          NOTES TO FINANCIAL STATEMENTS
                                DECEMBER 31, 1998

                                   (Continued)


       Net sales by country, denominated in U.S. dollars, were as follows, based
       on the  location  to which the  products  were  shipped  or the  services
       provided:

                                 FOR THE YEARS ENDED
                               1997              1998

        United States       $  4,757,722     $  3,453,854
        Japan                    697,974        1,906,440
        Thailand                 982,656        1,798,652
        Malaysia               1,376,947        2,486,663
        Other                  2,276,535          264,267

       FAIR VALUE OF FINANCIAL INSTRUMENTS

       The Company's  financial  instruments  consist primarily of cash and cash
       equivalents,  accounts  receivable  and  accounts  payable.  The carrying
       amounts of the Company's cash and cash equivalents,  accounts  receivable
       and  accounts  payable  approximate  fair  value due to their  short-term
       nature.

       USE OF ESTIMATES

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

       NET INCOME (LOSS) PER COMMON SHARE

       Basic earnings per common share is computed by dividing net income (loss)
       by the  weighted  average  number of shares of common  stock  outstanding
       during the year. Diluted earnings per common share is calculated the same
       as basic except,  if not  antidilutive,  stock options are included using
       the treasury  stock method to the extent that the average  share  trading
       price exceeds the exercise price. As of December 31, 1997 and 1998, there
       were  266,700 and 285,372  options  outstanding,  respectively.  Of these
       potentially  dilutive  securities,   70,647  and  116,424  qualified  for
       inclusion in the diluted  earnings per share  calculation for part of the
       years ended  December  31,  1997 and 1998,  respectively.  These  options
       yielded  incremental  shares of 11,910 and  8,849,  or  weighted  average
       incremental  shares  for the year of 2,978 and 8,965 for the years  ended
       December  31,  1997 and 1998,  respectively.  As a result,  the  year-end
       weighted  average shares  outstanding  were 3,245,478 and 3,251,465 as of
       December 31, 1997 and 1998, respectively.  Basic and diluted earnings per
       common  share for the years ended  December 31, 1997 and 1998 were equal;
       therefore,  no  reconciliation  between  basic and diluted  earnings  per
       common share is required.


                                      F-10

<PAGE>

                                 QC OPTICS, INC.

                          NOTES TO FINANCIAL STATEMENTS
                                DECEMBER 31, 1998

                                   (Continued)


       SEGMENT REPORTING

       In June 1997 the Financial  Accounting Standards Board (FASB) issued SFAS
       No.  131,  Disclosures  About  Segments  of  an  Enterprise  and  Related
       Information,  effective  for fiscal years  beginning  after  December 15,
       1997. SFAS No. 131 requires companies to report segment information using
       the  "management  approach"  of  organizing  the  Company.  Any  relevant
       divisions   within  the  Company,   whether  they  are   geographical  or
       product-line  related,  should be  disclosed  as a separate  segment  and
       should have a break out of various asset, liability,  revenue and expense
       information.  Based  upon QC  Optics'  analysis  of their  Company,  they
       believe  that  they  operate  in one  segment  and do not  analyze  their
       operations based upon separate georgraphical or product-line information.

(3)    INCOME TAXES

       The components of the income tax provision (benefit) are as follows:

                          FOR THE YEARS ENDED DECEMBER 31,
                                1997             1998

        Current-
           Federal        $     248,400     $     4,900
           State                 40,000           7,900
                          -------------     -----------
                                288,400          12,800
                          -------------     -----------
        Deferred-
           Federal             (120,275)         91,750
           State                (21,225)         14,250
                          -------------     -----------
                               (141,500)        106,000
                          -------------     -----------
                          $     146,900     $   118,800
                          =============     ===========

       The Company's  effective tax rate differs from the federal statutory rate
       of 34% in 1997 and 1998 due to the following:
<TABLE>
<CAPTION>

                                                                       1997             1998
       <S>                                                       <C>               <C>
        Computed tax provision at statutory rate                  $      133,347    $      112,160

        Increase resulting from-
            State taxes                                                    3,855               971
            Items not deductible for income tax purposes                   9,698             5,669
                                                                 ---------------   ---------------
                                                                  $      146,900    $      118,800
                                                                  ==============    ==============

</TABLE>


                                      F-11

<PAGE>

                                 QC OPTICS, INC.

