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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended July 31, 2004

OR

For the transition period from              to             

Commission File Number: 1-15529

OPTIO SOFTWARE, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (770) 576-3500

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 whether the registrant is an accelerated filer (as defined in Rule 126-2 of the Securities Exchange Act of 1934).    Yes  ¨    No  x

There were 19,562,288 shares of the Registrant’s common stock outstanding as of September 10, 2004.

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OPTIO SOFTWARE, INC.

FORM 10-Q

For the Quarterly Period Ended July 31, 2004

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FORWARD-LOOKING STATEMENTS

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. Such forward-looking statements are made pursuant to the “safe-harbor” provisions of the Private Securities Litigation Reform Act of 1995 and are made based on management’s current expectations or beliefs as well as assumptions made by, and information currently available to, management. These forward-looking statements include, among other things, statements regarding Optio Software, Inc.’s (“Optio”) anticipated costs and expenses, Optio’s capital needs and financing plans, product and service development, Optio’s growth strategies, integration of acquired entities, market demand for Optio’s products and services, relationships with Optio’s strategic marketing alliances, and competition. These forward-looking statements include, among others, those statements including the words “expects,” “anticipates,” “intends,” “believes” and similar language. Optio’s actual results may differ significantly from those projected in the forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to, risks associated with Optio’s reliance on strategic marketing and reseller relationships, collectibility of accounts receivable and notes receivable, fluctuations in operating results because of acquisitions or dispositions, failure to integrate new products and newly acquired companies, diversion of management resources relating to acquisitions, reduction in cash reserves relating to acquisitions, challenges relating to acquisitions and the possibility that this may cause Optio to no longer be profitable, the negative effect on Optio’s earnings relating to the amortization or potential write-down of acquired assets or goodwill, failure to retain the business relationships with existing customers from acquisitions, changes in competition, changes in economic conditions in the U.S. and in other countries in which Optio currently does business (both general and relative to the technology industry), delays or inability in developing new or unique software products, market acceptance of new products, the failure of new products to operate as anticipated, expectation of achieving and sustaining operating profits and earnings, including timing of such cash flows and company performance, disputes regarding Optio’s intellectual property, risks relating to the delisting of Optio’s stock, possible adverse results of pending or future litigation, or risks associated with Optio’s international operations. These and additional factors are set forth in “Safe Harbor Compliance Statement for Forward-Looking Statements” included as Exhibit 99.1 to this Quarterly Report on Form 10-Q. You should carefully review these risks and additional risks described in other documents Optio files from time to time with the Securities and Exchange Commission, including the Annual Report on Form 10-K that Optio has filed. You are cautioned not to place undue reliance on the forward-looking statements in this document, which speak only as of the date of this Quarterly Report on Form 10-Q. Optio undertakes no obligation to publicly release any revisions to the forward-looking statements or reflect events or circumstances after the date of this document.

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PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Optio Software, Inc.

Consolidated Condensed Balance Sheets

See accompanying notes.

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Optio Software, Inc.

Consolidated Condensed Statements of Operations

(Unaudited)

See accompanying notes.

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Optio Software, Inc.

Consolidated Condensed Statements of Operations

(Unaudited)

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Optio Software, Inc.

Consolidated Condensed Statement of Shareholders’ Equity

(Unaudited)

See accompanying notes.

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Optio Software, Inc.

Consolidated Condensed Statements of Cash Flows

(Unaudited)

See accompanying notes.

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Optio Software, Inc.

Notes to the Consolidated Condensed Financial Statements

(Unaudited)

1. Description of Business

Optio Software, Inc. (“Optio” or the “Company”) provides infrastructure software and services that enhance the form, content, distribution and availability of business critical information. The Company markets primarily to companies located principally in the United States and Europe. The industry in which the Company operates is subject to rapid change due to development of new technologies and products.

2. Basis of Presentation

Interim Financial Information

The accompanying interim consolidated condensed financial statements of the Company have been prepared in accordance with the instructions for Form 10-Q. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. In the opinion of management, all adjustments, consisting of normal recurring adjustments unless otherwise disclosed in a separate note, considered necessary for a fair presentation of the financial information for the interim period reported have been made.

