**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**Form
      10-K**





[X]
            
            Annual report pursuant to Section 13
              or 15(d)
              of the Securities Exchange Act of 1934For the fiscal year ended **October
              1, 2005**or[   ]
            
            Transition
                report pursuant to section 13 or 15(d) of the Securities Exchange
                Act of
                1934For the transition period from _______
              to
              _______.





Commission
      file number 0-11392





**SPAN-AMERICA
      MEDICAL SYSTEMS, INC.**





(Exact
      name of registrant as specified in its charter)






**South
                Carolina**
            **57-0525804**(State
                or other jurisdiction of incorporation or
                organization)
            (I.R.S.
                Employer Identification
                No.)**70
                Commerce Center, Greenville, South
                Carolina**
            **29615**(Address
                of principal executive
                offices)
            (Zip
                Code)Registrant’s
              telephone number, including area code
            
            **(864)
                288-8877**Securities Registered pursuant
              to
              section 12(b) of the Act:Title
                of each class
            Name
                of each exchange on which
                registeredNone
            NoneSecurities Registered pursuant
              to
              section 12(g) of the Act:Common
                stock, no par value(Title
                of
                class)





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act. Yes [  
      ] No [X]





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Act. Yes [  
      ] No [X]





Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days. Yes [X] No [  
      ]












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





Indicate
      by check mark whether the registrant is an accelerated filer (as defined in
      Rule
      12b-2 of the Act). Yes [  
      ] No [X]





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Act). Yes [  
      ] No [X]





The
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates computed by reference to the price at which the common equity
      was
      last sold as of the last business day of the registrant’s most recently
      completed second fiscal quarter was $22,127,338.





The
      number of shares of the registrant’s common stock, no par value, outstanding as
      of December 21, 2005 was 2,639,095.





Documents
      Incorporated By Reference





Portions
      of the Company’s Definitive Proxy Statement for the annual shareholders’ meeting
      to be held February 28, 2006 are incorporated by reference into Part
      III.













**PART
      I**





**Item
      1. Business**





**Forward-Looking
      Statements**





This
      annual report on Form 10-K includes forward-looking statements that describe
      anticipated results for Span-America Medical Systems, Inc. (the “Company” or
“Span-America”). These statements are estimates or forecasts about Span-America
      and its markets based on our beliefs, assumptions and expectations. These
      forward-looking statements therefore involve numerous risks and uncertainties.
      We wish to caution the reader that these forward-looking statements, such as,
      but not limited to, our expectations for future sales or expense changes
      compared with previous periods, are only predictions. Actual events or results
      may differ materially as a result of risks and uncertainties in our business.
      Such risks include but are not limited to the “Risk Factors” listed in Item 1A
      below and other risks referenced from time to time in our other Securities
      and
      Exchange Commission filings. We disclaim any obligation to update any
      forward-looking statement whether as a result of new information, future events
      or otherwise.




**Background**





Span-America
      Medical Systems, Inc. was incorporated under the laws of the state of South
      Carolina on September 21, 1970. We manufacture and distribute a variety of
      polyurethane foam products for the medical and custom products
      markets.





We
      began
      operations in 1975 as a manufacturer of polyurethane foam patient positioners.
      We soon expanded our product lines to produce flat and convoluted foam mattress
      overlays for the wound care market primarily in acute care hospitals. Wound
      care
      products aid in the treatment or prevention of pressure ulcers and diabetic
      ulcers, commonly known as bed sores. In the late 1970's we also began producing
      foam products for industrial applications, primarily to utilize excess
      manufacturing capacity. In 1985, we introduced the patented Geo-Matt â mattress
      overlay in the health care market, which became one of the Company’s leading
      products. About the same time, we began selling the Sleep Cloud® line of
      convoluted foam mattress overlay products to consumer bedding retailers
      throughout the United States. This marked our entry into the consumer bedding
      market.





We
      entered the replacement mattress segment of the medical market in 1992 through
      the acquisition of Healthflex, Inc., which included the PressureGuard® II
      replacement mattress. We have since significantly expanded the PressureGuard
      mattress line and have added the Geo-Mattress® product line to provide a broad
      line of therapeutic replacement mattresses that are sold direct and through
      distributors to hospitals, long-term care facilities, and home health care
      dealers throughout the Unites States and Canada.





In
      July
      2002, we acquired certain assets of Vadus, Inc. which included primarily patents
      and equipment related to the design and production of the Secure I.V.® line of
      short peripheral intravenous catheters. The product line was in the development
      stage at the time of the acquisition. We have completed the initial development
      of the product line and are manufacturing and marketing it to health care
      providers in the United States. The safety catheter segment is a separate
      segment for financial reporting purposes.






1





Our
      primary long-term strategy is to become a leading health care manufacturer
      and
      marketer specializing in wound management products used in the prevention and
      treatment of pressure ulcers. Most of the products in our medical segment are
      currently directed toward pressure management applications, and we are actively
      seeking to develop or acquire new products in this market segment. We also
      seek
      to further develop and manufacture consumer and industrial applications of
      our
      medical products. In addition, we intend to provide a line of intravenous
      catheters with unique features to fill a niche in the safety catheter market
      segment.





Our
      products are distributed primarily in the United States and to a lesser degree
      in several foreign countries. Total export sales during fiscal 2005 were
      approximately $2.1 million or 4% of total net sales. The majority of our export
      sales occurred in Canada. See Note 17 in the Notes to Financial Statements
      included in Item 8 of this report.





We
      maintain a website at *http://www.spanamerica.com* .
      Our
      reports and other filings made with the Securities and Exchange Commission
      are
      available free of charge on the website, which includes a link to the Company’s
      filings in the SEC’s EDGAR filing database.




**Industry
      Segment Data**





Please
      see Note 17 in the Notes to Financial Statements included in Item 8 of this
      report for additional information on industry segment data.





**Medical**





Span-America’s
      principal medical products consist of therapeutic support surfaces (polyurethane
      foam mattress overlays, non-powered replacement mattresses, and powered
      replacement mattresses), patient positioners, and seating products. We market
      these products to all health care settings, including acute care hospitals,
      long
      term care facilities, and home health care providers, primarily in North
      America. Sales of medical products represented 63% of total net sales in fiscal
      2005, 47% of total net sales in 2004, and 51% of total net sales in
      2003.





*Mattress
      Overlays.* Span-America produces a variety of foam mattress overlays, including convoluted
      foam pads and its patented Geo-Matt® overlay. The Geo-Matt design includes
      numerous individual foam cells that are cut to exacting tolerances on
      computer-controlled equipment to create a clinically effective mattress surface.
      Mattress overlays comprised approximately 6% of total net sales in fiscal 2005.
      These products are designed to provide patients with greater comfort and to
      assist in treating patients who have or are susceptible to developing pressure
      ulcers. Span-America's overlay products are mattress pads rather than complete
      mattresses and are marketed as less expensive alternatives to more complex
      replacement mattresses. The mattress overlays are designed for single patient
      use.






2






Our
      mattress overlays disperse body heat, increase air circulation beneath the
      patient, and reduce moisture build-up in order to prevent the development of
      pressure ulcers and promote healing. Their convoluted or geometrically contoured
      construction also reduces shear forces and more evenly distributes the patient's
      body weight, thereby reducing the pressure that causes ulcers.





*Therapeutic
      Mattresses* .
      Span-America’s non-powered therapeutic replacement mattresses (as distinguished
      from overlays) are of two types. Geo-Mattress® products are single-density or
      multi-layered foam mattresses topped with the same patented Geo-Matt surface
      used in our overlays. These mattresses are sold as alternatives to standard
      innerspring and all-foam mattresses often found in acute and long term care
      settings.





In
      1997,
      we introduced the Geo-Mattress Max, Plus, and Pro models of foam therapeutic
      replacement mattresses. In early 1999, we extended the product line with the
      release of the Geo-Mattress with Wings®. This product, which features raised
      perimeter bolsters for added patient safety, has been a significant contributor
      to overall Geo-Mattress sales. A second line extension, the Geo-Mattress Atlas®,
      was added in December 2000 to address the needs of obese patients.





Span-America’s
      more complex non-powered replacement mattresses consist of products from the
      PressureGuard® Series. The PressureGuard design was acquired through the
      acquisition of Healthflex, Inc. in February 1992. The original design combines
      a
      polyurethane foam shell and static air cylinders to form a replacement mattress
      that incorporates the comfort and pressure relieving features of both mattress
      overlays and more sophisticated dynamic mattresses. This original design, which
      we later used as the basis for powered versions (see below), was further refined
      through a complete technical upgrade of all PressureGuard components in November
      1997. In conjunction with this upgrade, some models were renamed to better
      reflect their functions.





In
      addition to the non-powered, static PressureGuard Renew® (formerly PressureGuard
      II), we also offer the PressureGuard CFT®. This model incorporates patented
      design principles of constant force technology. The PressureGuard CFT is unique
      in that it is a dynamic support surface that rivals very expensive powered
      surfaces in effectiveness, yet it requires no power source of any kind.





Span-America’s
      powered therapeutic replacement mattresses consist of the remaining models
      in
      the PressureGuard Series. In November 1993, we received FDA 510(k) marketing
      approval for the PressureGuard IV mattress system. Building on the comfort
      and
      support of the original PressureGuard design, PressureGuard IV was designed
      as a
      sophisticated, powered system for providing pressure reduction and patient
      comfort, with the added ability to turn the patient. The system was designed
      to
      automatically sense the patient’s weight and position and to continually adjust
      the pressures appropriately while slowly and quietly repositioning the patient
      at angles up to 30 degrees in cycles of up to two hours. The upgraded version,
      renamed the PressureGuard Turn Select®, incorporates all of these capabilities,
      as well as several additional features. Of particular note is a
      pendant-operated, microprocessor-controlled motion system which is built into
      the mattress rather than being hung on the bed frame as a separate
      unit.






3





Another
      powered system in the PressureGuard line is the PressureGuard APM®, a simpler
      but very effective alternating pressure mattress. The APM is targeted primarily
      at the long term care and home care markets. In 2000, we added a more
      feature-laden version of this mattress called the PressureGuard APM 2 .
      The
      APM 2 products
      were further upgraded with new features in 2003, such as the addition of the
      Deluxe control unit. The APM 2 gives
      the caregiver the flexibility to offer either alternating pressure or a basic
      lateral rotation modality by activating a toggle switch on the control panel.
      The APM 2 represents
      our single largest medical product in terms of revenues.





In
      late
      2001, Span-America introduced the PressureGuard Easy Air®, our first offering in
      the category of low-air-loss mattresses. The Easy Air incorporates several
      patent-pending design innovations which the company believes allow it to
      overcome common performance compromises inherent in competitive low-air-loss
      products. Additionally, the Easy Air was independently documented (see *Ostomy/Wound
      Management* ,
      January
      2003, Volume 49, Issue 1, pp. 32-42) to outperform all leading competitors
      at
      that time in controlling excess skin moisture, a key performance advantage
      in
      the competitive support surfaces marketplace.





All
      of
      the powered products in the PressureGuard Series are sold primarily through
      home
      health care equipment dealers for daily rental in home care, long term care
      and,
      less commonly, in acute care settings. Following the government’s 1998
      implementation of the Prospective Payment System of reimbursement, however,
      long
      term care facilities increasingly have elected to purchase these products
      outright through our distributors rather than continuing to rent
      them.





In
      fiscal
      2004, we worked with Hill-Rom Company, Inc. to develop a private-label version
      of our PressureGuard CFT mattress to be sold under the Hill-Rom name primarily
      to acute care hospitals. Hill-Rom, a division of Hillenbrand Industries, is
      a
      major supplier of hospital beds and various other types of patient care
      equipment. Since the initial work in 2004, we have expanded the private label
      CFT line to include several other therapeutic mattresses with additional
      features designed to meet Hill-Rom’s needs. The PressureGuard CFT product line
      was our fastest growing group of mattresses in fiscal 2005. We also manufacture
      private-label mattresses for other customers on a case-by-case basis, depending
      on market conditions and customer interest.





During
      fiscal 2005, replacement mattresses and related products made up approximately
      43% of total net sales.





*Patient
      Positioners.* Our
      specialty line of patient positioners is sold primarily under the trademark
      Span-Aids®. Span-Aids accounted for approximately 8% of our total net sales in
      fiscal 2005. This is our original product line and consists of over 300
      different foam items which aid in relieving the basic patient positioning
      problems of elevation, immobilization, muscle contracture, foot drop, and foot
      or leg rotation. Span-Aids patient positioners hold a patient's body in
      prescribed positions, provide greater patient comfort, and generally are used
      to
      aid long-term comatose patients or those in a weakened or immobilized condition.
      The positioners also help in the prevention of pressure ulcers by promoting
      more
      effective dispersion of pressure, heat and moisture. Span-Aids are intended
      for
      single-patient use throughout the patient's entire treatment program. Among
      the
      Span-Aids products presently marketed are abduction pillows, body aligners,
      head
      supports, limb elevators and various foot and wrist positioners. Our patient
      positioners are sold primarily to hospitals and long-term care facilities by
      several national medical products distributors.






4





*Seating
      Products.* Another
      product category in our medical segment consists of seating cushions and related
      seating products. Our offerings in this category can be subdivided into three
      main groups:





·
            wound
                healing aids,


·
            patient
                positioning and general pressure management products,
                and


·
            pressure
                management products without patient positioning
                elements.





Seating
      products made specifically as an aid to wound healing include the Isch-Dish® and
      Sacral Dish® pressure relief cushions. Seating products made for patient
      positioning and general pressure management include the Isch-Dish Thin, the
      Geo-Matt® ContourTM cushion, the EqualizerTM, and the EZ-DishTM. The Equalizer
      contoured positioning cushion has a multi-component design that includes a
      viscoelastic foam top, proprietary soft polymer inserts, and a contoured base.
      Like the Isch-Dish, the Equalizer is included among seating products covered
      for
      reimbursement by the Medicare system. This makes it an attractive option for
      durable medical equipment suppliers and rehab seating specialists. The EZ-Dish
      pressure relief cushion, which uses some of the features of the original
      Isch-Dish design, offers a simpler, more affordable solution to the seating
      problems of nursing home patients.





Seating
      products designed to address pressure management without additional positioning
      benefits include the Gel-T® cushion and the Geo-Matt and Geo-Matt PRT®
wheelchair cushions. The Gel-T is a gel/foam combination cushion that is
      especially popular with elderly patients. The Geo-Matt and Geo-Matt PRT cushions
      incorporate our proprietary Geo-Matt anti-shearing surface.





Seating
      products accounted for approximately 3% of total net sales in fiscal
      2005.





*Skin
      Care Products.* We also
      market the Selan® line of skin care creams and lotions under a license agreement
      with PJ Noyes Company. The products, which are manufactured by PJ Noyes, are
      used for cleaning, moisturizing and protecting patients’ skin and are primarily
      sold in long term care and acute care settings. The license agreement with
      PJ
      Noyes was scheduled to expire in December 2005, but it has been renewed for
      an
      additional five-year term. Sales of skin care products accounted for
      approximately 2% of our total net sales in fiscal 2005.





*Distributor
      Relationships.* We sell
      our medical products to customers of varying sizes. The largest of these
      customers are medical products distributors who re-sell our products to acute
      care hospitals and long term care facilities throughout North America. During
      2005, sales to the largest distributor of our medical products made up
      approximately 22% and sales to our four largest medical distributors made up
      approximately 59% of net sales in the medical segment. The loss of any one
      of
      these customers could have a material adverse effect on our
      business.






5






**Custom
      Products**





Span-America's
      custom products segment includes two major product lines: consumer bedding
      products and industrial foam products. Our consumer product line consists
      primarily of convoluted and contour-cut mattress overlays and specially designed
      pillows for the consumer bedding market. The consumer products are marketed
      to
      retailers through Louisville Bedding Company, a leading manufacturer and
      distributor of bedding products in North America. Louisville Bedding is the
      exclusive distributor of our consumer foam products pursuant to a distribution
      agreement between the companies, which expires in December 2006. The agreement
      is automatically renewed for successive three-year terms unless either party
      provides notice of their intent not to renew at least 60 days prior to the
      expiration date.





Our
      industrial product line consists primarily of foam packaging and cushioning
      materials. We also produce foam products that are used for flotation, sound
      insulation and gasketing purposes. The majority of these products are made
      to
      order according to customer specifications. To date, most of our industrial
      sales have been in the flotation and specialty packaging segments of the custom
      products market. We currently have one full-time sales representative and
      several manufacturer’s representatives selling our industrial foam fabrication
      capabilities primarily in the southeastern United States. Our customers
      represent a wide variety of markets, including the sports equipment, automotive,
      photographic film, durable goods and electronics industries.





Custom
      products represented approximately 37% of our total net sales in fiscal 2005,
      compared with 53% in fiscal 2004 and 49% in fiscal 2003. In fiscal 2005,
      approximately 87% of our total custom products sales were distributed through
      Louisville Bedding Company. The loss of this relationship would have a material
      adverse effect on our business.





**Safety
      Catheters**





In
      July
      2002, we acquired assets related to the Secure I.V.® protected short peripheral
      intravenous catheter from Vadus, Inc., a privately owned designer and
      manufacturer of catheters. The acquired assets consisted primarily of patents
      and equipment related to the design, production and sale of the Secure I.V.
      catheter. The Secure I.V. has FDA 510(k) approval and is protected by 16
      patents. The product line is currently being manufactured for Span-America
      by an
      unaffiliated contract manufacturing company. Net sales of Secure I.V. were
      less
      than 1% of total net sales in fiscal 2005. We operate this portion of our
      business as a separate business segment.