                          NOTES TO FINANCIAL STATEMENTS
                                DECEMBER 31, 1998

                                   (Continued)


       Deferred  income  taxes at December  31, 1997 and 1998  consisted  of the
       following:
<TABLE>
<CAPTION>

                                                                  1997              1998
       <S>                                                  <C>              <C>

        Deferred tax assets-
           Inventories                                       $      560,000   $      580,000
           Other reserves                                           303,000          218,000
           Net operating loss carryforwards                         487,000          432,000
                                                             --------------   --------------
                 Total gross deferred tax assets                  1,350,000        1,230,000
                 Less--Valuation allowance                          986,500          978,500
                                                              --------------  --------------
                 Net deferred tax assets                            363,500          251,500
                                                             --------------   --------------
        Deferred tax liabilities-
           Depreciation                                              14,000            8,000
                                                             --------------   --------------
                 Net deferred tax asset                      $      349,500   $      243,500
                                                             ==============   ==============
</TABLE>


       Under the Tax Reform  Act of 1986,  the  amount of the  benefit  from net
       operating  losses may be  impaired  or limited in certain  circumstances,
       including a  cumulative  stock  ownership  change of more than 50% over a
       three-year  period,  which  occurred in  connection  with the  management
       buyout, which was consummated on March 29, 1996. As a result, the Company
       is limited to approximately $161,000 of loss utilization per year.

       Limitations on the utilization of the Company's net operating losses have
       resulted  from the  management  buyout and  uncertainty  surrounding  the
       ability of the  Company  to  generate  future  income in order to realize
       deferred  tax  assets in the  future,  primarily  due to such  factors as
       dependence  on a  few  customers,  rapid  technological  change  and  the
       cyclical nature of the  semiconductor,  computer hard disk and flat panel
       display industries. Given the limitations,  management has concluded that
       realizability  of the  deferred  tax assets as of  December  31,  1998 is
       uncertain and has,  therefore,  provided a valuation  allowance against a
       portion of the deferred tax assets.

       For tax reporting purposes,  the Company has a U.S. federal net operating
       loss  carryforward  of  approximately  $1,270,000,  subject  to  Internal
       Revenue  Service (IRS) review and approval and certain IRS limitations on
       net operating  loss  utilization.  Utilization  of the net operating loss
       carryforward is contingent on the Company's ability to generate income in
       the future. The net operating loss carryforwards will expire from 2001 to
       2008 if not utilized.


                                      F-12

<PAGE>

                                 QC OPTICS, INC.

                          NOTES TO FINANCIAL STATEMENTS
                                DECEMBER 31, 1998

                                   (Continued)


(4)    COMMITMENTS AND CONTINGENCIES

       The  Company  leases its  operating  facilities  under two  noncancelable
       operating  lease  agreements,  the largest of which expires in 2001. Rent
       expense  for the years  ended  December  31,  1997 and 1998  amounted  to
       approximately  $255,000  and  $253,000,   respectively.   Future  minimum
       commitments under all noncancelable operating leases are approximately as
       follows:

                       1999                  $   228,000
                       2000                      229,000
                       2001                       97,000

(5)    EMPLOYEE BENEFIT PLAN

       The Company  sponsors a 401(k)  retirement  savings  plan (the Plan) that
       covers  substantially  all of the Company's  employees.  Participants may
       make voluntary  contributions of 1% to 16% of their annual  compensation.
       The  Company  makes  matching  contributions  up to 100%  of  participant
       voluntary  contributions up to a maximum of 2%, and an additional Company
       contribution can be made at the Company's discretion.