The accompanying financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended January 31, 2004, included in the Company’s Annual Report on Form 10-K, filed with the Securities and Exchange Commission on April 21, 2004. Results of operations for the three and six months ended July 31, 2004 are not necessarily indicative of the results for the year ending January 31, 2005.

Employee Stock Options

The Company accounts for stock based awards using the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”) and related interpretations. Under APB 25, when the exercise price of the Company’s stock options equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense is recorded.

Based on the additional disclosure requirements of SFAS 148, Accounting for Stock Based Compensation – Transition and Disclosure – an Amendment to SFAS 123, the following illustrates the assumptions and the effect on net income and net income per share if the Company had applied the fair value recognition provisions of SFAS 123.

Pro forma information regarding net income required by SFAS 123 Accounting for Stock-Based Compensation, requires that the information be determined as if the Company had accounted for its employee stock options granted subsequent to December 31, 1994 under the fair value method. The fair value for these options was estimated at the date of grant using the minimum value method through December 15, 1999, the date of the Company’s initial public offering. For those options granted subsequent to December 15, 1999, the fair value of each option was estimated on the date of grant using the Black-Scholes option pricing model with

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Optio Software, Inc.

Notes to the Consolidated Condensed Financial Statements

(Unaudited) – (Continued)

the following weighted-average assumptions used for the three months ended July 31, 2003 and 2004 and the six months ended July 31, 2003 and 2004: risk-free interest rates of 3.06% and 4.29% for the three months ended July 31 2003 and 2004, respectively; risk-free interest rates of 3.28% and 3.73% for the six months ended July 31, 2003 and July 31, 2004, respectively; no dividend yield; volatility of 122% and 151% for the three months ended July 31, 2003 and 2004, respectively; volatility of 129% and 151% for the six months ended July 31, 2003 and 2004, respectively; and an expected life of the options of 7.47 years for the three and six months ended July 31, 2003 and 7.43 for the three and six months ended July 31, 2004.

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting periods. The weighted-average fair value of options granted during the three months ended July 31, 2003 and 2004 equaled $0.60 and $1.29 per share, respectively. The weighted-average fair value of options granted during the six months ended July 31, 2003 and 2004 equaled $0.38 and $1.44 per share, respectively. The Company’s pro forma information as determined using the fair value method of accounting under SFAS 123, was as follows:

3. Net Income per Share

Net income per share has been computed in accordance with SFAS 128, Earnings per Share, which requires disclosure of basic and diluted earnings per share. Basic earnings per share excludes any dilutive effects of stock options. Diluted earnings per share includes the impact of potentially dilutive securities.

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Optio Software, Inc.

Notes to the Consolidated Condensed Financial Statements

(Unaudited) – (Continued)

The following table sets forth the computation of net income per share:

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Optio Software, Inc.

Notes to the Consolidated Condensed Financial Statements

(Unaudited) – (Continued)

4. Segment and Geographic Information

The Company is organized around geographic areas. Optio’s U.S. operations and Optio Europe represent Optio’s two reportable segments. Optio’s other foreign subsidiary is classified as “Other”. The foreign locations principally function as distributors of products developed by the Company in the United States. The accounting policies described in the summary of significant accounting policies are applied consistently across the segments. Intersegment sales are based on intercompany transfer prices to achieve a reasonable margin upon distribution.

Segment information for the six months ended July 31, 2003 and 2004 is summarized below.

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Optio Software, Inc.

Notes to the Consolidated Condensed Financial Statements

(Unaudited) – (Continued)