Since
      acquiring the assets of Secure I.V. we have completed the design and development
      of the product and have scaled up from prototype manufacturing to semi-automated
      production. Market test shipments of Secure I.V. began in late fiscal 2004.
      Based on initial feedback from customers, we decided in December 2004 to delay
      the full release of Secure I.V. in order to make three design enhancements
      to
      improve the product’s performance. By the fourth quarter of fiscal 2005, we had
      completed the design changes, testing and re-validation and re-introduced the
      product to the market. The product line is being marketed by a network of
      distributors who specialize in certain medical products, including intravenous
      catheters. We have a number of product evaluations currently ongoing at various
      locations throughout the United States. Sales to date have been minimal. The
      Secure I.V. segment is a new business unit for Span-America with little sales
      and production history. Consequently, there can be no assurance that these
      products will be successful in the market or that the segment will become
      profitable.






6





**Research
      and Development**





Span-America’s
      expenditures for research and development for the last three fiscal years are
      set forth in the following table:







Research
                  and Development Expense2005
              
              2004
              
              2003Medical
              
              $
              407,000
              
              $
              311,000
              
              $
              255,000Custom
                  products
              
              1,000
              
              11,000Safety
                  catheters
              
              733,000
              
              364,000
              
              301,000Total
                  R&D expense
              
              $
              1,141,000
              
              $
              686,000
              
              $
              556,000






We
      expect
      research and development costs in fiscal 2006 to be lower than in
      2005.





**Competition**





*Medical* .
      In the
      medical market segment, we face significant competition for sales of our foam
      mattress overlays. Probably the largest single source of competition for our
      mattress overlay products is from therapeutic replacement mattresses marketed
      by
      us and our competitors. Sales of overlays have been declining for several years
      as many customers have eliminated the need for mattress overlays by purchasing
      therapeutic replacement mattresses instead. However, once a customer has decided
      to purchase an overlay, the competition within the overlay market is primarily
      based on price and delivery for convoluted foam overlays and on price, product
      performance, quality and delivery for therapeutic overlays, e.g. the Geo-Matt
      overlay. Competition with respect to our Span-Aid patient positioners is
      primarily based on price. However, a secondary source of competition for patient
      positioners results from alternative methods, such as the use of pillows and
      other devices to position patients.





We
      believe that Span-America is among the top three nationwide suppliers of foam
      mattress overlays and patient positioners to the U.S. health care market. Our
      primary competitors in the overlay and positioner markets are the BioClinic
      division of Sunrise Medical, Inc., Kendall (a division of Tyco International)
      and Ehob, Inc.




The
      competition in the therapeutic replacement mattress market is based on product
      performance, price and durability. Potential customers typically select a
      product based on these criteria after conducting a formal clinical evaluation
      of
      sample mattresses for periods of one to six months. A secondary source of
      competition results from alternative products such as mattress overlays, which
      are significantly less expensive than replacement mattresses.






7





The
      market for therapeutic replacement mattresses was developed principally during
      the 1990’s. Competitors include BG Industries (now owned by The Encompass
      Group), Gaymar Industries, Inc., Hill-Rom (a division of Hillenbrand Industries,
      Inc.), Kinetic Concepts, Inc., Invacare Corporation, Sunrise Medical, Inc.,
      Direct Supply, Inc. and Medline Industries, Inc. These competitors use
      combinations of their own sales representatives and manufacturer’s
      representatives to sell directly to hospitals, distributors, and long-term
      care
      facilities nationwide.





Many
      of
      our competitors in the health care segment are larger and have greater resources
      than our Company. We believe our competitive advantages in the medical segment
      include innovative and patented product designs, product quality, manufacturing
      capabilities, distribution relationships, and customer
      responsiveness.





*Custom
      Products.* In the
      custom products segment, we have encountered significant competition for our
      mattress pad and pillow products. The competition is principally based on price,
      which is largely determined by foam density and thickness. However, competition
      also exists due to variations in product design and packaging. There are
      presently a number of companies with the manufacturing capability to produce
      similar bedding products. Our primary competitors in this market are Sleep
      Innovations, Inc., Leggett and Platt, Inc., and E.R. Carpenter Company, all
      of
      which are larger and have greater resources than we do. We also have a number
      of
      competitors in the market for our industrial products, including SCA Packaging
      North America (formerly Tuscarora, Inc.) and UFP Technologies, Inc. These
      competitors are larger and have greater resources than we do. The competition
      for industrial foam products is largely based on price. In some instances,
      however, design and delivery capabilities are also important. We believe our
      competitive advantages in the custom products segment include our distribution
      relationship with Louisville Bedding Company, innovative product designs, foam
      manufacturing and fabrication capabilities, low cost manufacturing processes,
      and customer responsiveness.





Within
      the last two years, we have encountered increasing competition in the consumer
      bedding market from visco foam products manufactured both in the United States
      and China. Visco foam, also known as visco-elastic foam or memory foam, has
      greater density and different properties than traditional polyurethane foam
      products. It responds to body temperature, conforms to the shape of the body,
      and generally has slower recovery time compared with traditional polyurethane
      foam. Visco foam is also significantly more expensive than traditional foam
      and
      is more difficult to handle and fabricate. Because visco foam is more difficult
      to cut and shape than traditional foam, the visco mattress pads currently on
      the
      market tend to be somewhat undifferentiated without unique surface designs.
      Although we currently fabricate and sell visco foam products, it is more
      difficult for us to differentiate our products from competing products because
      of the current commodity-like nature of visco foam mattress pads. In addition,
      since visco foam is significantly more expensive and heavier than traditional
      foam, it is more cost effective for overseas competitors (from China for
      example) to ship the products to the U.S. market.





*Safety
      Catheters* .
      Our
      Secure I.V. products compete in the protected short peripheral intravenous
      catheter marketplace. Three major companies, Medex, Inc. (acquired from Johnson
      and Johnson and subsequently acquired by Smiths Group plc), Becton Dickinson
      and
      Company, and B. Braun Medical, Inc. supply about 85% of this market. All of
      these companies have established national sales organizations and world-wide
      distribution networks. Their resources are greater than ours. We currently
      have
      distribution agreements with distributors in three distinct markets: acute
      care,
      alternate care and emergency medical services. Our emergency medical services
      distributor is a national distributor. The other distributors are regional
      but
      in combination offer national coverage.






8







We
      believe that Secure I.V.’s design offers a competitive advantage in that it
      allows for intravenous catheter insertions without the need for vein occlusion,
      which helps passively protect healthcare workers from exposure to blood-borne
      pathogens. However, potential customers may choose competing products over
      Secure I.V. because the competitors offer a wider range of custom variations
      for
      their safety catheters than we do for Secure I.V. In addition, the competitors
      are able to supply a wider variety of other medical devices to their customers.
      Because of design differences and economies of scale, competing devices are
      less
      costly to make.





**Major
      Customers**





We
      have a
      business relationship with Louisville Bedding Company to distribute our consumer
      foam products. Sales to Louisville Bedding during fiscal 2005 made up
      approximately 33% of our total net sales and approximately 87% of sales in
      the
      custom products segment.





We
      also
      have a business relationship with PSS World Medical, Inc. (“PSS”), to distribute
      certain of our medical foam products. Sales to PSS during fiscal 2005 made
      up
      approximately 14% of total net sales and approximately 22% of sales in the
      medical products segment.





See
      "Distributor Relationships" above and Notes 16 and 17 in the Notes to
      Financial Statements below for more information on major
      customers.




**Seasonal
      Trends**





Some
      seasonality can be identified in certain of our medical and consumer foam
      products. However, the fluctuations have minimal effect on our operations
      because of offsetting trends among these product lines. We have not experienced
      significant seasonal fluctuations in our industrial product line.





**Patents
      and Trademarks**




We
      hold
      41 United States patents and 5 foreign patents relating to various components
      of
      our patient positioners, mattress overlays, and replacement mattresses for
      the
      medical segment. Additional patent applications have been filed. We believe
      that
      these patents are important to our business. However, while we have a number
      of
      products covered by patents, there are competitive alternatives available which
      are not covered by these patents. Therefore, we do not rely solely on our
      patents to maintain our competitive position in our various
      markets.





Our
      principal patents include the patents on Geo-Matt, Geo-Mattress, PressureGuard,
      and Span-Aids products. The Geo-Matt and Geo-Mattress patents have remaining
      lives ranging from 1 to 8 years with additional patents pending. The
      PressureGuard patents have remaining lives ranging from 9 to 13 years with
      additional patents pending. The Span-Aids patents have remaining lives ranging
      from less than a year to 9 years.






9





As
      previously noted, in July 2002, we acquired assets related to the Secure I.V.®
catheter product line of Vadus, Inc., a privately owned designer and
      manufacturer of peripheral intravenous catheters. The Secure I.V. has FDA 510(k)
      approval and is protected by 11 U. S. patents and five foreign patents, all
      of
      which are owned by Span-America. The mark “Secure I.V.” is also Span-America’s
      registered trademark. We have also filed additional patent
      applications.





We
      hold
      37 federally registered trademarks and 17 foreign trademark registrations,
      including *Span-America,
      Span-Aids, Geo-Matt, Geo-Mattress, PressureGuard,* and *Isch
      Dish* in
      the
      medical and consumer segments *.* Other
      federal registration applications are presently pending. We believe that these
      trademarks are readily identifiable in their respective markets and add value
      to
      our product lines.




**Raw
      Materials and Backlog**





Polyurethane
      foam and nylon/vinyl mattress covers and tubes account for approximately 80%
      of
      our raw materials. In addition, we use corrugated shipping cartons, polyethylene
      plastic packaging material and hook-and-loop fasteners. We believe that our
      basic raw materials are in adequate supply and are available from many suppliers
      at competitive prices.





During
      October 2005, we received notice from our largest foam suppliers that the price
      of polyurethane foam would increase significantly in early November 2005. The
      price increases were caused by hurricane damage in the Gulf Coast region, which
      affected the supply of chemicals used in manufacturing foam, and by the higher
      price of natural gas, which increased the cost of other chemicals used in
      manufacturing foam. See Item 1A, “Risk Factors” and Item 7, “Management’s
      Discussion and Financial Analysis” for more information on the recent price
      increases for polyurethane foam.





As
      of
      October 1, 2005, we had unshipped orders of approximately $1.8 million, which
      represents a 76% increase compared to our backlog of $1.0 million at fiscal
      year
      end 2004. Most of the increase occurred in our medical products segment and
      was
      due to a large order for powered mattresses and one for seating products at
      fiscal year end 2005. Our order backlog fluctuates significantly from month
      to
      month. Consequently, the 76% increase in backlog at fiscal year end 2005 is
      not
      necessarily indicative of sales trends for the coming fiscal year. All orders
      in
      the current backlog are expected to be filled in the 2006 fiscal
      year.




**Employees**





We
      had
      293 full-time employees as of October 1, 2005. Of these employees, six were
      officers, 19 were management personnel, 24 were administrative and clerical
      personnel, 23 were sales personnel, and 221 were manufacturing employees. We
      are
      not a party to any collective bargaining agreement and have never experienced
      an
      interruption or curtailment of operations due to labor controversy. We believe
      that our relations with our employees are good.






10




**Supervision
      and Regulation**





The
      Federal Food, Drug and Cosmetic Act, and regulations issued or proposed
      thereunder, provide for regulation by the Food and Drug Administration (the
      "FDA") of the marketing, manufacture, labeling, packaging and distribution
      of
      medical devices, including our products. These regulations require, among other
      things, that medical device manufacturers register with the FDA, list devices
      manufactured by them, and file various types of reports. In addition, our
      manufacturing facilities are subject to periodic inspections by regulatory
      authorities and must comply with "good manufacturing practices" as required
      by
      the FDA and state regulatory authorities. We believe that we are in substantial
      compliance with applicable regulations and do not anticipate having to make
      any
      material expenditures as a result of FDA or other regulatory
      requirements.





We
      are
      certified as an ISO 9001 and ISO 13485 supplier for our PressureGuard mattress
      products from the Greenville, South Carolina plant. These standards are prepared
      by the American Society for Quality Control Standards Committee to correspond
      to
      the International Standard ISO 9001:2000. ISO (the International Organization
      for Standardization) is a worldwide federation of national standards bodies
      dealing with quality-system requirements that can be used by a supplier to
      demonstrate its capability and for the assessment of the capability of a
      supplier by external parties. Compliance with ISO standard 13485 is required
      by
      Health Canada for all Class II medical devices sold there. The certification
      is
      subject to reassessment at six month intervals. We have maintained our
      certification based on the results of ISO audits conducted during fiscal year
      2005.




**Environmental
      Matters**





Our
      manufacturing operations are subject to various government regulations
      pertaining to the discharge of materials into the environment. We believe that
      we are in substantial compliance with applicable regulations. We do not
      anticipate that continued compliance will have a material effect on our capital
      expenditures, earnings or competitive position.





**Item
      1A. Risk Factors**





**Our
      sales volume and profit margins could be negatively affected by volatile pricing
      and supply conditions in the market for polyurethane foam caused by recent
      hurricane damage in the Gulf Coast region.** We were
      notified in early October 2005 by our foam suppliers that prices for
      polyurethane foam, our largest volume raw material, would increase effective
      November 7, 2005 in the range of 10% to 37%, depending on the type of foam.
      Shortly thereafter, we were notified of an additional 10% surcharge to be placed
      on most types of foam effective October 24, 2005. The cost of polyurethane
      foam
      represented approximately 44% of our total cost of goods sold in fiscal 2005.
      So
      an increase in foam raw material costs that we are not able to offset could
      have
      a significant negative effect on our sales volume and
      profitability.






11





Foam
      cost
      increases of this magnitude are unprecedented in our industry. We believe the
      increases have both short-term and long-term components. The short-term
      component of the increase is caused by interruptions to the supply of TDI,
      a key
      chemical used in foam manufacturing. These supply problems were caused by recent
      hurricane damage in the Gulf Coast region, where a number of the chemical
      manufacturers are located. We believe the TDI problem will be resolved during
      the next three to six months as manufacturers return to normal operations.
      The
      longer-term component of the foam price increase is related to the price of
      polyol, another key chemical used in the production of foam. The price of polyol
      is related to natural gas prices, which have increased significantly during
      the
      last year. We expect the price of polyol to exert upward pressure on foam prices
      as long as natural gas prices remain high.





**Our
      sales and earnings could decline as a result of our actions to increase sales
      prices in response to the unusually high raw material cost increases discussed
      above.** We will
      attempt to offset these raw material cost increases by raising sales prices,
      changing product specifications, or other cost-saving efforts. As we raise
      our
      sales prices, particularly in the consumer market, we could lose sales volume
      if
      competitors are willing to offer our customers lower prices on similar products.
      If we lose sales volume, earnings could decline because of the loss of
      profitable sales and because our fixed costs might not decline as fast as
      revenues in the event of the loss of a large customer. In addition, pricing
      established in certain supply contracts could prevent us from immediately
      raising sales prices and therefore could result in a decline in profitability.
      We can offer no assurance that we will be able to fully offset the higher raw
      material costs.





**Our
      earnings could be negatively affected by raw material cost increases other
      than
      those related to polyurethane foam as described above.** Besides
      polyurethane foam, our other major raw material categories include nylon
      mattress covers, vinyl bags, vinyl air cylinders, electronic components for
      mattresses and corrugated cartons. Raw materials are our single largest cost
      category in the business, representing approximately 71% of our total cost
      of
      goods sold in fiscal 2005. Cost increases in these raw materials could have
      a
      significant effect on earnings if we are unable to recover the higher costs
      through sales price increases or other means.





**The
      loss of a key distributor or customer in the Company’s medical or custom
      products segments could cause a rapid and significant sales decline, which
      would
      likely result in a decline in earnings.** Many of
      our medical products are sold through large national distributors in the United
      States and Canada. We do not maintain long-term distribution agreements with
      most of these distributors. Instead, we supply them based on purchase orders
      that are issued by the customers on a daily or weekly basis. These
      supplier-customer relationships can generally be ended by either party with
      minimal notice. Consequently, if a large customer or distributor decided to
      discontinue purchasing our products, our sales and earnings could quickly
      decline. In addition, all of our consumer foam products are sold through our
      exclusive distributor, Louisville Bedding Company, under a marketing and
      distribution agreement that expires in December 2006. The agreement is
      automatically renewed for successive three-year terms unless either party
      provides notice of their intent not to renew at least 60 days prior to the
      expiration date. For more information on major customers and information on
      our
      business segments, see Notes 16 and 17 in the Notes to Financial Statements,
      Item 1. “Business - Industry Segment Data - Medical - Distributor Relationships”
and “Business - Industry Segment Data - Custom Products.”






12





**The
      Secure I.V. product line is just emerging from development stage and therefore
      involves greater risks and uncertainties than our more established product
      lines.** We have
      recently completed design and development of the Secure I.V. safety catheter
      and
      have begun sales and marketing efforts for this new product line. At this early
      stage in the product’s life cycle, we cannot accurately predict the degree of
      success that Secure I.V. might achieve in the marketplace. Although our product
      has a unique design that to our knowledge is not available elsewhere in the
      market, we are competing against larger companies with more experience in the
      safety catheter market, well-established distribution channels and greater
      resources than Span-America. Consequently, it could take a significant amount
      of
      time and additional investment for Secure I.V. sales and earnings to have a
      meaningful impact on our operating results. We cannot offer assurance that
      Secure I.V. sales will become meaningful or that the safety catheter segment
      will become profitable. See “Impairment of Long-Lived Assets” in Management’s
      Discussion and Financial Analysis and Note 17 in the Notes to Financial
      Statements for more information on the safety catheter segment.