       The Company charged to expense approximately $76,000 and $100,000 related
       to  contributions  to the Plan for the years ended  December 31, 1997 and
       1998, respectively. Included in accrued expenses is approximately $60,000
       and $71,000 for Company matching and  discretionary  contributions to the
       Plan for the years ended December 31, 1997 and 1998, respectively.

(6)    STOCK OPTION PLANS

       In June 1996, the Board of Directors  approved the 1996 Stock Option Plan
       (the 1996  Plan)  under  which  employees,  including  directors  who are
       employees,  may be granted  options to purchase  shares of the  Company's
       common stock at not less than fair market value on the date of grant,  as
       determined  by the Board of  Directors.  The 1996 Plan  also  allows  for
       nonqualified  stock options to be issued to employees and nonemployees at
       prices that are less than fair market  value.  Options  granted under the
       1996 Plan are  exercisable  for up to a 10-year  period  from the date of
       grant.  The  Company  has  reserved  360,000  shares of common  stock for
       issuance  under the 1996 Plan. To date, all options have been issued with
       an exercise price at or above fair market value at the date of grant.

       In June 1997, 64,996 options  previously granted under the 1996 Plan were
       repriced  from an  original  exercise  price  of  $5.10  per  share to an
       exercise price of $3.25 per share with vesting and option life calculated
       from the  original  grant date.  In November  1997,  the Company  granted
       options  under the 1996 Plan for the  purchase of 26,500  shares at $4.13
       per share,  the estimated  fair market value on the date of grant,  which
       become  exercisable  over three years beginning one year from the date of
       grant.  In  January  1998,  20,232  options at $5.10 per share and 26,500
       options at $4.13 per share  previously  granted  under the 1996 Plan were
       repriced to an exercise price of $3.625 per share with vesting and


                                      F-13

<PAGE>

                                 QC OPTICS, INC.

                          NOTES TO FINANCIAL STATEMENTS
                                DECEMBER 31, 1998

                                   (Continued)


       option life  calculated  from the original  grant date.  In October 1998,
       63,132 options at $3.625 per share and 43,108 options at $3.250 per share
       previously granted under the 1996 Plan were repriced to an exercise price
       of $1.313 per share with  vesting  and option  life  calculated  from the
       original grant date. In 1998, the Company  granted options under the 1996
       Plan for the purchase of 33,000 shares at $1.313 to $3.625 per share, the
       estimated  fair  market  value  on  the  date  of  grant,   which  become
       exercisable over three years beginning one year from the date of grant.

       In June 1996,  the Board of Directors  approved a Director  Formula Stock
       Option Plan (the Formula Plan) in which options will be granted beginning
       on June 18, 1996, and every four years thereafter,  immediately following
       the Company's annual meeting of stockholders, options shall be granted to
       eligible  nonemployee  directors.  Each director will receive  options to
       purchase 15,000 shares of common stock, which vest and are exercisable in
       16 equal  installments over a period of four years beginning on the first
       day of the fiscal quarter  immediately  following the grant.  The options
       may be  exercised  at the fair market value of the shares of common stock
       on the date of grant.  The Company has reserved  100,000 shares of common
       stock for issuance under the Formula Plan.

       In June 1997, the Company granted  options to a new nonemployee  director
       under the Formula  Plan for the  purchase  of 15,000  shares at $3.25 per
       share, the estimated fair market value on the date of grant, which become
       exercisable  as previously  discussed.  In January 1998,  30,000  options
       previously  granted under the Formula Plan were repriced from an original
       exercise  price of $5.10 per  share to an  exercise  price of $3.625  per
       share with vesting and option life  calculated  from the  original  grant
       date.

