Gross profit The Company's gross profit decreased 8.5%, from $1,707.7 million in 1996 to $1,561.8 million in 1997. As a percentage of net revenues, gross profit decreased from 41.4% in 1996 to 38.9% in 1997, primarily as a result of the reduction in average selling prices and a less favorable product mix.

Cost of sales increased slightly from $2,414.7 million in 1996 to $2,457.4 million in 1997, primarily due to an increase in production volume related to higher sales volume and higher depreciation charges linked to the higher level of capital investment.

The exchange rate impact on gross profit in 1997 compared to 1996 was marginal, as the negative impact of the appreciation of the U.S. dollar on net revenues was only slightly higher than the positive impact on cost of sales. See "-- Impact of Changes in Exchange Rates." Cost of sales in 1997 and 1996 was net of $6.2 million and $4.6 million, respectively, of funds received through government subsidies to offset industrialization costs (which include certain costs incurred to bring prototype products to the production stage) included in cost of sales.

Selling, general and administrative expenses Selling, general and administrative expenses increased 7.9%, from $421.1 million in 1996 to $454.3 million in 1997, reflecting higher expenditure in the marketing organization and for information technology. As a percentage of net revenues, selling, general and administrative expenses increased from 10.2% in 1996 to 11.3% in 1997, due primarily to the increase in selling, general and administrative expenses and the decrease in net revenues.

Research and development expenses Research and development expenses increased 14.8%, from $532.3 million in 1996 to $610.9 million in 1997. The Company continued to invest heavily in research and development, and plans to continue increasing its research and development staff. The Company is allocating significant financial resources to expand its market leadership in key applications, reflecting the commitment to continuous service and innovation. As a percentage of net revenues, research and development expenses increased from 12.9% in 1996 to 15.2% in 1997. The Company's reported research and development expenses do not include design center, process engineering, pre-production or industrialization costs.

Other income and expenses Other income and expenses decreased from income of $45.1 million in 1996 to income of $23.2 million in 1997. Other income and expenses include primarily funds received from government agencies in connection with the Company's research and development programs, the cost of new plant start-ups, as well as foreign currency gains and losses, the costs of certain activities relating to intellectual property and miscellaneous revenues and expenses. The decrease in other income and expenses resulted primarily from higher start-up costs of new production facilities and from a decrease in funds received from government agencies in connection with the Company's research and development programs.

Operating income The Company's operating income decreased 35.0%, from $799.4 million in 1996 to $519.8 million in 1997, primarily as a result of the decrease in net revenues and the increase in research and development expenses, which more than offset the favorable exchange rate impact.

Net interest expenses Net interest expenses decreased from $11.2 million in 1996 to $2.6 million in 1997 reflecting primarily improved cash flow during 1997, and a slight reduction in interest rates.

Income tax expense Provision for income tax was $113.0 million in 1997 compared to $171.6 million in 1996, primarily as a result of the substantial decrease in income before income taxes and minority interests. The accrued effective tax rate increased slightly from 21.6% in 1996 to 21.8% in 1997. The still favorable 1997 rate was mainly due to the application of favorable tax regimes in certain countries. As certain of these benefits may not be available after 1997, the Company could experience an increase in the effective tax rate in the coming years.

1996 versus 1995

Following the growth that the worldwide semiconductor market experienced in 1994 and 1995, total industry sales declined in 1996 compared to 1995. See "-- Overview." However, the Company enjoyed significant growth in net revenues in 1996 despite lower average selling prices compared to 1995. Coupled with improvements in manufacturing productivity, this revenue growth led to strong increases in operating income and net income in 1996.

Net revenues Net sales increased 15.8%, from $3,520.7 million in 1995 to $4,078.3 million in 1996. The increase in net sales of $557.6 million was primarily a result of an improved product mix, including sales of new products, in each of the Company's principal product groups. The exchange rate impact on net sales in 1996 was not significant. See "-- Impact of Changes in Exchange Rates." Other revenues (consisting primarily of co-development contract fees, certain contract indemnity payments and patent royalty income) increased from $33.7 million in 1995 to $44.1 million in 1996, primarily due to an increase in licensing fees and co-development fees, partly offset by a decrease in patent and royalty income. As a result net revenues increased 16.0%, from $3,554.4 million in 1995 to $4,122.4 million in 1996.