**We
      currently have a sole source contract manufacturer for the Secure I.V. product
      line.** The
      Secure I.V. product line is presently being manufactured for Span-America by
      a
      single unaffiliated company that specializes in contract manufacturing
      operations. Having a sole-source manufacturer for the Secure I.V. product line
      creates additional risks for the safety catheter segment that we do not have
      in
      our other segments. Since the products are manufactured by an unaffiliated
      company, we have somewhat less control over product costs, manufacturing
      efficiency and quality than we do for products manufactured directly by us.
      These risks are mitigated by the terms of our agreement with our supplier and
      by
      procedures put in place to ensure that the products meet necessary quality
      standards. Our agreement with the contract manufacturer expires in September
      2007 but may be terminated by either party with 90 days notice under certain
      conditions as specified in the agreement. Our source of supply is also subject
      to risks related to the contract manufacturer, including management or strategic
      changes and property and casualty risks for an off-site location. If we were
      required to move our production equipment to another location, it could cause
      a
      delay in supplying our products to the market and additional expenses for
      moving, set-up and re-validation of the production line.





**Our
      sales volume could decline as a result of competition from low-cost foreign
      imports.** Within
      the last two years, we have experienced increased competition in our medical
      and
      custom products segments from low-cost foreign imports. In the medical segment,
      the number of low-cost, imported mattress products has increased in the last
      two
      years, but it has not yet had a significant impact on our medical business.
      We
      have potentially greater exposure to low-cost imports in our consumer bedding
      product lines because those products have more commodity-like characteristics
      than our medical products and our customers, who are generally national
      retailers, are more likely to change suppliers to buy lower-cost products.
      Therefore, we could lose significant parts of our consumer bedding business
      if
      we are unable to compete effectively with low-cost imports.






13





**Our
      business is subject to the loss of existing sales or slower growth rates due
      to
      the impact of competitive products and pricing** .
      All
      three of our business segments operate in highly competitive market
      environments. For each of our product lines, there are a number of alternative
      products in the market with similar features and benefits offered by several
      competitors, some of whom have greater resources than Span-America.





**Our
      medical business could lose sales volume or could have lower sales growth rates
      as a result of government reimbursement changes in the medical
      market.** A number
      of our medical products are eligible for reimbursement by Medicare. We have
      no
      direct dealings with Medicare reimbursement, but our customers often submit
      reimbursement requests to Medicare. For example, we might sell therapeutic
      mattresses to a home health care dealer who in turn rents our mattresses to
      patients. Medicare reimburses the dealer for some or all of the patient’s rental
      cost. If Medicare reimbursement rates are reduced, the demand for our medical
      products that are covered by Medicare could also be reduced.





**Certain
      of our medical products and all of our Secure I.V. products are classified
      as
      medical devices and are regulated by the FDA.** These
      regulations require, among other things, that medical device manufacturers
      register with the FDA, list devices manufactured by them, and file various
      types
      of reports. In addition, our manufacturing facilities and those of our contract
      manufacturer for the Secure I.V. products are subject to periodic inspections
      by
      regulatory authorities and must comply with "good manufacturing practices"
      as
      required by the FDA and state regulatory authorities. Although we believe we
      are
      in substantial compliance with applicable regulations, the existence of the
      regulations creates the risk of a product recall and related expenses as well
      as
      the risk of additional expenses required to meet the regulatory
      requirements.





**Item
      1B. Unresolved Staff Comments**





None





**Item
      2. Properties**





We
      own
      our principal office and manufacturing facility which is located in Greenville,
      South Carolina. This facility contains approximately 180,000 square feet used
      by
      the medical and custom products segments and is located on a 13-acre site.
      This
      includes a 58,000 square foot plant expansion undertaken in 2005 which was
      substantially completed on November 1, 2005. The addition will be used for
      manufacturing and storage purposes and replaced a 22,000 square foot storage
      building which we leased until October 31, 2005 at a cost of $7,700 per
      month.





We
      produce foam mattress overlays for the medical and consumer markets in a 40,000
      square foot leased facility in Norwalk, California. Our lease expires on
      December 31, 2006 and provides for a rental rate of $18,657 per month,
      increasing annually to $20,198 per month.





We
      consider the South Carolina and California facilities to be suitable and
      adequate for their intended purposes.






14





**Item
      3. Legal Proceedings**





There
      are
      currently no pending or threatened legal claims against Span-America. However,
      from time to time we are a party to various legal actions arising in the normal
      course of business. We believe that as a result of legal defenses and insurance
      arrangements with parties believed to be financially capable, there are no
      proceedings threatened or pending against us that, if determined adversely,
      would have a material adverse effect on our business or financial
      position.





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





No
      matters were submitted to a vote of security holders during the fourth quarter
      of our 2005 fiscal year.





**PART
      II**





**Item
      5. Market for the Registrant's Common Equity, Related Stockholder Matters and
      Issuer Repurchases of Equity Securities**





The
      common stock of Span-America Medical Systems, Inc. trades on the National Market
      Tier of The NASDAQ Stock Market® under the symbol SPAN. As of October 1, 2005,
      there were 2,611,768 common shares outstanding. As of December 21, 2005, there
      were 233 shareholders of record and approximately 1,050 beneficial shareholders.
      The closing price of Span-America's stock on December 21, 2005 was $10.71 per
      share.





Selected
      quarterly stock price data is shown on the following table.







**Quarterly
                  Stock Price Data****First**
              
              
              **Second**
              
              
              **Third**
              
              
              **Fourth**
              
              
              **Year****For
                  Fiscal 2005**High
              
              $
              12.50
              
              $
              13.70
              
              $
              11.19
              
              $
              12.95
              
              $
              13.70Low
              
              
              10.42
              
              
              10.00
              
              
              8.62
              
              
              8.81
              
              
              8.62**For
                  Fiscal 2004**High
              
              
              13.72
              
              
              14.97
              
              
              13.99
              
              
              13.68
              
              
              14.97Low
              
              
              9.21
              
              
              12.41
              
              
              11.15
              
              
              10.30
              
              
              9.21






The
      Company has paid a regular quarterly cash dividend since January 1990. In July
      2004, the Board increased the quarterly dividend to $0.04 per share from $0.035
      per share. In December 2004, the Board declared a special cash dividend of
      $0.40
      per share payable on January 12, 2005 to all shareholders of record on December
      22, 2004. In July 2005, the Board increased the quarterly dividend to $0.045
      per
      share from $0.04 per share. Future dividend payments will depend upon the
      Company's earnings and liquidity position.






15






In
      September 1994, the Board of Directors approved a resolution changing their
      annual Director’s compensation from cash to stock. Each non-employee Director
      receives 1,000 shares of Company common stock per year in lieu of annual cash
      compensation. As compensation for additional duties, the Chairman of the Board
      receives an additional 1,000 shares, and the Chairman of the Audit Committee
      receives an additional 500 shares of Company common stock per year. The
      following table sets forth information about unregistered shares of common
      stock
      issued in fiscal year 2005 to our non-employee Directors for their service
      as
      Directors. The shares issued in fiscal 2005 included 500 shares issued to a
      Director elected for an interim period that was served in 2004.






Issue Date
            #
                Shares of Common
              Stock
                Issued
            Fair
                Market Value on
              Issue
                Date ($ Per Share)
            Aggregate
              Value03/09/05
            9,000
            $10.33
            $
                92,970






We
      did
      not register the shares issued to non-employee Directors in reliance on the
      exemption provided by Section 4(2) of the Securities Act of 1933, as amended,
      which exempts stock issued outside of a public offering from registration
      requirements.





The
      information regarding equity compensation plans set forth under Item 12 below
      is
      incorporated herein by reference.






16





**Item
      6. Selected Financial Data**





Selected
      Financial Data for the Company’s last five fiscal years is shown in the table
      below.




**Five-Year
                  Financial Summary**(Amounts
                  in thousands, except per share and employee data)**2005**
              
              2004
              
              2003
              
              2002
              
              2001For
                  the year:Net
                  sales
              
              **$**
              **48,439**
              
              $
              49,929
              
              $
              41,575
              
              $
              33,536
              
              $
              29,075Gross
                  profit
              
              **14,713**
              
              12,691
              
              11,134
              
              10,175
              
              8,910Operating
                  income
              
              **3,133**
              
              2,308
              
              1,440
              
              1,717
              
              1,297Net
                  income
              
              **2,439**
              
              1,985
              
              1,399
              
              1,658
              
              1,260Cash
                  flow from operations
              
              
              **2,589**
              
              
              2,812
              
              
              1,147
              
              
              1,486
              
              
              2,362Capital
                  expenditures
              
              
              **2,405**
              
              
              1,997
              
              
              1,647
              
              
              559
              
              
              461Per
                  share:Net
                  income:Basic
              
              **$**
              **0.94**
              
              $
              0.77
              
              $
              0.55
              
              $
              0.66
              
              $
              0.50Diluted
              
              
              **0.89**
              
              
              0.73
              
              
              0.53
              
              
              0.64
              
              
              0.50Cash
                  dividends declared
              
              
              **0.565**
              
              
              0.145
              
              
              0.14
              
              
              0.12
              
              
              0.12At
                  end of year:Working
                  capital
              
              
              **10,638**
              
              
              11,623
              
              
              10,814
              
              
              11,058
              
              
              9,844Property
                  and equipment - net
              
              
              **8,090**
              
              
              6,185
              
              
              4,817
              
              
              3,632
              
              
              3,425Total
                  assets
              
              
              **28,666**
              
              
              27,098
              
              
              24,156
              
              
              22,076
              
              
              20,328Shareholders'
                  equity
              
              
              **21,561**
              
              
              20,419
              
              
              18,525
              
              
              17,394
              
              
              15,928Book
                  value per share
              
              
              **8.26**
              
              
              7.88
              
              
              7.26
              
              
              6.85
              
              
              6.33Number
                  of employees
              
              
              **293**
              
              
              303
              
              
              299
              
              
              254
              
              
              228Key
                  ratios:Return
                  on net sales
              
              
              **5.0**
              **%**
              
              4.0
              %
              
              3.4
              %
              
              4.9
              %
              
              4.3
              %Return
                  on average shareholders' equity
              
              
              **11.6**
              **%**
              
              10.2
              %
              
              7.8
              %
              
              9.9
              %
              
              8.2
              %Return
                  on average total assets
              
              
              **8.7**
              **%**
              
              7.7
              %
              
              6.1
              %
              
              7.8
              %
              
              6.4
              %Current
                  ratio
              
              
              **3.0**
              
              
              3.3
              
              
              3.5
              
              
              4.2
              
              
              4.0






17






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





**OVERVIEW**


Span-America
      manufactures and markets a comprehensive selection of pressure management
      products for the medical market, including Geo-Matt®, PressureGuard®,
      Geo-Mattress®, Span-Aids®, Isch-Dish®, and Selan® products. We also manufacture
      consumer mattress pads and pillows for the retail bedding market and custom
      foam
      and packaging products for the industrial market. In addition, we have recently
      begun manufacturing and marketing the Secure I.V.® line of safety catheters for
      the short peripheral intravenous catheter market. We group these products into
      three business segments: medical, custom products and safety catheters. Our
      revenues, profits and cash flows are derived from the development, manufacture
      and sale of these products.





**RESULTS
      OF OPERATIONS FISCAL 2005 VS. 2004**





**Summary**


Net
      sales
      in fiscal 2005 decreased 3% to $48.4 million compared with $49.9 million in
      fiscal 2004. The decrease was the result of sales declines in the custom
      products segment that were not fully offset by strong sales growth in the
      medical segment. Sales in the custom products segment declined 32% to $18.1
      million while sales in the medical segment rose by 30% to $30.3
      million.





Net
      income rose 23% in fiscal 2005 to a record $2.4 million, or $0.89 per diluted
      share, compared with $2.0 million, or $0.73 per diluted share, in fiscal 2004.
      The increase in earnings resulted primarily from higher unit sales of
      PressureGuard® and Geo-Mattress® therapeutic surfaces for the medical market and
      a more profitable product mix, as sales rose in the higher margin medical
      segment and fell in the lower margin custom products segment.





**Sales**


Sales
      in
      our medical segment rose 30% to $30.3 million in fiscal 2005 compared with
      $23.3
      million the previous year. The medical sales growth was led by our therapeutic
      support surfaces (or mattresses) which increased by 58% over 2004 levels. We
      sell these specialty mattresses to hospitals, long-term care facilities and
      home
      care dealers throughout the United States and Canada. Increased sales of the
      PressureGuard CFT® mattresses, sold mostly in the acute care market, made up
      about half of the total growth in the medical segment. The PressureGuard APM®
and Easy Air® powered therapeutic surfaces and the Geo-Mattress foam mattresses
      also made up a significant portion of our medical sales growth during the year.
      The APM, Easy Air and Geo-Mattress products are sold primarily in the long
      term
      care and home care sections of the medical market. In other medical product
      lines, sales of seating products increased 10%, Selan® skin care products rose
      by 9%, and patient positioners decreased by 9% due to lower export sales. Sales
      of overlays were down by 14%, continuing a long-term trend of customers
      switching to replacement mattresses from mattress overlays. Our medical business
      achieved solid growth in fiscal 2005 primarily because of increased customer
      acceptance of our therapeutic mattresses, particularly in the long-term care
      market, and the initial success of our private label mattresses in the acute
      care market. The combination of increasing medical mattress sales and declining
      overlay sales makes our total medical sales more volatile from quarter to
      quarter because mattresses are capital purchase items with longer selling
      cycles, whereas overlays are generally consumable items where repeat orders
      are
      common. We expect total medical sales to increase during fiscal 2006, but the
      rate of growth will likely be lower than that achieved in fiscal
      2005.






18





Our
      custom products segment consists of consumer bedding products and specialty
      foam
      products for the industrial market. Sales in the custom products segment
      declined 32% during fiscal 2005 to $18.1 million from $26.5 million in fiscal
      2004. Most of the custom products 2005 sales decrease was due to lower unit
      volumes of pillows and Geo-Systems® mattress pads sold to major retailers
      through Louisville Bedding Company, our exclusive distributor for consumer
      foam
      products. Louisville Bedding is a leading manufacturer and distributor of
      bedding products in North America. Sales of consumer bedding products decreased
      34% in 2005 to $15.6 million. The decline in consumer bedding sales resulted
      from increased competition in the mattress pad business, particularly from
      visco
      foam products, and in pillow products where a portion of our business was lost
      to a competing visco foam pillow manufactured in China. In addition, we lost
      a
      smaller part of our mattress pad business due to a customer switching from
      our
      branded products to a lower cost private-label version. We are working closely
      with Louisville Bedding to develop new sales programs and products that could
      stabilize or reverse the recent trend of declining consumer sales. However,
      we
      can give no assurance that these efforts will be successful. We expect consumer
      sales in fiscal 2006 to be similar to fiscal 2005 levels.





In
      the
      other part of the custom products segment, industrial sales declined by 14%
      to
      $2.5 million. The industrial sales decline was caused by the loss of business
      with several existing customers due to a temporary acquisition-related purchase
      slowdown by a large customer, a customer’s manufacturing operation being moved
      outside the United States, and pricing competition. We believe industrial sales
      in fiscal 2006 will be slightly higher than those of fiscal 2005.





In
      the
      safety catheter segment, sales were $6,000 as we recorded the first shipments
      of
      the redesigned Secure I.V. product line in the fourth quarter of fiscal 2005.
      The Secure I.V. safety catheter was not offered for sale in the first three
      quarters of fiscal 2005 pending the completion of design enhancements. We began
      shipping market test samples of the product in the latter part of fiscal 2004.
      However, in December 2004 we decided to delay the full release of the Secure
      I.V. as a result of initial customer feedback that revealed the potential
      benefits of making three design improvements to the product. The design
      improvements were completed in the fourth quarter of fiscal 2005, and we began
      limited shipments of the new products. We expect sales of Secure I.V. to
      increase in fiscal 2006, but the rate of increase is difficult to predict
      because it will depend on manufacturing speed and reliability, selling price,
      and the market’s acceptance of this new product. We continue to be optimistic
      about the future prospects for the safety catheter segment, but we do not expect
      the segment to be profitable in fiscal 2006. We believe the operating loss
      for
      the segment in fiscal 2006 will be less than that of fiscal 2005.






19








**Gross
      Profit**


Our
      gross
      profit level increased by 16% to $14.7 million during fiscal 2005 from $12.7
      million in fiscal 2004. The gross profit margin percentage rose to 30.4% for
      fiscal 2005 compared with 25.4% for fiscal 2004. The increases in gross profit
      level and margin were due to higher sales volumes in the medical segment. The
      medical segment typically has a higher gross margin than the custom products
      segment because many of our medical products are patented and proprietary.
      We
      expect the gross margin percentage during fiscal 2006 to be slightly lower
      than
      that of fiscal 2005.





**Selling,
      Research & Development and Administrative Expenses**


Selling
      and marketing expenses increased 11% to $7.7 million, or 15.8% of sales, in
      fiscal 2005 compared with $6.9 million, or 13.9% of sales, in fiscal 2004.
      Most
      of the increase occurred in the medical segment and was due to higher expenses
      for commissions, sales salaries and shipping costs. Selling and marketing
      expenses increased as a percent of sales primarily because of the decline in
      custom products sales during the year. We believe that total selling and
      marketing expenses for fiscal 2006 will increase over 2005 levels due to planned
      programs in the medical and safety catheter segments and expected future growth
      in the medical segment.