       PRO FORMA STOCK-BASED COMPENSATION EXPENSE

       SFAS No.  123,  Accounting  for  Stock-Based  Compensation,  sets forth a
       fair-value-based method of recognizing stock-based  compensation expense.
       As  permitted  by SFAS No.  123,  the  Company has elected to continue to
       apply  Accounting  Principles  Board  Opinion  No. 25 to account  for its
       stock-based  compensation plans. Had compensation cost for awards granted
       under the Company's stock-based  compensation plans been determined based
       on the fair value at the grant dates consistent with the method set forth
       under SFAS No. 123, the effect on the Company's net income and net income
       per common and common equivalent shares would have been as follows:

<TABLE>
<CAPTION>
                                                              1997              1998
       <S>                                                 <C>               <C>
        Net income-
           As reported                                      $  245,296        $  211,083
           Pro forma                                           166,528           100,596
        Diluted net income per common and common
        equivalent shares-
           As reported                                      $      .08        $      .06
           Pro forma                                               .05               .03

</TABLE>


                                      F-14

<PAGE>

                                 QC OPTICS, INC.

                          NOTES TO FINANCIAL STATEMENTS
                                DECEMBER 31, 1998

                                   (Continued)


       Compensation  expense for options  granted is reflected  over the vesting
period;  therefore,  future  compensation  expense may  increase  as  additional
options are granted.

       The fair value of each option grant was estimated on the grant date using
the  Black-Scholes  option  pricing  model with the  following  weighted-average
assumptions:

                                                          1997             1998

        Volatility                                         42%               46%
        Risk-free interest rate                          6.38%             4.97%
        Expected life of options                    5.28 years        4.44 years
        Dividends                                         none              none

       The  Black-Scholes   option  pricing  model  was  developed  for  use  in
       estimating  the fair  value of  traded  options,  which  have no  vesting
       restrictions  and are fully  transferable.  In addition,  option  pricing
       models  require  the input of highly  subjective  assumptions,  including
       expected stock price volatility. Because the Company's stock options have
       characteristics  significantly different from those of traded options and
       because changes in the subjective input assumptions can materially affect
       the fair value estimate,  in management's opinion, the existing models do
       not  necessarily  provide a reliable  single measure of the fair value of
       its employee stock options.


                                      F-15

<PAGE>

                                 QC OPTICS, INC.

                          NOTES TO FINANCIAL STATEMENTS
                                DECEMBER 31, 1998

                                   (Continued)


       Stock Option Activity

       A summary of the Company's stock option activity is as follows:
<TABLE>
<CAPTION>

                                                                     YEAR ENDED DECEMBER 31, 1997
                                                            1996 PLAN                        FORMULA PLAN
                                                                     WEIGHTED                           WEIGHTED
                                                   NUMBER OF         AVERAGE          NUMBER OF         AVERAGE
                                                    SHARES        EXERCISE PRICE       SHARES        EXERCISE PRICE
       <S>                                          <C>            <C>                 <C>            <C>
        Options outstanding, beginning of year       223,064        $    5.68           30,000         $    5.10
                                                ============        =========      ===========         =========
          Granted                                     26,500             4.13           15,000              3.25
          Exercised                                        -                -                -                 -
          Repricing--Extinguish old options          (64,996)            5.10                -                 -
          Repricing--Distribute new options           64,996             3.25                -                 -
          Forfeited                                  (27,864)            4.27                -                 -
                                                ------------                       -----------
        Options outstanding, end of year             221,700        $    5.13           45,000         $    4.48
                                                ============        =========      ===========         =========
        Options exercisable                          136,733        $    5.81           13,125         $    4.84
                                                ============        =========      ===========         =========
        Options available for grant                  138,300                            55,000
                                                ============                       ===========
        Weighted-average fair value of                              $    1.66                          $    1.81
                                                                    =========                          =========
        options (whose exercise price equals
        market value) granted or repriced
        during the year

</TABLE>

                                      F-16

<PAGE>

                                 QC OPTICS, INC.