5. Legal Proceedings

On November 13, 2001, a lawsuit styled Kevin Dewey vs. Optio Software, Inc., et. al. was filed in the United States District Court for the Southern District of New York. The complaint was filed against the underwriters in Optio’s initial public offering as well as Optio and certain officers and directors of Optio, by a single plaintiff purportedly on behalf of persons purchasing Optio’s common stock between December 14, 1999 and December 6, 2000 and seeks class action status. Optio is a co-defendant with approximately 300 other issuers in this suit. The complaint includes allegations of violations of (i) Section 11 of the Securities Act of 1933 by all named defendants, (ii) Section 12(a)(2) of the Securities Act of 1933 by the underwriter defendants, (iii) Section 15 of the Securities Act of 1933 by the individual defendants, and (iv) Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder by the underwriter defendants. The complaint alleges that Optio’s prospectus was materially false and misleading because it failed to disclose, among other things, that: (i) the underwriters had solicited and received excessive and undisclosed commissions from certain investors in exchange for which the underwriters allocated to those investors material portions of a limited number of Optio shares issued in connection with the Optio initial public offering; and (ii) the underwriters had entered into agreements with customers whereby the underwriters agreed to allocate Optio shares to those customers in the Optio initial public offering in exchange for which the customers agreed to purchase additional Optio shares in the aftermarket at pre-determined prices. The complaint seeks unspecified amounts as compensatory damages as a result of Optio’s alleged actions, as well as punitive damages and reimbursement for the plaintiff’s attorney’s fees and associated costs and expenses of the lawsuit. A proposal to settle the claims against Optio and other companies and individual defendants in the litigation was conditionally accepted by Optio. The completion of the settlement is subject to a number of conditions, including Court approval. Under the settlement, the plaintiffs will dismiss and release all claims against participating defendants in exchange for a contingent payment guaranty by the insurance companies

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Optio Software, Inc.

Notes to the Consolidated Condensed Financial Statements

(Unaudited) – (Continued)

collectively responsible for insuring the issuers in the action, and the assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. Under the guaranty, all the insurers for all the issuers will be required to pay an amount equal to $1.0 billion less any amounts ultimately collected by the plaintiffs from the underwriter defendants in all the cases. The disposition of this matter is limited to Optio’s $300,000 corporate insurance deductible. The Company has completed payment of the insurance deductible through payment of legal fees. Optio will have no additional exposure unless the insurance companies become insolvent. Optio’s insurance companies currently have an A or AA rating. The range of loss, if any, cannot be estimated and thus no potential loss is reflected in Optio’s financial statements.

6. Note Receivable

As further explained in Notes 3 and 4 of the Notes to Consolidated Financial Statements included in Optio’s Annual Report on Form 10-K, Optio holds a note receivable from M2 Systems Corporation (“M2 Systems”) as partial consideration for the sale by Optio of its Muscato Corporation (“Muscato”) and Translink Solutions Corporation business units. Under the terms of the note, M2 Systems was required to make payments of $100,000 each on September 1, 2003 and December 1, 2003 and a payment of $115,000 on June 1, 2004. M2 Systems failed to make these payment on their respective due dates; however, payment was made prior to an event of default. The payment of $115,000 due September 1, 2004 was made when due.

During the third quarter of fiscal year 2004, as a result of M2 Systems’ failure to make timely payments, management determined that this was an indication that it was probable that Optio would be unable to collect all amounts due according to the contractual terms of the note. At that time, the loan was considered impaired and was written down to the assessed fair value of the collateral. As of October 31, 2003, the collateral, including technology, accounts receivable, fixed assets and the discounted net cash flows of maintenance contracts was estimated to have an approximate fair value of $2.8 million, substantially less than the $3.7 million note receivable balance as of October 31, 2003. Thus Optio recorded an impairment charge of $900,000 during the year ended January 31, 2004. Optio continues to reassess the value of the collateral on an ongoing basis. The amount of the note receivable recorded could be materially different under different conditions or using different assumptions, including the varying assumptions regarding the fair value of the collateral. If M2 Systems defaults on the note and the collateral proves to be of no value to the Company, the Company would incur an additional loss of approximately $2.5 million. The Company has the right to receive the quarterly financial statements of M2 Systems and Muscato and has certain audit rights as to the collateral for the note; therefore, the Company periodically assesses the value of the collateral and the note, as reflected on the Company’s financial statements.

7. Subsequent Event

On August 10, 2004, Optio consummated the merger of VertiSoft Corporation (“VertiSoft”), a privately held Georgia corporation, and Optio Software II, Inc., a wholly owned subsidiary of Optio, whereby VertiSoft became the surviving wholly owned subsidiary of Optio. The consideration given for the common stock of VertiSoft included $340,000 in cash, the issuance of 1.5 million shares of Optio common stock, the issuance of 340,000 stock options and future conditional cash payments of $225,000 to be paid out in various installments over the following two years, contingent upon the achievement of certain customer retention and product development goals. The cash component of the consideration given was paid from funds generated from the on-going operations of Optio. The acquired assets consist primarily of accounts receivable, software,

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Optio Software, Inc.