Total
      R&D expenses increased 66% to $1.1 million in fiscal 2005 compared with
      $686,000 in fiscal 2004. The majority of the increase occurred in the safety
      catheter segment and was related to new product development efforts for the
      Secure I.V. product line. R&D expense for the safety catheter segment in
      fiscal 2005 increased 102% to $733,000 compared with $364,000 in the prior
      year.
      The increased costs were primarily due to higher expenses for labor, scrapped
      material, engineering and product development related to design changes and
      production test runs. We expect R&D expenses for the safety catheter segment
      to decline in fiscal 2006 as we shift away from product development efforts
      toward sales and marketing activities. We consider safety catheters to be a
      separate reportable segment based on product type and distribution channels.
      See
      Note 17 in the Notes to Financial Statements for additional information on
      the
      safety catheter segment. We expect that total R&D expenses in fiscal 2006
      will be less than those of 2005 because of the planned reduction in safety
      catheter development costs.





General
      and administrative expenses remained level at $2.8 million in fiscal 2005.
      Lower
      professional fees, incentive compensation and bad debt expenses were offset
      by
      higher costs for property and casualty insurance and administrative salaries.
      We
      expect general and administrative expenses for 2006 to be slightly higher than
      2005 levels.





Operating
      profit increased 36% to $3.1 million compared to $2.3 million in fiscal 2004.
      The increase was primarily caused by higher medical sales volume and a more
      profitable product mix.





**Non-Operating
      Income**


Investment
      income increased by 11% to $113,000 in fiscal 2005 compared with $102,000 in
      fiscal 2004. The increase in investment income was the result of higher interest
      rates and slightly higher average balances of marketable securities in fiscal
      2005.






20





Royalty
      income decreased 9% to $498,000 in fiscal 2005 compared with $545,000 in fiscal
      2004 as a result of lower sales volume of the Safety-Lok® shielded syringe
      product licensed to Becton Dickinson and Company (BD). Our license agreement
      with BD will expire in December 2005 due to the expiration of the related
      patents. We expect to receive the final royalty payment from BD in February
      2006.





Other
      non-operating income for 2005 included a $26,000 gain on the sale of
      manufacturing equipment. We expect total non-operating income for fiscal 2006
      to
      be significantly lower than 2005 levels because of lower royalty income as
      described above.





**Net
      Income and Dividends**


Net
      income for fiscal 2005 increased 23% to $2.4 million, or $0.89 per diluted
      share, compared with $2.0 million, or $0.73 per diluted share, in fiscal 2004.
      The increase was due primarily to higher sales volume in the medical segment
      and
      a more profitable sales mix.





During
      fiscal 2005, we paid dividends of approximately $1.5 million, or 60% of net
      income, for the year. This amount represented three quarterly dividends of
      $0.04
      per share, one quarterly dividend of $0.045 and one special dividend of $0.40
      per share.




**RESULTS
      OF OPERATIONS FISCAL 2004 VS. 2003**





**Summary**


Net
      sales
      in fiscal 2004 increased 20% to $49.9 million compared with $41.6 million in
      fiscal 2003. The increase was the result of sales growth in our custom products
      and medical business segments. Custom products sales were up 31% to $26.5
      million. Sales in the medical segment rose by 9% to $23.3 million.





Net
      income increased 42% in fiscal 2004 to $2.0 million, or $0.73 per diluted share,
      compared with $1.4 million, or $0.53 per diluted share, in fiscal 2003. Our
      increase in earnings resulted from higher sales volume, lower labor costs from
      manufacturing process improvements, and slower growth in selling and
      administrative expenses.





**Sales**


Sales
      in
      the custom products segment rose 31% during fiscal 2004 to $26.5 million from
      $20.2 million in fiscal 2003. Most of the 2004 sales increase in the custom
      products segment was due to higher unit volumes of pillows and Geo-SystemsTM
mattress pads sold to Wal-Mart and other major retailers through Louisville
      Bedding Company, our exclusive distributor for consumer foam products. Sales
      of
      consumer bedding products increased 36% in 2004 to $23.6 million. In the other
      part of the custom products segment, industrial sales declined by 1% to $2.9
      million. The industrial sales decline was caused by the loss of business as
      some
      customers moved their manufacturing operations outside the United
      States.





Sales
      in
      our medical segment rose 9% to $23.3 million in fiscal 2004 compared with $21.3
      million the previous year. The medical sales growth was led by our
      PressureGuard® and Geo-Mattress® therapeutic mattresses which increased by 17%
      over 2003 levels. Most of the mattress growth came from our PressureGuard®
APM 2 ®,
      CFT®
and Geo-Mattress Wings® products. In other medical product lines, sales of
      patient positioners increased by 4%, seating products increased 9%, and Selan®
skin care products rose by 5%. Sales of overlays were down by 3%, continuing
      a
      long-term trend of customers switching to replacement mattresses from mattress
      overlays.






21





In
      the
      safety catheter segment, sales were $59,000 as we recorded the first shipments
      of the new Secure I.V. ® product line in the third and fourth quarters of fiscal
      2004.





**Gross
      Profit**


Our
      gross
      profit level increased by 14% to $12.7 million during fiscal 2004 from $11.1
      million in fiscal 2003. The increase in gross profit level was due to higher
      sales volume and improved labor efficiencies. The gross profit margin percentage
      declined to 25.4% for fiscal year 2004 compared with 26.8% for fiscal 2003.
      The
      decline in gross margin percentage resulted from higher sales of consumer
      products in 2004 compared with 2003 as they carry lower margins than most of
      our
      medical products. The gross margin percentage in 2004 was also lowered slightly
      by new depreciation expense for Secure I.V. production equipment.





**Selling,
      Research & Development and Administrative Expenses**


Selling
      and marketing expenses increased 7% to $6.9 million, or 13.9% of sales, in
      fiscal 2004 compared with $6.5 million, or 15.5% of sales, in fiscal 2003.
      Most
      of the increase occurred in the medical segment and was due to higher
      expenditures for shipping, incentive compensation, advertising and trade shows.
      In addition, marketing expense in the custom products segment increased in
      2004
      due to a special promotion program for consumer bedding products. Sales and
      marketing expenses declined as a percent of sales because most of our sales
      growth for fiscal 2004 came from the custom products segment, which has much
      lower selling and marketing expenses than the medical segment.





Total
      research and development expenses increased 23% to $686,000 in fiscal 2004
      compared with $556,000 in fiscal 2003. The increase was nearly evenly divided
      between the medical and safety catheter segments and stemmed from new product
      development efforts in both segments. R&D expense for the safety catheter
      segment in fiscal 2004 increased 21% to $364,000 compared with $301,000 in
      fiscal 2003.





General
      and administrative expenses increased 3% to $2.8 million in fiscal 2004 from
      $2.7 million in 2003 due to higher property and casualty insurance costs and
      incentive compensation expense which was partly offset by lower professional
      fees and bad debt expense.





**Non-Operating
      Income**


Investment
      income increased by 21% to $102,000 in fiscal 2004 compared with $84,000 in
      fiscal 2003. The increase was the result of a $39,000 pre-tax gain on the sale
      of Prudential Financial common stock received through Prudential’s
      demutualization process. The gain was partially offset by a decline in
      investment income, which was the result of lower interest rates and a lower
      average balance of marketable securities in fiscal 2004.






22





Royalty
      income decreased 9% to $545,000 in fiscal 2004 compared with $598,000 in fiscal
      2003 as a result of lower sales volume of the Safety-Lok® shielded syringe
      product licensed to Becton Dickinson and Company (BD).





Other
      non-operating income for 2004 also included a $12,000 loss on the retirement
      of
      certain equipment.





**Net
      Income and Dividends**


Net
      income increased 42% in fiscal 2004 to $2.0 million, or $0.73 per diluted share,
      compared with $1.4 million, or $0.53 per diluted share, in fiscal 2003. The
      increase in earnings resulted from higher sales volume, lower labor costs from
      manufacturing process improvements, and slower growth in selling and
      administrative expenses.





During
      fiscal 2004, we paid dividends of $374,000, or 19% of net income, for the year.
      This amount represented three quarterly dividends of $0.035 per share and one
      of
      $0.04 per share.





**LIQUIDITY
      AND CAPITAL RESOURCES**


We
      generated cash from operations of $2.6 million during fiscal 2005, which was
      an
      8% decline compared with $2.8 million in fiscal 2004. The major factors
      contributing to the change in cash flow during the year were higher net income,
      increases in depreciation and amortization expense, and a decrease in prepaid
      expenses due mainly to a reduction in prepaid insurance caused by a change
      in
      the policy year. Those additions to cash flow were offset by a reduction in
      our
      net deferred tax liability, increases in accounts receivable and inventory
      due
      to higher sales levels, and the addition of inventory for the safety catheter
      segment.





Working
      capital decreased by $985,000 or 8%, to $10.6 million during fiscal 2005. The
      decline was caused by lower year-end balances of cash and marketable securities
      related to capital expenditures, a special dividend payment and the reduction
      in
      prepaid insurance expense as described above. Our working capital level was
      also
      affected by an increase in accounts payable associated with higher sales levels
      and an increase in income taxes payable due to increased earnings. Our current
      ratio decreased to 3.0 at October 1, 2005 from 3.3 at fiscal year end
      2004.





Accounts
      receivable, net of allowances, increased 9% to $7.2 million at the end of fiscal
      2005 compared with $6.6 million at the end of fiscal 2004. The majority of
      the
      increase resulted from higher sales in the medical segment particularly in
      the
      last two months of fiscal 2005 compared with the same period in fiscal 2004.
      The
      days sales outstanding (or average collection time), calculated using a 12-month
      average for accounts receivable balances, increased to 44 days in 2005 compared
      with 43 days in 2004. All of our accounts receivable are unsecured.





Inventory,
      net of reserves, increased by $499,000 (18%) to $3.2 million at October 1,
      2005
      compared with $2.7 million at October 2, 2004. Approximately $313,000 (63%)
      of
      the increase occurred in the safety catheter segment because of a January 2005
      change in our contract manufacturing agreement that required us to begin
      carrying Secure I.V. inventory for the first time. The remaining part of the
      increase was due to higher raw material levels in the custom products and
      medical segments. Inventory turns for fiscal 2005 decreased to 11.4 times from
      14.2 times in fiscal 2004 primarily because of the increase in safety catheter
      inventory. We expect inventory levels in fiscal 2006 to be slightly higher
      than
      those of fiscal 2005.






23





Net
      property and equipment increased by 31% during fiscal 2005. The change resulted
      from the combination of building and equipment purchases of $2.4 million
      partially offset by regular depreciation expense. Shortly after the close of
      fiscal 2005, we completed the addition of 58,000 square feet of manufacturing
      and storage space to our plant in Greenville, South Carolina. The total cost
      of
      the expansion was $2.6 million, but as of October 1, 2005 we had incurred
      related project costs of approximately $2.2 million because the building was
      approximately 85% complete at fiscal year end. We expect capital expenditures
      in
      fiscal 2006 to be significantly less than fiscal 2005 primarily because no
      building expansion is planned in 2006 and capital expenditures will be limited
      mainly to investments in new equipment.





From
      time
      to time, we purchase forward contracts for foreign currency to lock in exchange
      rates for future payments on manufacturing equipment that we order. The foreign
      exchange contracts are used to eliminate foreign currency fluctuations during
      the six to nine month period between the date the order is placed and the date
      of final payment. Realized gains and losses, if any, are included in the cost
      of
      the related equipment. Unrealized gains and losses on open contracts are not
      material to our results of operations or financial condition. We held no forward
      contracts as of October 1, 2005. We have not engaged in foreign currency
      transactions since fiscal year 2003. However, it is possible that we will do
      so
      again in fiscal 2006 due to anticipated purchases of equipment manufactured
      in
      Germany.





Our
      trade
      accounts payable increased 5% in fiscal 2005 to $2.7 million. The increase
      in
      payables was primarily the result of higher sales levels and associated
      purchases during the last two months of the fiscal year. Accrued and sundry
      liabilities increased by 10% during the year to $2.7 million compared with
      $2.4
      million last year. The increase was mostly due to higher accruals for income
      taxes.





In
      December 2004, our board of directors declared a special cash dividend of $0.40
      per share, or $1.0 million that was paid on January 12, 2005 to shareholders
      of
      record on December 22, 2004.





We
      believe that funds on hand and funds generated from operations are adequate
      to
      finance our operations and expected capital requirements during fiscal 2006.
      During early fiscal 2005, we renegotiated certain terms of the supply agreement
      with the contract manufacturer for our Secure I.V. product line. The new terms
      require us to pay approximately $8,200 per week in labor and overhead charges
      for production of the Secure I.V. catheter in lieu of a per unit charge. This
      weekly charge is expected to remain in effect for the next six to 12 months,
      depending on actual production volume, and can be changed by the mutual
      agreement of both parties.





**OFF-BALANCE-SHEET
      ARRANGEMENTS**


We
      have
      no off-balance-sheet arrangements.






24





**CONTRACTUAL
      OBLIGATIONS**


The
      following table summarizes our significant contractual obligations and
      commercial commitments at October 1, 2005 and the future periods in which such
      obligations are expected to be settled in cash. For additional information
      regarding these obligations, see the referenced footnotes to in the Notes to
      Financial Statements under Item 8 below.





Payments
                  Due by PeriodContractual
                  Obligations
              
              
              
              Less
                  Than
              
              
              
              
              
              More
                  Than(dollars
                  in thousands)
              
              Total
              
              1
                  Year
              
              1-3
                  Years
              
              3-5
                  Years
              
              5
                  YearsOperating
                  leases - Note 18
              
              $
              308
              
              $
              247
              
              $
              61Purchase
                  obligations - Note 19
              
              
              3,125
              
              
              625
              
              
              1,250
              
              $
              1,250Deferred
                  compensation - Note 10
              
              
              899
              
              
              114
              
              
              227
              
              
              227
              
              $
              331Total
                  contractual obligations
              
              $
              4,332
              
              $
              986
              
              $
              1,538
              
              $
              1,477
              
              $
              331






**IMPACT
      OF INFLATION AND COST OF RAW MATERIALS**


Inflation
      was a moderate factor for our operations in fiscal 2005. We received price
      increases on certain of our polyurethane foam raw materials on October 1, 2004,
      February 1, 2005, April 1, 2005 and May 16, 2005. We recovered the majority
      of
      the cost of these increases by raising sales prices, improving manufacturing
      efficiencies and other cost reduction efforts. However, future increases in
      the
      cost of polyurethane foam will likely have a larger impact on the business
      in
      fiscal 2006 than we experienced in 2005.





As
      we
      announced on October 13, 2005, our largest foam suppliers notified us of price
      increases of 10% to 37%, depending on the type of foam, effective November
      7,
      2005. We were later notified of an additional 10% surcharge placed on most
      types
      of foam effective October 24, 2005. These increases have now occurred. We expect
      the price increases to affect both the supply of competitive products and the
      demand for products that include foam as a major raw material component. Based
      on conversations with our suppliers, we do not expect Span-America to be on
      allocation for any key foam raw materials. We believe that a portion of the
      higher foam costs will be a short-term problem since they are being caused
      by
      Gulf Coast hurricane-related disruptions in the supply of certain chemicals
      used
      in the foam manufacturing process. A portion of the price increases may be
      longer-term in nature since they are related to higher natural gas costs. We
      plan to raise our sales prices in tandem with the increased costs of foam,
      but
      we do not expect to recoup all of our higher raw material costs due to
      competition in certain markets and pricing established in certain contracts.
      At
      this point, we expect that the higher foam prices could reduce our earnings
      in
      fiscal 2006, but we cannot quantify the effect until we have some operating
      history with the increased costs, potential shifts in demand and related
      competitive factors.





**CRITICAL
      ACCOUNTING POLICIES**


This
      discussion and analysis of financial condition and results of operations is
      based on our financial statements which we prepare in conformity with accounting
      principles generally accepted in the United States of America. The preparation
      of our financial statements requires us to make estimates and assumptions that
      affect the reported amounts of assets, liabilities, revenues and expenses.
      These
      estimates and assumptions are based on historical experience and on various
      other factors that we believe are reasonable under the circumstances, the
      results of which form the basis for making judgments about the carrying values
      of assets and liabilities that are not readily apparent from other sources.
      These estimates and assumptions also require the application of certain
      accounting policies, many of which require us to make estimates and assumptions
      about future events and their impact on amounts reported in our financial
      statements and related notes. We periodically review our accounting policies
      and
      estimates and make adjustments when facts and circumstances
      dictate.






25





Actual
      results may differ from these estimates under different assumptions or
      conditions. Any differences may have a material impact on our financial
      condition and results of operations.





In
      addition to the accounting policies which are more fully described in the Notes
      to Financial Statements included in this report, we have identified the
      following critical accounting policies used in the preparation of our financial
      statements.





**Allowance
      for Doubtful Accounts**


Credit
      evaluations are undertaken to set credit limits for all customers. On a
      quarterly basis, we evaluate past due items in the accounts receivable listing
      and provide what we estimate to be adequate reserves for doubtful accounts.
      Customer economic conditions may change and increase the risk of collectibility
      and may require additional provisions which would negatively impact our
      operating results. As of October 1, 2005, our provision for doubtful accounts
      represented approximately 1.6% of total accounts receivable, or
      $116,000.





**Inventories**


We
      regularly review inventory quantities on hand and adjust for excess and obsolete
      inventory based primarily on historical usage rates and our estimated forecast
      of product demand and production. Actual demand may differ from our estimate,
      in
      which case we may have understated or overstated the provision required for
      obsolete and excess inventory, which would have an impact on our operating
      results. As of October 1, 2005, our provision for excess and obsolete inventory
      represented approximately 12.7% of total inventories, or $469,000.





We
      began
      to carry Secure I.V. inventory in fiscal 2005. Since we have limited sales
      and
      production history for this new product line, our future estimates for Secure
      I.V. inventory reserves could be more volatile than those in our medical and
      custom products segments.