                          NOTES TO FINANCIAL STATEMENTS
                                DECEMBER 31, 1998

                                   (Continued)
<TABLE>
<CAPTION>


                                                                      YEAR ENDED DECEMBER 31, 1998
                                                            1996 PLAN                        FORMULA PLAN
                                                   NUMBER OF         WEIGHTED         NUMBER OF         WEIGHTED
                                                    SHARES           AVERAGE           SHARES           AVERAGE
                                                                  EXERCISE PRICE                     EXERCISE PRICE
       <S>                                          <C>            <C>                 <C>            <C>
        Options outstanding, beginning of year       221,700        $    5.13           45,000         $    4.48
                                                ============        =========      ===========         =========
          Granted                                     33,000             2.71                -                 -
          Exercised                                        -                -                -                 -
          Repricing--Extinguish old options         (152,972)            3.80          (30,000)             5.10
          Repricing--Distribute new options          152,972             2.02           30,000              3.63
          Forfeited                                  (14,328)            3.16                -                 -
                                                ------------                       -----------
        Options outstanding, end of year             240,372        $    3.78           45,000         $    3.50
                                                ============        =========      ===========         =========
        Options exercisable                          165,240        $    4.79           24,375         $    3.54
                                                ============        =========      ===========         =========
        Options available for grant                  119,628                            55,000
                                                ============                       ===========
        Weighted-average fair value of                              $    0.97                          $    1.48
                                                                    =========                          =========
        options (whose exercise price equals
        market value) granted or repriced
        during the year

</TABLE>


       A summary of the status of the  Company's  stock  options at December 31,
       1998 is as follows:

                           OPTIONS OUTSTANDING AND EXERCISABLE
                EXERCISE PRICE       NUMBER         REMAINING CONTRACTUAL
                                                            LIFE

                   --------------------- 1996 PLAN -----------------
                     $1.313            47,740        7.5 to 10 years

                     $5.100            10,000              7.5 years

                     $6.300           107,500              7.5 years

                   ------------------- FORMULA PLAN ----------------

                     $3.250             5,625              8.5 years

                     $3.625            18,750              7.5 years


                                      F-17

<PAGE>

                                 QC OPTICS, INC.

                          NOTES TO FINANCIAL STATEMENTS
                                DECEMBER 31, 1998

                                   (Continued)


(7)    REVOLVING LINE OF CREDIT

       The  Company has a revolving  line-of-credit  with State  Street Bank and
       Trust Company. The revolving line-of-credit agreement was amended on June
       29, 1998 and allows for maximum  borrowings  of  $2,000,000  and requires
       monthly  payment of  interest on the  outstanding  balance to maturity on
       June 30, 2000.  Borrowings under the revolving  line-of-credit  agreement
       are limited to 80% of qualifying  accounts  receivable.  Borrowings under
       the  agreement  bear interest at the bank's prime rate (7.75% at December
       31, 1998). The terms of the loan agreement provide for the maintenance of
       certain specified  financial ratios including the quick ratio and debt to
       equity,  minimum  earnings  tests  and  other  negative  and  affirmative
       covenants and  restricts  certain  transactions  without the bank's prior
       written  consent.  As of December  31, 1998 the Company was in default of
       the minimum earnings covenant of the revolving line-of-credit  agreement.
       The  Company  obtained  a waiver  of this  covenant  for the  year  ended
       December  31, 1998.  At December  31, 1998 the Company had no  borrowings
       outstanding under the revolving line-of-credit agreement and availability
       of approximately $411,000.

(8)    VOTING TRUST

       On October 27, 1995, the Company and certain management  employees of the
       Company  entered  into a voting  trust  agreement  known as the QC Optics
       Voting Trust (the Voting Trust), of which the president of the Company is
       trustee.  The Voting  Trust  continues  in force for a period of 21 years
       from October 27, 1995 unless terminated  earlier as a result of a merger,
       dissolution, sale of all or substantially all of the Company's assets, or
       liquidation.



                                      F-18