**Warranty
      Obligations**


We
      warrant certain of our products for a specific period of time against
      manufacturing or performance defects. We provide for the estimated future cost
      of warranty obligations in cost of goods sold when the related revenue is
      recognized. The accrued warranty cost represents our best estimate at the time
      of sale of the total cost that we will incur to repair or replace covered
      products or parts. The amount of accrued estimated warranty cost is primarily
      based on historical experience as well as current information on repair costs.
      Actual warranty cost could differ from the estimated amounts. On a quarterly
      basis, we review the accrued balances and update the historical warranty cost
      trends. If we were required to accrue additional warranty cost in the future,
      it
      would negatively affect operating results. Our actual warranty expense was
      $174,000 in fiscal 2005 and $157,000 in fiscal 2004. See Notes 7 and 8 in the
      Notes to Financial Statements for more information on product
      warranties.






26





**Impairment
      of Goodwill**


As
      required by SFAS No. 142, we evaluate goodwill in our medical business unit
      for
      impairment at least annually or more frequently if events occur or circumstances
      change that could reduce the fair value of our medical business unit. For fiscal
      year end 2005, we determined that the fair value of the medical business unit
      exceeded its carrying value and thus no impairment charge was required. In
      assessing the value of goodwill, we must make assumptions regarding estimated
      future cash flows and other factors to determine the fair value of the medical
      business unit. If these estimates or their related assumptions change in the
      future, we may be required to record impairment charges which would negatively
      impact operating results. As of October 1, 2005, the carrying value of goodwill
      was $1.9 million.





**Impairment
      of Long-Lived Assets**


“Impairment”
      is the condition that exists when the carrying amount of a long-lived asset
      or
      asset group is greater than its fair value. As required by SFAS No. 144, we
      evaluate long-lived assets for potential impairment whenever events occur or
      circumstances indicate that the carrying amount of the assets may not be
      recoverable. The carrying amount of a long-lived asset is not recoverable if
      it
      exceeds the sum of the undiscounted cash flows expected to result from the
      use
      and eventual disposition of the asset. If the carrying amount of a long-lived
      asset is not recoverable and is greater than its fair value, the asset is
      impaired and an impairment loss must be recognized. To date, we have had no
      indicators of impairment for long-lived assets. However, our investment in
      the
      safety catheter business unit raises the possibility of a future impairment
      loss
      because the new business unit has little sales and production history and is
      just emerging from the development phase. We do not currently expect this
      segment to suffer impairment in the foreseeable future; however, we can offer
      no
      assurance to this effect. If the assets associated with the safety catheter
      segment became impaired, the impairment loss could be as much as the total
      assets of the safety catheter segment. (See Note 17 in the Notes to Financial
      Statements.) If such an event had occurred as of October 1, 2005, our assets
      and
      operating income would have been reduced by up to $3.0 million, and net income
      after taxes would have been reduced by up to $2.0 million, or $0.72 per diluted
      share, using the weighted average diluted shares outstanding at fiscal year
      end
      2005. The actual amount of any future impairment loss could be more or less,
      depending on the level of assets and the degree of impairment at the time we
      determine an impairment charge is necessary.





**Present
      Value of Deferred Compensation**


We
      are
      obligated to make fixed payments under a retirement agreement over the remaining
      life of Span-America’s founder as discussed in Note 10 “Deferred Compensation”
in the Notes to Financial Statements. We have fully accrued the present value
      of
      the expected payments due over the executive’s estimated life expectancy. In
      calculating this present value we estimated an effective long-term interest
      rate
      of 8%. If actual long-term interest rates declined significantly and we were
      required to accrue additional deferred compensation costs in the future, it
      would negatively affect operating results. As of October 1, 2005, we had
      recorded a deferred compensation liability of $980,000, including current and
      deferred portions. If we reduced the discount rate by 1%, the deferred
      compensation liability would be increased by $62,000 and pre-tax income would
      be
      reduced by the same amount.






27





**Item
      7A. Qualitative and Quantitative Disclosures About Market
      Risk**





We
      are
      exposed to financial market risk in two areas: short-term investments and cash
      value of life insurance. As of October 1, 2005, we had short-term investments
      of
      $4.1 million which were classified as available for sale. Included in these
      short-term investments are approximately $3.9 million of high quality and highly
      liquid corporate commercial paper and bonds known as “variable rate demand
      notes” or “low floaters.” The bonds are issued by municipalities or companies
      and are backed by letters of credit from federally insured banks. The bonds
      carry the credit rating of the underlying bank and are therefore highly rated.
      The interest rate on the bonds is a floating rate which is reset weekly by
      the
      re-marketing agent based on market rates for comparable securities. We can
      liquidate the bonds at any time with a settlement date of five to seven days
      after the trade date. Using the level of securities available for sale at fiscal
      year end 2005, a 100 basis point increase or decrease in interest rates for
      one
      year would increase or decrease after-tax earnings by approximately
      $39,000.





Our
      $4.1
      million in short-term investments at fiscal year end also included approximately
      $170,000 in a portfolio of investment grade preferred stocks. The preferred
      shares are generally callable within three to five years and have an after-tax
      dividend yield currently higher than the variable rate demand notes described
      above. Dividends from the preferred stocks are generally paid quarterly and
      qualify for the 70% dividends received deduction available to corporate holders
      of the preferred shares. These shares are traded on the New York Stock Exchange
      and per share prices are subject to interest rate risks similar to
      intermediate-term bonds as well as specific company risk factors. We believe
      that substantial fluctuations in long-term interest rates or prices of the
      preferred stocks would not have a material effect on our financial
      position.





In
      addition, our other assets at October 1, 2005 include $1.7 million in cash
      value
      of life insurance, which is subject to market risk related to equity pricing
      and
      interest rate changes. The cash value is generated from life insurance policies
      which are being used as the funding vehicle for a retirement program for
      Span-America’s founder and former chairman. The cash value is invested in a
      combination of fixed income life insurance contracts and a portfolio of mutual
      funds managed by an insurance company. The fixed income contracts are similar
      to
      fixed income bond funds and are therefore subject to interest rate and company
      risk. The mutual fund portfolios invest in common stocks and bonds in accordance
      with their individual investment objectives. These portfolios are exposed to
      stock market and interest rate risk similar to comparable mutual funds. We
      believe that substantial fluctuations in equity markets and interest rates
      and
      the resulting changes in cash value of life insurance would not have a material
      adverse effect on our financial position. During the fiscal year ended October
      1, 2005, cash value of life insurance increased by 6.4%, creating after-tax
      income of approximately $90,000.





28






**Item
        8. Financial Statements and Supplementary Data**
  **Span-America
        Medical Systems, Inc.**
 **Financial
        Statements**
 
 **October
        1, 2005**
 
 ContentsReport
                  of Independent Registered Public Accounting Firm
                30Financial
                  StatementsStatements
                  of Income
                31Balance
                  Sheets
                32Statements
                  of Changes in Shareholders’Equity
                    and Other Comprehensive Loss
                33Statements
                  of Cash Flows
                34Notes
                  to Consolidated Financial Statements
                35
   29
   **Report
        of Independent Registered Public Accounting Firm**
  
 Shareholders
        and Board of Directors
 Span-America
        Medical Systems, Inc.
 Greenville,
        South Carolina
 
 
 We
        have
        audited the accompanying balance sheets of Span-America Medical Systems,
        Inc. as
        of October 1, 2005 and October 2, 2004 and the related statements of income,
        changes in shareholders’ equity and other comprehensive loss, and cash flows for
        each of the years in the three year period ended October 1, 2005. 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 the Standards of the Public Company
        Accounting Oversight Board (United States). 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 Span-America Medical Systems,
        Inc.,
        as of October 1, 2005 and October 2, 2004 and the results of its operations
        and
        its cash flows for each of the years in the three year period ended October
        1,
        2005 in conformity with accounting principles generally accepted in the United
        States of America.
 
  /s/
                  ELLIOTT DAVIS,
                  LLC
 
 Greenville,
        South Carolina
 November
        2, 2005
   30
  **Statements
                    of Income**Years
                    Ended**October
                    1,**
                
                
                October
                    2,
                
                
                September
                    27,**2005**
                
                
                2004
                
                
                2003Net
                    sales
                
                **$**
                **48,439,310**
                
                $
                49,929,129
                
                $
                41,574,603Cost
                    of goods sold
                
                
                **33,725,836**
                
                
                37,238,586
                
                
                30,440,681Gross
                    profit
                
                
                **14,713,474**
                
                
                12,690,543
                
                
                11,133,922Selling
                    and marketing expenses
                
                
                **7,656,876**
                
                
                6,924,720
                
                
                6,455,468Research
                    and development expenses
                
                
                **1,141,198**
                
                
                686,413
                
                
                556,421General
                    and administrative expenses
                
                
                **2,781,951**
                
                
                2,771,205
                
                
                2,682,221**11,580,025**
                
                
                10,382,338
                
                
                9,694,110Operating
                    income
                
                
                **3,133,449**
                
                
                2,308,205
                
                
                1,439,812Non-operating
                    income (expense):Investment
                    income
                
                
                **113,342**
                
                
                101,958
                
                
                84,046Royalty
                    income
                
                
                **497,516**
                
                
                545,072
                
                
                597,687Other
                
                
                **29,600**
                
                
                (8,326
                )
                
                (7,751
                )**640,458**
                
                
                638,704
                
                
                673,982Income
                    before income taxes
                
                
                **3,773,907**
                
                
                2,946,909
                
                
                2,113,794Provision
                    for income taxes (Note 12)
                
                
                **1,335,000**
                
                
                962,000
                
                
                715,000Net
                    income
                
                **$**
                **2,438,907**
                
                $
                1,984,909
                
                $
                1,398,794Earnings
                    per share of common stock (Note 13)Net
                    income:Basic
                
                **$**
                **0.94**
                
                $
                0.77
                
                $
                0.55Diluted
                
                **$**
                **0.89**
                
                $
                0.73
                
                $
                0.53Dividends
                    per share of common stock
                
                **$**
                **0.565**
                
                $
                0.145
                
                $
                0.14Weighted
                    average shares outstanding:Basic
                
                
                **2,603,932**
                
                
                2,579,451
                
                
                2,544,882Diluted
                
                
                **2,739,149**
                
                
                2,731,873
                
                
                2,659,699See
                    accompanying notes.
   31


**Balance
                  Sheets****October
                  1,**
              
              October
                  2,**2005**
              
              2004**ASSETS**Current
                  assets:Cash
                  and cash equivalents
              
              **$**
              **894,386**
              
              $
              1,707,598Securities
                  available for sale (Note 2)
              
              **4,106,326**
              
              4,673,528Accounts
                  receivable, net of allowances of $116,000(2005)
                  and $140,000 (2004)
              
              **7,232,522**
              
              6,615,086Inventories
                  (Note 3)
              
              **3,216,483**
              
              2,717,573Prepaid
                  expenses and deferred income taxes
              
              **557,172**
              
              912,404Total
                  current assets
              
              **16,006,889**
              
              16,626,189Property
                  and equipment, net (Note 4)
              
              **8,089,511**
              
              6,184,786Goodwill,
                  net of accumulated amortization of$1,027,765
                  (2005 and 2004) (Note 5)
              
              **1,924,131**
              
              1,924,131Other
                  assets (Notes 5 and 6)
              
              **2,645,314**
              
              2,362,819**$**
              **28,665,845**
              
              $
              27,097,925**LIABILITIES
                  AND SHAREHOLDERS' EQUITY**Current
                  liabilities:Accounts
                  payable
              
              **$**
              **2,704,100**
              
              $
              2,570,352Accrued
                  and sundry liabilities (Note 7)
              
              
              **2,664,618**
              
              
              2,432,898Total
                  current liabilities
              
              
              **5,368,718**
              
              
              5,003,250Deferred
                  income taxes (Note 12)
              
              
              **869,000**
              
              
              776,000Deferred
                  compensation (Note 10)
              
              
              **866,750**
              
              
              899,283Total
                  liabilities
              
              
              **7,104,468**
              
              
              6,678,533Commitments
                  and contingencies (Note 19)Shareholders'
                  equity (Notes 11 and 13)Common
                  stock, no par value, 20,000,000 sharesauthorized;
                  issued and outstanding shares 2,611,768(2005)
                  and 2,592,218 (2004)
              
              
              **707,016**
              
              
              557,856Additional
                  paid-in capital
              
              
              **41,882**
              
              
              19,297Retained
                  earnings
              
              
              **20,814,191**
              
              
              19,842,239Accumulated
                  other comprehensive loss
              
              
              **(1,712**
              **)**Total
                  shareholders' equity
              
              
              **21,561,377**
              
              
              20,419,392**$**
              **28,665,845**
              
              $
              27,097,925See
                  accompanying notes.






32






**Statements
                  of Changes in Shareholders' Equity and Other Comprehensive
                  Loss**AccumulatedAdditional
              
              
              
              OtherCommon
                  Stock
              
              Paid-in
              
              Retained
              
              ComprehensiveShares
              
              Amount
              
              Capital
              
              Earnings
              
              Loss
              
              TotalBalance
                  at September 28, 2002
              
              2,538,870
              
              $
              196,340
              
              $
              8,527
              
              $
              17,188,799
              
              $
              -
              
              $
              17,393,666Net
                  income for the 2003 fiscal year
              
              
              
              
              
              
              
              1,398,794
              
              
              
              1,398,794Common
                  stock issued to Directors
              
              8,000
              
              64,000
              
              
              
              
              
              
              
              64,000Common
                  stock issued onexercise
                  of stock options
              
              
              5,284
              
              
              23,641
              
              
              
              
              
              
              
              
              
              
              
              23,641Tax
                  benefits for stock options exercised
              
              
              
              
              
              
              
              
              1,508
              
              
              
              
              
              
              
              
              1,508Cash
                  dividends paid or declared($0.14
                  per share)
              
              
              
              
              
              
              
              
              
              
              
              (356,268
              )
              
              
              
              
              (356,268
              )Balance
                  at September 27, 2003
              
              
              2,552,154
              
              
              283,981
              
              
              10,035
              
              
              18,231,325
              
              
              -
              
              
              18,525,341Net
                  income for the 2004 fiscal year
              
              
              
              
              
              
              
              
              
              
              
              1,984,909
              
              
              
              
              
              1,984,909Common
                  stock issued to Directors
              
              
              8,500
              
              
              114,750
              
              
              
              
              
              
              
              
              
              
              
              114,750Common
                  stock issued onexercise
                  of stock options
              
              
              31,564
              
              
              159,125
              
              
              
              
              
              
              
              
              
              
              
              159,125Tax
                  benefits for stock options exercised
              
              
              
              
              
              
              
              
              9,262
              
              
              
              
              
              
              
              
              9,262Cash
                  dividends paid or declared($0.145
                  per share)
              
              
              
              
              
              
              
              
              
              
              
              (373,995
              )
              
              
              
              
              (373,995
              )Balance
                  at October 2, 2004
              
              
              2,592,218
              
              
              557,856
              
              
              19,297
              
              
              19,842,239
              
              
              -
              
              
              20,419,392Net
                  income for the 2005 fiscal year
              
              
              
              
              
              
              
              
              
              
              
              2,438,907
              
              
              
              
              
              2,438,907Other
                  comprehensive loss forthe
                  2005 fiscal year
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,712
              )
              
              (1,712
              )Common
                  stock issued to Directors
              
              
              9,000
              
              
              92,970
              
              
              
              
              
              
              
              
              
              
              
              92,970Common
                  stock issued onexercise
                  of stock options
              
              
              10,550
              
              
              56,190
              
              
              
              
              
              
              
              
              
              
              
              56,190Tax
                  benefits for stock options exercised
              
              
              
              
              
              
              
              
              11,566
              
              
              
              
              
              
              
              
              11,566Stock
                  option compensation expense
              
              
              
              
              
              
              
              
              11,019
              
              
              
              
              
              
              
              
              11,019Cash
                  dividends paid or declared($0.565
                  per share)
              
              
              
              
              
              
              
              
              
              
              
              (1,466,955
              )
              
              
              
              
              (1,466,955
              )**Balance
                  at October 1, 2005**
              
              
              **2,611,768**
              
              **$**
              **707,016**
              
              **$**
              **41,882**
              
              **$**
              **20,814,191**
              
              **$**
              **(1,712**
              **)**
              **$**
              **21,561,377**See
                  accompanying notes.






33






**Statements
                  of Cash Flows**Years
                  Ended**October
                  1,**
              
              October
                  2,
              
              September
                  27,**2005**
              
              2004
              
              2003**OPERATING
                  ACTIVITIES:**Net
                  income
              
              **$**
              **2,438,907**
              
              $
              1,984,909
              
              $
              1,398,794Adjustments
                  to reconcile net income to netcash
                  provided by operating activities:Depreciation
              
              **715,706**
              
              618,559
              
              449,844Amortization
              
              **128,769**
              
              98,449
              
              77,203Provision
                  (recovery) for losses on accounts receivable
              
              **34,263**
              
              (6,830)
              
              86,884Provision
                  for deferred income taxes
              
              **(122,434)**
              
              385,262
              
              107,508(Gain)
                  loss on sale and disposal of property and equipment
              
              **(26,246)**
              
              11,596
              
              10,864Increase
                  in cash value of life insurance
              
              **(101,233)**
              
              (121,464)
              
              (126,809)Deferred
                  compensation
              
              **(32,533)**
              
              (30,124)
              
              (27,892)Stock
                  compensation expense
              
              **11,019**Changes
                  in operating assets and liabilities:Accounts
                  receivable
              
              **(671,343)**
              
              (669,888)
              
              (1,076,820)Inventory
              
              **(498,910)**
              
              (178,248)
              
              (580,937)Prepaid
                  expenses and other assets
              
              **457,496**
              
              (80,334)
              
              (123,123)Accounts
                  payable and accrued expenses
              
              
              **255,402**
              
              
              799,651
              
              
              951,487Net
                  cash provided by operating activities
              
              
              **2,588,863**
              
              
              2,811,538
              
              
              1,147,003**INVESTING
                  ACTIVITIES:**Purchases
                  of marketable securities
              
              
              **(3,719,866**
              **)**
              
              (1,800,000
              )Proceeds
                  from sales of marketable securities
              
              
              **4,305,000**
              
              
              1,273,636
              
              
              1,705,000Purchases
                  of property and equipment
              
              
              **(2,405,418**
              **)**
              
              (1,997,491
              )
              
              (1,647,291
              )Proceeds
                  from sale of property and equipment
              
              
              **26,246**
              
              
              
              
              
              1,000Payments
                  for other assets
              
              
              **(185,295**
              **)**
              
              (165,237
              )
              
              (147,586
              )Net
                  cash used for investing activities
              
              
              **(1,979,333**
              **)**
              
              (2,689,092
              )
              
              (88,877
              )**FINANCING
                  ACTIVITIES:**Dividends
                  paid
              
              
              **(1,466,955**
              **)**
              
              (373,995
              )
              
              (356,268
              )Common
                  stock issued upon exercise of options
              
              
              **44,213**
              
              
              147,815
              
              
              14,175Net
                  cash used for financing activities
              
              
              **(1,422,742**
              **)**
              
              (226,180
              )
              
              (342,093
              )(Decrease)
                  increase in cash and cash equivalents
              
              
              **(813,212**
              **)**
              
              (103,734
              )
              
              716,033Cash
                  and cash equivalents at beginning of year
              
              
              **1,707,598**
              
              
              1,811,332
              
              
              1,095,299Cash
                  and cash equivalents at end of year
              
              **$**
              **894,386**
              
              $
              1,707,598
              
              $
              1,811,332See
                  accompanying notes.






34







**NOTES
      TO FINANCIAL STATEMENTS**


**October
      1, 2005**





**1.
      SIGNIFICANT ACCOUNTING POLICIES**





**Description
      of Business**


The
      Company manufactures and distributes replacement mattresses, mattress overlays,
      patient positioners, seating cushions, and skin care products for the medical
      market and pillows, mattress pads and various foam products for the custom
      products market throughout the United States and Canada. In addition, the
      Company has recently begun manufacturing and marketing the Secure I.V. line
      of
      intravenous catheters to the health care market in North America. The catheter
      product line was acquired in early development stage in 2002.





**Cash
      and Cash Equivalents**


The
      Company considers all cash equivalents to be highly liquid investments with
      a
      maturity when purchased of three months or less. Depending on market conditions,
      the Company may maintain a centralized cash management program whereby its
      excess cash balances are invested in commercial paper and are considered cash
      equivalents. Cash balances in the Company’s accounts usually exceed federally
      insured limits.





**Accounts
      Receivable**


The
      Company provides credit in the normal course of business and performs ongoing
      credit evaluations on certain of its customers, but generally does not require
      collateral to support such receivables. The Company also establishes an
      allowance for doubtful accounts based upon factors surrounding the credit risk
      of specific customers, historical trends and other information. Account balances
      are charged against the allowance after all collection efforts have been
      exhausted and potential for recovery is considered remote.





**Inventories**


Inventories
      are valued at the lower of cost (first-in, first-out method) or
      market.





**Property
      and Equipment**


Property
      and equipment is stated at cost. Maintenance, repairs, and minor replacements
      that do not improve or extend the useful lives of assets are expensed when
      incurred. Depreciation is computed using the straight-line method. Estimated
      useful lives for buildings and land improvements range from 15 to 35 years.
      The
      estimated useful lives of all other property and equipment range from 3 years
      to
      15 years. For income tax purposes, substantially all depreciation is computed
      using accelerated methods.




Construction
      in progress is stated at cost, which includes the cost of construction and
      other
      direct costs attributable to the construction. No provision for depreciation
      is
      made on construction in progress until the relevant assets are completed and
      put
      into use. In December 2004, the Company signed a letter of intent with a
      construction company to expand the Greenville, SC plant by 58,000 square feet
      at
      a planned cost of $2.6 million. As of October 1, 2005, the Company had incurred
      expansion-related costs of approximately $2.2 million. The balance in
      construction in progress as of October 2, 2004 represented a roof replacement
      in
      process. (See Note 4.)






35





**Intangibles**


Intangible
      assets are amortized using the straight-line method. Costs of patents are
      amortized over periods ranging from 10 to 17 years, and trademarks are amortized
      over periods of 5 or 10 years. Goodwill, costs in excess of the fair value
      of
      net assets, acquired from two separate acquisitions, is accounted for under
      Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other
      Intangible Assets.” See Note 5. Accumulated amortization of intangible assets at
      October 1, 2005 and October 2, 2004 was approximately $2,419,000 and $2,291,000,
      respectively. The Company reviews annually the recoverability of the carrying
      value of these assets in accordance with SFAS No. 142 and SFAS No. 144
“Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
      to
      be Disposed Of.” The Company also reviews long-lived assets and the related
      intangible assets for impairment whenever events or changes in circumstances
      indicate the carrying amount of such assets may not be recoverable.





**Revenue
      Recognition**


Revenue
      is recognized by the Company when goods are shipped and title passes to the
      customer. There are no customer acceptance provisions, and the right to return
      exists only in cases of damaged product, non-compliance with customer
      specifications or warranty claims.




The
      Company has applied the accounting and disclosure requirements of Securities
      and
      Exchange Commission Staff Accounting Bulletin (SAB) No. 101.





**Advertising
      Costs**


Advertising
      costs are expensed as incurred.





**Shipping
      and Handling Costs**


Shipping
      and handling costs that are not reimbursed by customers are charged to selling
      and marketing expenses and were approximately $1,516,000 in 2005, $1,445,000
      in
      2004 and $1,365,000 in 2003.





**Fair
      Value of Financial Instruments**


The
      carrying amounts reported in the balance sheet for cash and cash equivalents,
      securities available for sale, accounts receivable, cash value of life
      insurance, accounts payable, and debt approximate their fair values. The fair
      values of the Company’s securities available for sale are based on quoted market
      prices when available, or quoted market prices of financial instruments with
      similar characteristics.





**Earnings
      Per Share of Common Stock**


Earnings
      per share of common stock are computed based on the weighted average number
      of
      shares outstanding during each period in accordance with SFAS No. 128, “Earnings
      Per Share.” (See Note 13).





36






**Stock-Based
      Compensation**


"During
      December 2004, the Financial Accounting Standards Board (FASB) issued SFAS
      No.
      123R “Share-Based Payment”, which requires the Company to measure and recognize
      compensation expense for all stock-based payments at fair value. This statement
      eliminated the ability to account for share-based compensation transactions
      using Accounting Principles Board Opinion 25, “Accounting for Stock Issued to
      Employees” (“APB No. 25”). Stock-based payments include stock option grants. The
      Company grants options to purchase common stock to some of its employees under
      various plans at prices equal to the market value of the stock on the dates
      the
      options were granted. The Company adopted SFAS No. 123R in the fourth quarter
      of
      fiscal 2005 using the modified prospective method. Total compensation expense
      for share-based payment arrangements for fiscal 2005 was $11,000.





Prior
      to
      adopting SFAS No. 123R, the Company accounted for stock options under APB No.
      25. Accordingly, no compensation expense was charged to operations in previous
      fiscal years. If compensation expense for the plans had been determined based
      on
      the fair value at the grant dates for awards under the plans consistent with
      the
      accounting method available under SFAS No. 123 “Accounting for Stock Based
      Compensation,” the Company's net income and net income per common share would
      have been reduced to the proforma amounts indicated below:




**2005**
              
              2004
              
              2003Net
                  incomeAs
                  reported
              
              **$**
              **2,438,907**
              
              $
              1,984,909
              
              $
              1,398,794Add
                  stock-based employee compensationexpense
                  included in reported net income,net
                  of taxes
              
              **11,019**Deduct
                  stock-based employeecompensation
                  expense determined underfair-value-based
                  method for allawards,
                  net of taxes - after adoption of SFAS 123R
              
              **(11,019**
              **)**Deduct
                  stock-based employeecompensation
                  expense determined underfair-value-based
                  method for allawards,
                  net of taxes - prior to adoption of SFAS 123R
              
              
              **(140,166**
              **)**
              
              (156,594
              )
              
              (144,391
              )Pro
                  forma
              
              **$**
              **2,298,741**
              
              $
              1,828,315
              
              $
              1,254,403Basic
                  net income per common shareAs
                  reported
              
              **$**
              **0.94**
              
              $
              0.77
              
              $
              0.55Stock
                  option expense, net of taxes
              
              
              0.05
              
              
              0.06
              
              
              0.06Pro
                  forma
              
              **$**
              **0.88**
              
              $
              0.71
              
              $
              0.49Diluted
                  net income per common shareAs
                  reported
              
              **$**
              **0.89**
              
              $
              0.73
              
              $
              0.53Stock
                  option expense, net of taxes
              
              
              **0.05**
              
              
              0.06
              
              
              0.06Pro
                  forma
              
              **$**
              **0.84**
              
              $
              0.67
              
              $
              0.47





The
      fair
      value of each option grant is estimated on the date of grant using the
      Black-Scholes option pricing model with the following weighted average
      assumptions for grants made in 2005, 2004, and 2003, respectively: risk-free
      interest rates of 4.08%, 4.14%, and 3.26%; dividend yields of 1.5%, 1.1%, and
      1.6%; volatility factors of the expected market price of the Company's common
      stock of 32.3%, 38.9%, and 38.4%; and a weighted average expected life of the
      option of eight years for all three periods.






37






**Fiscal
      Year**


The
      Company’s fiscal year ends on the Saturday nearest to September 30. Fiscal years
      2005 and 2003 were 52-week years. Fiscal year 2004 was a 53-week year. Fiscal
      year 2006 will be a 52 -week year.





**Income
      Taxes**


In
      accordance with SFAS No. 109, “Accounting for Income Taxes,” the liability
      method is used in accounting for income taxes. Under this method, deferred
      tax
      assets and liabilities are determined based on differences between financial
      reporting and tax bases of assets and liabilities and are measured using the
      enacted tax rates and laws that will be in effect when the differences are
      expected to reverse.





**Use
      of Estimates**


The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect the amounts reported in the financial
      statements and accompanying notes. Although these estimates are based on
      management’s knowledge of current events and actions planned for the future, the
      estimates may ultimately differ from actual results.





**Recently
      Issued Accounting Standards**


In
      November 2004, the FASB issued SFAS No. 151, “Inventory Costs - An Amendment of
      ARB No. 43, Chapter 4”. SFAS No. 151 clarifies that abnormal amounts of idle
      facility expense, freight, handling costs and spoilage should be expensed as
      incurred and not included in overhead. Further, SFAS No. 151 requires that
      allocation of fixed and production facilities overheads to conversion costs
      should be based on normal capacity of the production facilities. The provisions
      in this statement are effective for inventory costs incurred during fiscal
      periods beginning after June 15, 2005. The Company does not believe that the
      adoption of SFAS No. 151 will have a significant effect on its future financial
      statements.


In
      December 2004, the FASB issued SFAS No. 153, “Exchanges of Non-monetary Assets -
      An Amendment of APB No. 29”. The provisions of this statement are effective for
      non-monetary asset exchanges occurring in fiscal periods beginning after June
      15, 2005. This statement eliminates the exception to fair value for exchanges
      of
      similar productive assets and replaces it with a general exception for exchange
      transactions that do not have commercial substance, that is, transactions that
      are not expected to result in significant changes in the cash flows of the
      reporting entity. The Company does not believe that the adoption of SFAS No.
      153
      will have a significant effect on its future financial statements.





Other
      accounting standards that have been issued or proposed by FASB or other
      standards-setting bodies that do not require adoption until a future date are
      not expected to have a material impact on the Company's financial statements
      upon adoption.






38








**Reclassifications**


Certain
      prior year amounts have been reclassified to conform with the current year
      presentation in the accompanying financial statements. These reclassifications
      had no effect on previously reported results of operations or retained
      earnings.





**2.
      SECURITIES AVAILABLE FOR SALE**





The
      variable rate demand notes included in securities available for sale are carried
      at aggregate cost which approximates market. Preferred stocks are carried at
      market value. Unrealized holding losses were $1,712 during fiscal year 2005.
      The
      Company had no unrealized holding gains or losses during fiscal years 2004
      or 2003.




**2005**
              
              2004Variable
                  rate demand notes
              
              **$**
              **3,938,171**
              
              $
              4,673,528Preferred
                  stocks
              
              
              **168,155****$**
              **4,106,326**
              
              $
              4,673,528





**3.
                  INVENTORIES****2005**
              
              2004Raw
                  materials
              
              **$**
              **2,412,803**
              
              $
              1,900,433Finished
                  goods
              
              
              **803,680**
              
              
              817,140**$**
              **3,216,483**
              
              $
              2,717,573





**4.
                  PROPERTY AND EQUIPMENT****2005**
              
              2004Land
              
              **$**
              **317,343**
              
              $
              317,343Land
                  improvements
              
              **246,172**
              
              246,172Buildings
              
              
              **4,317,011**
              
              
              4,041,391Construction
                  in progress
              
              
              **2,233,042**
              
              
              130,000Machinery
                  and equipment
              
              
              **8,624,238**
              
              
              8,647,093Furniture
                  and fixtures
              
              
              **427,175**
              
              
              433,128Automobiles
              
              
              **9,520**
              
              
              9,520Leasehold
                  improvements
              
              
              **12,330**
              
              
              12,330**16,186,831**
              
              
              13,836,977Less
                  accumulated depreciation
              
              
              **8,097,320**
              
              
              7,652,191**$**
              **8,089,511**
              
              $
              6,184,786






39






**5.
      GOODWILL AND OTHER INTANGIBLES**





As
      of
      October 1, 2005, the Company had goodwill (net of accumulated amortization)
      of
      $1,924,131 and patents and trademarks (net of accumulated amortization) of
      $762,757. All goodwill is part of the medical segment. Patents and trademarks
      are part of the medical and safety catheter segments. The Company has
      re-assessed the useful lives of goodwill and patents and trademarks. Goodwill
      was determined to have an indefinite useful life. Amortization of goodwill
      ceased on September 29, 2001 as a result of the Company’s adoption of SFAS No.
      142 at the beginning of fiscal year 2002. The useful lives of individual patents
      and trademarks were reviewed and no material changes were required. No
      impairment losses were recorded on the Company’s intangible assets as a result
      of the adoption of SFAS No. 142 based on the goodwill impairment
      test.





Amortization
      expense for patents and trademarks during fiscal years 2005, 2004 and 2003
      was
      $128,769, $98,449 and $77,203, respectively. Estimated amortization expense
      for
      the next five fiscal years is as follows:




**Estimated****Amortization**Fiscal
                  years
              
              **Expense**2006
              
              **$**
              **107,211**2007
              
              
              **80,370**2008
              
              
              **77,750**2009
              
              
              **75,950**2010
              
              
              **73,782**




**6.
      OTHER ASSETS**




**2005**
              
              2004Patents
                  and trademarks, net of accumulated amortizationof
                  $1,391,551(2005) and $1,262,781 (2004)
              
              **$**
              **762,757**
              
              $
              706,232Cash
                  value of life insurance policies
              
              
              **1,679,703**
              
              
              1,578,469Other
              
              
              **202,854**
              
              
              78,118**$**
              **2,645,314**
              
              $
              2,362,819


40







**7.
      ACCRUED AND SUNDRY LIABILITIES**


**2005**
              
              2004Salaries
                  and other compensation
              
              **$**
              **1,347,808**
              
              $
              1,343,908Federal
                  and state income taxes
              
              **333,889**
              
              123,952Payroll
                  taxes accrued and withheld
              
              
              **111,638**
              
              
              128,926Property
                  taxes
              
              
              **144,800**
              
              
              129,054Medical
                  insurance
              
              
              **77,850**
              
              
              155,462Warranty
                  reserve
              
              
              **243,477**
              
              
              212,564Vendor
                  rebates
              
              
              **221,030**
              
              
              183,000Customer
                  deposits
              
              
              **141,016**
              
              
              119,326Other
              
              
              **43,110**
              
              
              36,706**$**
              **2,664,618**
              
              $
              2,432,898








**8.
      PRODUCT WARRANTIES**





The
      Company offers warranties of various lengths to its customers depending on
      the
      specific product sold. The Company’s warranties require it to repair or replace
      non-performing products during the warranty period at no cost to the customer.
      At the time revenue is recognized for covered products, the Company records
      a
      liability for estimated costs that may be incurred under its warranties. The
      costs are estimated based on historical experience and any recent warranty
      trends that have been identified. (Although historical warranty costs have
      been
      within expectations, there can be no assurance that future warranty costs will
      not exceed historical amounts.) The Company periodically assesses the adequacy
      of its recorded liability and adjusts the balance as necessary.





Changes
      in the Company’s product warranty liability for the years ended October 1, 2005
      and October 2, 2004 are as follows:




**2005**
              
              2004Accrued
                  liability at beginning of year
              
              **$**
              **212,564**
              
              $
              141,723Increases
                  in reserve
              
              
              **204,613**
              
              
              228,241Expenses
              
              
              **(173,700**
              **)**
              
              (157,400
              )Accrued
                  liability at end of year
              
              **$**
              **243,477**
              
              $
              212,564




**9.
      BORROWINGS**





The
      Company paid no interest expense during fiscal years 2005, 2004, or
      2003.





**10.
      DEFFERRED COMPENSATION**





The
      Company is obligated to make fixed payments of approximately $114,000 per year
      to its founder and former chief executive officer pursuant to a retirement
      agreement. The payments will be made for the longer of the executive’s remaining
      life or his ex-wife's remaining life, if she survives him. The Company has
      fully
      accrued the present value of the expected payments due over the combined life
      expectancy of the executive and his ex-wife. The Company recognized expenses
      of
      approximately $81,000 in 2005, $83,000 in 2004, and $86,000 in 2003 related
      to
      this agreement. An 8% discount rate was used in measuring the present value
      of
      the Company's deferred compensation obligation.






41





**11.
      SHAREHOLDERS’ EQUITY**





In
      March
      1997, the Board adopted the 1997 Stock Option Plan (“1997 Plan”). The 1997 Plan
      authorized the Board to grant options to key officers and employees of the
      Company for up to 200,000 shares of the Company's common stock. Options granted
      under the 1997 Plan are generally granted at the fair market value on the date
      of grant. These options become exercisable and vested at the greater of 1,000
      shares per year or 20% of the grant. Vested options expire 10 years from the
      date of grant for continuing employees, or three months after termination for
      employees who leave the Company.





In
      November 1991, the Board adopted the 1991 Stock Option Plan (“1991 Plan”). The
      1991 Plan authorized the Board to grant options of up to 200,000 shares of
      the
      Company's common stock to officers and key employees and 50,000 shares to
      directors who are neither officers nor employees of the Company. All other
      terms
      and conditions of the 1991 Plan are similar to the 1997 Plan. The 1991 Plan
      was
      terminated on November 7, 2001. The termination does not affect options
      outstanding under the plan, but no further options can be granted under the
      1991
      Plan.





In
      March
      1987, the Board of Directors adopted the 1987 Stock Option Plan (“1987 Plan”).
      The 1987 Plan authorized the Board to grant options of up to 200,000 shares
      of
      the Company's common stock to officers and key employees of the Company. All
      other terms and conditions of the 1987 Plan are similar to the 1997 Plan. The
      1987 Plan was terminated on March 31, 1997. The termination does not affect
      options outstanding under the plan, but no further options can be granted under
      the 1987 Plan.







42






A
      summary
      of activity under the Company’s three stock option plans is as
      follows.




Outstanding
              
              ExercisableWeighted
              
              
              
              
              
              WeightedAverage
              
              
              
              
              
              AverageShares
              
              
              Number
                  of
              
              
              Ex.
                  Price
              
              
              Number
                  of
              
              
              Ex.
                  PriceAvailable
              
              
              Shares
              
              
              Per
                  Share
              
              
              Shares
              
              
              Per
                  ShareBalance
                  at 9/28/02
              
              
              121,950
              
              
              273,000
              
              $
              5.01
              
              
              239,400
              
              $
              4.99Fiscal
                  Year 2003Granted
              
              
              (28,250
              )
              
              28,250
              
              
              7.97Exercised
              
              
              
              
              
              (3,000
              )
              
              4.73Forfeited
              
              
              3,000
              
              
              (3,000
              )
              
              8.38Forfeitures
                  terminated
              
              
              (3,000
              )
              
              
              
              
              8.38Balance
                  at 9/27/03
              
              
              93,700
              
              
              295,250
              
              
              5.26
              
              
              263,850
              
              
              5.13Fiscal
                  Year 2004Granted
              
              
              (23,750
              )
              
              23,750
              
              
              13.58Exercised
              
              
              
              
              
              (29,500
              )
              
              5.01ForfeitedForfeitures
                  terminatedBalance
                  at 10/2/04
              
              
              69,950
              
              
              289,500
              
              
              5.97
              
              
              267,800
              
              
              5.70**Fiscal
                  Year 2005****Granted**
              
              
              **(25,000**
              **)**
              
              **25,000**
              
              
              **11.85****Exercised**
              
              
              
              
              
              **(9,200**
              **)**
              
              **4.79****Forfeited****Forfeitures
                  terminated****Balance
                  at 10/1/05**
              
              
              **44,950**
              
              
              **305,300**
              
              **$**
              **6.48**
              
              
              **291,300**
              
              **$**
              **6.29**




A
      summary
      of stock options outstanding and exercisable at fiscal year end 2005 is shown
      below.




Outstanding
              
              ExercisableWeightedWeighted
              
              Average
              
              
              
              WeightedAverage
              
              Remaining
              
              
              
              
              AverageRanges
                  of Exercise
              
              Number
                  of
              
              Ex.
                  Price
              
              Contract
              
              Number
                  of
              
              Ex.
                  PricePrices
              
              Shares
              
              Per
                  Share
              
              Life
                  (yrs)
              
              Shares
              
              Per
                  Share$
                  3.55  -  $  4.91
              
              
              116,800
              
              $
              4.11
              
              
              2.5
              
              
              114,800
              
              $
              4.095.41  -     7.97
              
              
              139,750
              
              
              6.30
              
              
              4.5
              
              
              137,750
              
              
              6.2811.85 
                  -   13.58
              
              
              48,750
              
              
              12.69
              
              
              8.9
              
              
              38,750
              
              
              12.84$
                  3.55  - $13.58
              
              
              305,300
              
              $
              6.48
              
              
              4.4
              
              
              291,300
              
              $
              6.29






43






The
      Board
      of Directors adopted a stock purchase incentive plan in February 2000. The
      2000
      Restricted Stock Plan was created to encourage management employees of the
      Company to purchase and hold the Company's common stock. Plan benefits are
      paid
      in shares of the Company’s common stock. Benefits earned and accrued under the
      plan were $13,392 in 2005, $11,977 in 2004, and $11,310 in 2003. The Company
      issued stock valued at $11,977 in 2005, leaving a vested balance of $13,392
      at
      October 1, 2005.





In
      March
      1997 the Board of Directors approved the 1997 Long-Term Incentive Stock Option
      Plan for certain executives of the Company based on achievement of specified
      financial goals by fiscal year end 1999. As of October 1, 2005, the Company
      has
      accrued compensation expense of $23,150 related to this plan.





**12.
      INCOME TAXES**





Deferred
      income taxes reflect the net tax effects of temporary differences between the
      carrying amounts of assets and liabilities for financial reporting purposes
      and
      the amounts used for income tax purposes. Significant components of the
      Company’s deferred tax liabilities and assets as of October 1, 2005 and October
      2, 2004 are as follows:




**2005**
              
              2004Deferred
                  tax liabilities:Depreciation
              
              **$**
              **1,171,000**
              
              $
              1,083,000Other
              
              
              **10,000**
              
              
              172,000Total
                  deferred tax liabilities
              
              
              **1,181,000**
              
              
              1,255,000Deferred
                  tax assets:Deferred
                  compensation
              
              
              **312,000**
              
              
              304,000Accrued
                  expenses
              
              
              **320,000**
              
              
              303,000Intangible
                  assets
              
              
              
              
              
              3,000Inventory
              
              
              **106,000**Other
              
              
              **38,000**
              
              
              106,000Total
                  deferred tax assets
              
              
              **776,000**
              
              
              716,000Net
                  deferred tax liabilities
              
              **$**
              **405,000**
              
              $
              539,000




The
      Company made income tax payments, net of refunds, of approximately $974,000,
      $617,000, and $782,000 in fiscal years 2005, 2004, and 2003,
      respectively.






44








Federal
      and state income tax provisions consist of the following:




**2005**
              
              2004
              
              2003Current:Federal
              
              **$**
              **1,357,000**
              
              $
              443,000
              
              $
              541,000State
              
              **112,000**
              
              90,000
              
              52,000**1,469,000**
              
              
              533,000
              
              
              593,000Deferred:Federal
              
              
              **(133,000**
              **)**
              
              425,000
              
              
              111,000State
              
              
              **(1,000**
              **)**
              
              4,000
              
              
              11,000**(134,000**
              **)**
              
              429,000
              
              
              122,000Income
                  tax expense
              
              **$**
              **1,335,000**
              
              $
              962,000
              
              $
              715,000




Income
      tax expense differs from the amounts computed by applying the federal tax rate
      to income before income taxes as follows:




**2005**
              
              2004
              
              2003Computed
                  tax at the statutory rate
              
              **$**
              **1,283,000**
              
              $
              1,002,000
              
              $
              719,000Increases
                  (decreases):State
                  income taxes, net of federal tax benefit
              
              
              **74,000**
              
              
              62,000
              
              
              42,000Tax-exempt
                  investment income
              
              
              **(36,000**
              **)**
              
              (18,000
              )
              
              (22,000
              )Extraterritorial
                  income exclusion
              
              
              **(18,000**
              **)**
              
              (24,000
              )
              
              (9,000
              )Officer's
                  life insurance
              
              
              **(31,000**
              **)**
              
              (38,000
              )
              
              (43,000
              )Other,
                  net
              
              
              **63,000**
              
              
              (22,000
              )
              
              28,000Income
                  tax expense
              
              **$**
              **1,335,000**
              
              $
              962,000
              
              $
              715,000






45





**13.
      EARNINGS PER SHARE OF COMMON STOCK**





The
      following table sets forth the computation of basic and diluted earnings per
      share of common stock in accordance with SFAS No. 128.




**2005**
              
              2004
              
              2003Numerator
                  for basic and dilutedearnings
                  per share:Net
                  income
              
              **$**
              **2,438,907**
              
              $
              1,984,909
              
              $
              1,398,794Denominator:Denominator
                  for basic earnings per share:Weighted
                  average shares
              
              
              **2,603,932**
              
              
              2,579,451
              
              
              2,544,882Effect
                  of dilutive securities:Employee
                  and board stock options
              
              
              **135,217**
              
              
              152,422
              
              
              114,817Denominator
                  for diluted earnings per share:Adjusted
                  weighted average sharesand
                  assumed conversions
              
              
              **2,739,149**
              
              
              2,731,873
              
              
              2,659,699Net
                  income per share:Basic
              
              **$**
              **0.94**
              
              $
              0.77
              
              $
              0.55Diluted
              
              **$**
              **0.89**
              
              $
              0.73
              
              $
              0.53




**14.
      EMPLOYEE BENEFITS AND INCENTIVE PLANS**





The
      Company has an employee savings and investment plan (401(k) plan) available
      to
      employees meeting eligibility requirements. The Company matches a percentage
      of
      the employee contributions, with certain limitations. Contributions by the
      Company amounted to approximately $164,000, $158,000, and $144,000 for the
      2005,
      2004, and 2003 fiscal years, respectively.





**15.
      RELATED-PARTY TRANSACTIONS**





The
      Company paid approximately $138,000 in 2004, and $102,000 in 2003 in legal
      fees
      to a firm having a member who was also a director of the Company until July
      2004.





**16.
      MAJOR CUSTOMERS**





The
      Company has a business relationship with a customer to distribute certain of
      its
      medical products to hospitals and other treatment facilities throughout the
      United States. Sales generated by this customer amounted to approximately 13%
      of
      total sales in 2005, 8% in 2004, and 7% in 2003.






46





The
      Company has a business relationship with another customer to distribute certain
      of its consumer products. Sales to this customer amounted to 33% of net sales
      in
      2005, 47% in 2004, and 40% in 2003.





See
      Note
      17 for further information about sales to major customers.





**17.
      OPERATIONS AND INDUSTRY SEGMENTS**





The
      Company reports on three segments of business: medical, custom products, and
      safety catheters. The safety catheter segment, which was acquired during fiscal
      2002, had no sales in fiscal 2003 because the Secure I.V. product line was
      still
      in the development phase. This industry segment information corresponds to
      the
      markets in the United States and Canada for which the Company manufactures
      and
      distributes its polyurethane foam, packaging, and other products and therefore
      complies with the requirements of SFAS No. 131, “Disclosures about Segments of
      an Enterprise and Related Information.”






47






The
      following table summarizes certain information on industry
      segments:




**2005**
              
              2004
              
              2003Net
                  sales:Medical
              
              **$**
              **30,338,548**
              
              $
              23,339,157
              
              $
              21,330,122Custom
                  products
              
              **18,094,490**
              
              26,530,908
              
              20,244,481Safety
                  catheters
              
              **6,272**
              
              59,064Total
              
              **$**
              **48,439,310**
              
              $
              49,929,129
              
              $
              41,574,603Operating
                  profit (loss):Medical
              
              **$**
              **5,519,942**
              
              $
              3,053,548
              
              $
              2,469,596Custom
                  products
              
              **(225,966**
              **)**
              637,578
              
              254,225Safety
                  catheters
              
              **(1,499,697**
              **)**
              (684,421
              )
              (504,575
              )Total
              
              **3,794,279**
              
              3,006,705
              
              2,219,246Corporate
                  expense
              
              **(660,830**
              **)**
              (698,501
              )
              (779,433
              )Other
                  income
              
              **640,458**
              
              638,705
              
              673,981Income
                  before income taxes
              
              **$**
              **3,773,907**
              
              $
              2,946,909
              
              $
              2,113,794Identifiable
                  assets:Medical
              
              **$**
              **13,094,814**
              
              $
              9,045,678
              
              $
              8,774,857Custom
                  products
              
              
              **5,838,000**
              
              
              6,808,154
              
              
              6,406,753Safety
                  catheters
              
              
              **3,035,118**
              
              
              2,996,127
              
              
              1,417,980Corporate
              
              
              **6,697,913**
              
              
              8,247,966
              
              
              7,556,067**$**
              **28,665,845**
              
              $
              27,097,925
              
              $
              24,155,657Depreciation
                  and amortization expenses:Medical
              
              **$**
              **288,629**
              
              $
              230,407
              
              $
              229,209Custom
                  products
              
              
              **214,368**
              
              
              283,019
              
              
              251,150Safety
                  catheters
              
              
              **340,606**
              
              
              202,682
              
              
              45,805Corporate
              
              
              **872**
              
              
              900
              
              
              883**$**
              **844,475**
              
              $
              717,008
              
              $
              527,047Capital
                  expenditures:Medical
              
              **$**
              **1,540,520**
              
              $
              189,303
              
              $
              302,546Custom
                  products
              
              
              **834,680**
              
              
              198,290
              
              
              312,102Safety
                  catheters
              
              
              **30,218**
              
              
              1,609,898
              
              
              1,032,643**$**
              **2,405,418**
              
              $
              1,997,491
              
              $
              1,647,291




Total
      sales by industry segment include sales from unaffiliated customers as reported
      in the Company’s statements of income. In calculating operating profit,
      non-allocable general corporate expenses, interest expense, other income, and
      income taxes are not included, but certain corporate operating expenses incurred
      for the benefit of all segments are included on an allocated basis.






48




Identifiable
      assets are those assets that are used in the operations of each segment on
      an
      allocated basis. Amounts shown for corporate assets consist primarily of cash,
      marketable securities, and cash surrender value of life insurance.





The
      Company has several customers whose sales represent significant portions of
      sales in their respective business segments. In the medical segment, sales
      to
      the top four distributors represented 59% of net medical sales in 2005, 52%
      in
      2004, and 52% sales in 2003. In the custom products segment, sales to one
      customer accounted for 87% of net custom products sales in 2005, 89% in 2004,
      and 82% in 2003.





Export
      sales, primarily to Canada, were approximately, $2,127,000 in 2005, $2,988,000
      in 2004 and $2,174,000 in 2003.





**18.
      OPERATING LEASES**





The
      Company leases truck equipment in South Carolina and manufacturing facilities
      in
      South Carolina and California. All of the leases require the Company to pay
      certain insurance and maintenance costs.





Rental
      expense for all operating leases was $321,000 in 2005, $339,000 in 2004, and
      $299,000 in 2003.





Future
      minimum lease payments under non-cancelable operating leases with initial terms
      of one year or more at October 1, 2005 were $247,000 for fiscal 2006 and $61,000
      for 2007.





**19.
      COMMITMENTS AND CONTINGENCIES**





The
      Company is committed to minimum purchases of $625,000 of Selan® skin care
      products per calendar year through 2010. Previously, the Company was committed
      to purchases of $500,000 per calendar year through 2005. For the fiscal years
      ended 2005, 2004, and 2003, purchases under this commitment were $763,000,
      $635,000, and $622,000, respectively.





In
      December 2004, the Company signed a letter of intent with a construction company
      to expand the Greenville, SC plant by 58,000 square feet at a planned cost
      of
      $2.6 million. As of October 1, 2005, the Company had incurred expansion-related
      costs of approximately $2.2 million. The remaining portion of the project cost
      is expected to be financed from internally generated cash. The addition was
      substantially complete by November 1, 2005.





The
      Company’s supply terms with the contract manufacturer for its Secure I.V.
      product line require payment of approximately $8,200 per week in labor and
      overhead charges for production of the Secure I.V. catheter in lieu of a per
      unit charge. This weekly charge is expected to remain in effect for the next
      six
      to 12 months, depending on actual production volume, and can be changed by
      the
      mutual agreement of both parties.






49





From
      time
      to time the Company is a defendant in legal actions involving claims arising
      in
      the normal course of business. The Company believes that, as a result of legal
      defenses and insurance arrangements, none of these actions should have a
      material adverse effect on its operations or financial condition.





**20.
      QUARTERLY FINANCIAL DATA (Unaudited)**





Selected
      quarterly financial data are shown on the following table.




**Quarterly
                  Financial Data (Unaudited)**(Amounts
                  in thousands, except per share data)**First**
              
              
              **Second**
              
              
              **Third**
              
              
              **Fourth**
              
              
              **Year****For
                  Fiscal 2005**Net
                  sales
              
              $
              10,778
              
              $
              12,955
              
              $
              10,626
              
              $
              14,080
              
              $
              48,439Gross
                  profit
              
              
              3,259
              
              
              3,846
              
              
              3,118
              
              
              4,490
              
              
              14,713Operating
                  income
              
              
              612
              
              
              762
              
              
              439
              
              
              1,320
              
              
              3,133Net
                  income
              
              
              499
              
              
              600
              
              
              418
              
              
              922
              
              
              2,439Earnings
                  per shareBasic
              
              
              0.19
              
              
              0.23
              
              
              0.16
              
              
              0.35
              
              
              0.94Diluted
              
              
              0.18
              
              
              0.22
              
              
              0.15
              
              
              0.34
              
              
              0.89**For
                  Fiscal 2004**Net
                  sales
              
              $
              11,508
              
              $
              12,869
              
              $
              11,901
              
              $
              13,651
              
              $
              49,929Gross
                  profit
              
              
              2,902
              
              
              3,378
              
              
              2,992
              
              
              3,419
              
              
              12,691Operating
                  income
              
              
              490
              
              
              599
              
              
              535
              
              
              684
              
              
              2,308Net
                  income
              
              
              422
              
              
              498
              
              
              470
              
              
              595
              
              
              1,985Earnings
                  per shareBasic
              
              
              0.16
              
              
              0.19
              
              
              0.18
              
              
              0.23
              
              
              0.77Diluted
              
              
              0.16
              
              
              0.18
              
              
              0.17
              
              
              0.22
              
              
              0.73






50







**Item
      9. Changes in and Disagreements with Accountants on Accounting and Financial
      Disclosure**





None





**Item
      9A. Controls and Procedures**





The
      Company has evaluated, with the participation of the Chief Executive Officer
      and
      Chief Financial Officer, the effectiveness of the Company’s disclosure controls
      and procedures as of the end of the period covered by this annual report (the
      “Evaluation Date”), and, based on this evaluation, the Company’s Chief Executive
      Officer and Chief Financial Officer have concluded that these controls and
      procedures were effective at the Evaluation Date. There were no changes in
      the
      Company’s internal controls over financial reporting during the last quarter of
      fiscal 2005 that have materially affected or are reasonably likely to materially
      affect its internal control over financial reporting.





Disclosure
      controls and procedures are the Company’s controls and other procedures that are
      designed to ensure that information required to be disclosed by the Company
      in
      the reports that it files or submits under the Exchange Act is recorded,
      processed, summarized and reported, within the time periods specified in the
      Securities and Exchange Commission’s rules and forms. Disclosure controls and
      procedures include, without limitation, controls and procedures designed to
      ensure that information required to be disclosed by the Company in the reports
      that it files or submits under the Exchange Act is accumulated and communicated
      to the Company’s management, including its Chief Executive Officer and Chief
      Financial Officer, as appropriate to allow for timely decisions regarding
      required disclosure.





**Item
      9B. Other information**





None




**PART
      III**





**Item
      10. Directors and Executive Officers of the Registrant**





Information
      required under Item 10 of Part III is incorporated herein by reference to
      portions of the definitive Proxy Statement filed or to be filed with the
      Securities and Exchange Commission on or prior to 120 days following the end
      of
      the Company's 2005 fiscal year under the headings “Election of Directors,”
“Executive Officers,” “Section 16(a) Beneficial Ownership Reporting Compliance”
and “Election of Directors - Code of Ethics.”





**Item
      11. Executive Compensation**





Information
      required under Item 11 of Part III is incorporated herein by reference to
      portions of the definitive Proxy Statement filed or to be filed with the
      Securities and Exchange Commission on or prior to 120 days following the end
      of
      the Company's 2005 fiscal year under the heading "Compensation of Directors
      and
      Executive Officers."






51






**Item
      12. Security Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters**





The
      information under the heading “Security Ownership of Certain Beneficial Owners
      and Management” set forth in the Company’s definitive Proxy Statement filed or
      to be filed with the Securities and Exchange Commission on or prior to 120
      days
      following the end of the Company’s 2005 fiscal year is incorporated herein by
      reference.





The
      following table summarizes information regarding the Company’s equity
      compensation plans as of October 1, 2005:





Plan
                category
            Number
                of securities to be issued upon exercise of outstanding options,
                warrants
                and rights
            Weighted-average
                exercise price of outstanding options, warrants and rights
            Number
                of securities remaining available for future issuance under equity
                compensation plans (excluding securities reflected in column
                (a))(a)
            (b)
            (c)Equity
                compensation plans approved by security holders
            305,300
            $6.48
            133,515Equity
                compensation plans not approved by security holders
            0
            0
            0(1)Total
            305,300
            $6.48
            133,515(1)
                Under the Company’s director compensation arrangements, there is no set
                amount of equity securities authorized for issuance, but the Company
                currently anticipates issuing approximately 8,500 shares annually.





For
      additional information on the Company’s stock option plans, see Note 11 in the
      Notes to Financial Statements for the year ended October 1, 2005.





See
      Item
      5 of Part II for more information on shares of the Company’s common stock issued
      to Directors in lieu of their annual cash compensation.





**Item
      13. Certain Relationships and Related Transactions**





The
      information required under Item 13 of Part III is incorporated herein by
      reference to portions of the definitive Proxy Statement filed or to be filed
      with the Securities and Exchange Commission on or prior to 120 days following
      the end of the Company's 2005 fiscal year under the heading "Certain
      Relationships and Related Transactions."






52






**Item
      14. Principal Accountant Fees and Services**





Additional
      information required under Item 14 of Part III is incorporated herein by
      reference to portions of the definitive Proxy Statement filed or to be filed
      with the Securities and Exchange Commission on or prior to 120 days following
      the end of the Company's 2005 fiscal year under the heading "Principal
      Accountant Fees and Services."





**PART
      IV**





**Item
      15. Exhibits, Financial Statement Schedules**




(a)
            (1)
            Financial StatementsThe
              response to this portion of Item 15 is submitted under Item 8, Financial
              Statements and Supplementary Data, beginning on page 29.(2)
            Financial Statement
              SchedulesThe response to this portion of Item
              15 is
              submitted below under Item 15(c).






53






(3) Listing
      of Exhibits




3.1
              
              Restated Articles of
                Incorporation: Incorporated by reference to Exhibit 3(a) to the Company’s
                Registration Statement on Form S-18, Commission File No.
                0-11392.3.1.1
              
              Articles of Amendment
                filed with
                the South Carolina Secretary of State on February 6, 1989: Incorporated
                by
                reference to Exhibit 3.1.1 to the Company’s Annual Report on Form 10-K for
                the fiscal year ended September 28, 1991.3.1.2
              
              Articles of Amendment
                filed with
                the South Carolina Secretary of State on March 5, 1992: Incorporated
                by
                reference to Exhibit 4.4 to the Company’s Registration Statement on Form
                S-2 dated May 11, 1992, Commission File No. 33-47670.3.1.3
              
              Articles of Amendment
                filed with
                the South Carolina Secretary of State on April 22, 1993: Incorporated
                by
                reference to Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q
                for the quarter ended April 3, 1993.3.2
              
              Amended and Restated
                By-Laws dated
                February 4, 1997: Incorporated by reference to Exhibit 3.0 to the
                Company’s Quarterly Report on Form 10-Q for the quarter ended March 29,
                1997.3.2.1
              
              Amendment
                  to the Company's By-laws dated March 13, 2003: Incorporated by
                  reference
                  to Exhibit 3.2 to the Company's report on Form 8-K dated March
                  13, 2003,
                  Commission File No. 000-11392.3.2.2
              
              Amendment
                  to the Company's By-laws dated November 7, 2003: Incorporated by
                  reference
                  to Exhibit 3.2.2 to the Company’s Annual Report on Form 10-K for the
                  fiscal year ended September 27, 2003 (the “2003 10-K”), Commission File
                  No. 0-11392.4.1
              
              Specimen
                  of Common Stock certificate: Incorporated by reference to Exhibit
                  1 to the
                  Form S-8 filed on January 8,1990,
                  Commission File No. 33-32896.4.2
              
              The
                  Registrant hereby agrees to furnish to the Securities and Exchange
                  Commission upon request a copy of any instrument with respect to
                  long-term
                  debt not being registered in a principal amount less than 10% of
                  the total
                  assets of the Registrant on a consolidated basis.4.3
              
              Amended
                  and Restated Shareholder Rights Agreement dated March 24, 2003,
                  between
                  Span-America Medical Systems, Inc. and American Stock Transfer
& Trust
                  Company as Rights Agent: Incorporated by reference to Exhibit 4.1
                  to the
                  Company's report on Form 8-K dated March 24,
                  2003.
   54
   4.3.1
                
                Amendment
                    No. 1 to the Amended and Restated Shareholder Rights Agreement
                    dated
                    November 19, 2003: Incorporated by reference to Exhibit 4.1 to
                    the
                    Company's report on Form 8-K dated December 2, 2003.4.4
                
                Agreement
                    among Span-America Medical Systems, Inc., Jerry Zucker, and Robert
                    B.
                    Johnston, dated December 17, 2003, regarding nomination of Mr.
                    Johnston to
                    the Span-America Board of Directors: Incorporated by reference
                    to Exhibit
                    4.4 to the 2003 10-K.10.1
                
                Patent
                    Assignment and Royalty Agreement between Donald C. Spann and
                    the Company,
                    with letter amendment thereto: Incorporated by reference to Exhibit
                    10(c)
                    to the Form S-18 filed on June 2, 1983, Commission File No.
                    2-832-74-A.10.2*
                
                1987
                    Stock Option Plan: Incorporated by reference to Exhibit 10 to
                    the
                    Company's Annual Report on Form 10-K for the fiscal year ended
                    October 2,
                    1987, Commission File No. 0-11392.10.2.1*
                
                Amendment
                    No. 1 to the 1987 Stock Option Plan: Incorporated by reference
                    to Exhibit
                    10.2.2 to the Company’s Annual Report on Form 10-K for the fiscal year
                    ended October 3, 1998 (the “1998 10-K”), Commission File No.
                    0-11392.10.3*
                
                1991
                    Stock Option Plan: Incorporated by reference to Exhibit 10.6
                    to the
                    Company’s Annual Report on Form 10-K for the fiscal year ended September
                    28, 1991 (the “1991 10-K”), Commission File No.
                    0-11392.10.3.1*
                
                Amendment
                    No. 1 to the 1991 Stock Option Plan: Incorporated by reference
                    to Exhibit
                    10.4.2 to the 1998 10-K.10.4*
                
                Retirement
                    Agreement dated February 6, 1991 between the Company and Donald
                    C. Spann:
                    Incorporated by reference to Exhibit 10.7 to the 1991
                    10-K.10.5*
                
                Voluntary
                    Resignation Agreement dated July 30, 1993 between the Company
                    and Donald
                    C. Spann: Incorporated by reference to Exhibit 10.1 to the Company's
                    Quarterly Report on Form 10-Q for the quarter ended July 3, 1993,
                    Commission File No. 0-11392.10.6*
                
                1997
                    Stock Option Plan: Incorporated by reference to Exhibit 10.14
                    to the
                    Company’s Annual Report on Form 10-K for the fiscal year ended September
                    27, 1997 (the “1997 10-K”), Commission File No.
                    0-11392.10.6.1*
                
                Amendment
                    No. 1 to the 1997 Stock Option Plan: Incorporated by reference
                    to Exhibit
                    10.14.2 to the 1998 10-K.
   55
   10.7*
                  
                  1997
                      Long Term Incentive Stock Option Plan: Incorporated by reference
                      to
                      Exhibit 10.15 to the 1997 10-K.10.8
                  
                  Distribution
                      Agreement dated March 1, 1999 between the Company and Louisville
                      Bedding
                      Corporation: Incorporated by reference to Exhibit 10.16 to
                      the Company’s
                      Annual Report on Form 10-K for the fiscal year ended September
                      30, 2000
                      (the “2000 10-K”), Commission File No. 000-11392.10.8.1
                  
                  Addendum
                      to Distribution Agreement between Louisville Bedding Company
                      and
                      Span-America Medical Systems, Inc. dated January 1, 2002: Incorporated
                      by
                      reference to Exhibit 10.17 to the Company’s Quarterly Report on Form 10-Q
                      for the quarter ended March 30, 2002.10.9
                  
                  Asset
                      Purchase Agreement By and Among Span-America Medical Systems,
                      Inc., Vadus,
                      Inc., and Certain Stockholders of Vadus, Inc. dated February
                      1, 2002,
                      including amendments dated May 20, 2002 and July 9, 2002: Incorporated
                      by
                      reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q
                      for the quarter ended June 29, 2002.10.10
                  
                  Production,
                      Marketing and Product Development Support Agreement between
                      Span-America
                      Medical Systems, Inc. and Vadus, Inc. dated February 1, 2002:
                      Incorporated
                      by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form
                      10-Q for the quarter ended June 29, 2002.10.11*
                  
                  Severance
                      Protection Agreement between the Company and James D. Ferguson
                      dated July
                      25, 2002: Incorporated by reference to Exhibit 10.20 of the
                      Company’s
                      Annual Report on Form 10-K for the fiscal year ended September
                      28, 2002
                      (the “2002 10-K”), Commission File No. 000-11392.10.12*
                  
                  Severance
                      Protection Agreement between the Company and Robert E. Ackley
                      dated July
                      25, 2002: Incorporated byreference
                      to Exhibit 10.21 of the 2002 10-K.10.13*
                  
                  Severance
                      Protection Agreement between the Company and Richard C. Coggins
                      dated July
                      25, 2002: Incorporated by reference to Exhibit 10.22 of the
                      2002
                      10-K.10.14*
                  
                  Severance
                      Protection Agreement between the Company and James R. O’Reagan dated July
                      25, 2002: Incorporatedby
                      reference to Exhibit 10.23 of the 2002 10-K.10.15*
                  
                  Severance
                      Protection Agreement between the Company and Clyde A. Shew
                      dated July 25,
                      2002: Incorporated byreference
                      to Exhibit 10.24 of the 2002 10-K.10.16*
                  
                  Severance
                      Protection Agreement between the Company and Wanda J. Totton
                      dated
                      February 11, 2004: Incorporated by reference to Exhibit 10.1
                      of the
                      Company’s Quarterly Report on Form 10-Q for the quarter ended April
                      3,
                      2004.
   56
   10.17*
                  
                  Span-America
                      Medical Systems, Inc. 2000 Restricted Stock Plan: Incorporated
                      by
                      reference to Exhibit B to the Company’s Definitive Proxy Statement filed
                      with the Commission on January 11, 2001.10.18
                  
                  Amended
                      Private Label Product Supply Agreement between the Company
                      and Hill-Rom
                      Company, Inc. dated September 14, 2004.23.1
                  
                  Consent
                      of Elliott Davis, LLC.31.1
                  
                  Officer
                      Certifications Pursuant to Section 302.32.1
                  
                  Officer
                      Certifications Pursuant to Section 906.*
                  Management
                    contract or compensatory plan or arrangement.(b)ExhibitsThe
                    exhibits required by this section of Item 15 are attached hereto
                    or
                    incorporated by reference.(c)Financial
                    Statement Schedules




**Schedule
                    VIII Valuation and Qualifying Accounts**COL.
                    A
                
                COL.
                    B
                
                COL
                    C.
                
                COL.
                    D
                
                
                
                COL.
                    EADDITIONS(1)Balance
                    at
                
                Charged
                    to
                
                
                
                
                
                Balance
                    atBeginning
                    of
                
                Costs
                    and
                
                Deductions-
                
                
                
                End
                    ofDescription
                
                Period
                
                Expenses
                
                Describe
                
                
                
                
                PeriodYear
                    Ended October 1, 2005Deducted
                    from asset accounts:Reserve
                    for uncollectible accounts
                
                $
                140,000
                
                $
                34,263
                
                $
                58,263
                
                
                (a)
                
                $
                116,000Year
                    Ended October 2, 2004Deducted
                    from asset accounts:Reserve
                    for uncollectible accounts
                
                $
                175,000
                
                $
                (6,830
                )
                $
                28,170
                
                
                (a)
                
                $
                140,000Year
                    Ended September 27, 2003Deducted
                    from asset accounts:Reserve
                    for uncollectible accounts
                
                $
                211,000
                
                $
                86,884
                
                $
                122,884
                
                
                (a)
                
                $
                175,000(a)
                    Uncollectible accounts written off.


All
        other
        schedules for which provision is made in the applicable accounting regulations
        of the Securities and Exchange Commission are not required under the related
        instructions or are inapplicable, and therefore have been
        omitted.






57






SIGNATURES





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





SPAN-AMERICA
      MEDICAL SYSTEMS, INC.




By: /s/ Thomas D. Henrion
                
                December
                    22, 2005Thomas D. HenrionChairman of the Board




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




/s/
                James D. Ferguson
              
              President, Chief Executive
                OfficerJames D. Ferguson
              
              (Principal Executive Officer)/s/ Richard C. Coggins
              
              Chief
                Financial Officer and DirectorRichard C. Coggins
              
              (Principal
                Financial Officer)/s/ Gwendolyn L. Randolph
              
              ControllerGwendolyn L. Randolph/s/ Robert H. Dick
              
              DirectorRobert H. Dick/s/ Thomas F. Grady, Jr.
              
              DirectorThomas F. Grady, Jr./s/ Guy R. Guarch
              
              DirectorGuy R. Guarch/s/ Thomas D. Henrion
              
              DirectorThomas D. Henrion/s/ Robert B. Johnston
              
              DirectorRobert B. Johnston/s/ Douglas E. Kennemore
              
              DirectorDouglas E. Kennemore, M.D./s/ Peter S. Nyberg
              
              DirectorPeter S. NybergDecember
                  22,
                  2005






58