Notes to the Consolidated Condensed Financial Statements

(Unaudited) – (Continued)

machinery, equipment, furniture and fixtures, cash, and all of the interests, rights and benefits accruing to VertiSoft under any sales orders, sales contracts, service agreements, and purchase orders. In connection with the acquisition, Optio also assumed the liabilities of VertiSoft, consisting primarily of promissory notes payable (totaling approximately $1,100,000), accounts payable, accrued payroll, and service agreements.

VertiSoft provides document management solutions designed to streamline information access and distribution for physicians and clinical, medical records and financial services staff through a single interface or Composite Patient View^™. Its patented electronic document management system, QuickRecord, provides secure, individualized access to patient information retrieved from any system, inside or outside the enterprise.

In connection with the transaction described above, Optio entered into a written employment agreement with Donald H. French. Mr. French serves as Senior Vice President of Healthcare Products for Optio. Mr. French’s employment agreement has a three year term. Mr. French’s current employment agreement provides for a base salary of $200,000. In addition, Mr. French was granted an option to acquire 350,000 shares of common stock at $1.10 per share (the “Options”). The Options vest over a period of four years. Upon Mr. French’s death, resignation for good reason (as defined in the agreement) or termination without cause, the Company will be obligated to pay him his then-current base salary for the remaining term of the employment agreement. If Mr. French’s employment is terminated by reason of disability, he will receive his base salary for twelve months less any payments made to him under any long-term or short-term disability insurance policies. If Mr. French is terminated for cause, including resignation, or the mutual consent of the parties, he will receive no severance. Mr. French’s employment agreement includes post-employment restrictive covenants not to compete, solicit Optio’s customers or recruit Optio’s employees.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

Optio is engaged primarily in the development, sale and support of infrastructure software that enhances the form, content, distribution and availability of business information. Optio’s primary business consists of providing software and services that addresses organizations’ needs for customized information delivered via print, fax and e-mail to users of enterprise and healthcare applications.

Optio markets and sells its software and services throughout the United States, Europe and the Asia Pacific region, through its direct sales force and certified resellers. Optio has offices in the United States, France, the United Kingdom and Germany. Optio also offers consulting services, which provide customers with implementation assistance and training. No single customer accounted for 10% or more of Optio’s revenue for the three or six months ended July 31, 2004 or 2003.

Critical Accounting Policies and Use of Estimates

Optio has identified significant accounting policies and estimates that are critical to the understanding of its financial statements.

Revenue Recognition

Overview

The Company’s revenue consists of fees for licenses of the Company’s software products, maintenance, consulting services and customer training. The Company generally charges fees for licenses of its software products either based on the number of Central Processing Units (“CPUs”) on which the product is installed or, to a lesser extent, based on the number of persons or hospital beds registered to use the product. The Company’s revenue recognition policies are in accordance with Statement of Position (“SOP”) No. 97-2, Software Revenue Recognition, as amended by SOP No. 98-9, Software Revenue Recognition, With Respect to Certain Transactions and the Securities and Exchange Commission’s Staff Accounting Bulletin (“SAB”) No. 101, Revenue Recognition in Financial Statements, as amended by SAB 104, Revenue Recognition.

License Fees

The Company licenses its products through its direct sales force and indirectly through resellers. In general, software license revenues are recognized when a non-cancelable license agreement has been signed and the customer acknowledges an unconditional obligation to pay, the software product has been delivered, there are no significant uncertainties surrounding product acceptance, the fees are fixed or determinable and collection is considered probable. Delivery is considered to have occurred when title and risk of loss have been transferred to the customer, which generally occurs when media containing the licensed programs is provided to a common carrier. In case of electronic delivery, delivery occurs when the customer is given access to the licensed programs. If collectibility is not considered probable, revenue is recognized when the fee is collected. The Company enters into reseller arrangements that typically provide for sublicense fees payable to the Company based upon a percentage of list price. The Company does not grant its resellers the right of return.

The Company recognizes revenue using the residual method pursuant to the requirements of SOP No. 97-2, as amended by SOP No. 98-9. Revenues recognized from multiple-element software

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arrangements are allocated to each element of the arrangement based on the fair values of the elements, such as licenses for software products, maintenance, consulting services or customer training. The determination of fair value is based on objective evidence, which is specific to the Company. The Company limits its assessment of objective evidence for each element to either the price charged when the same element is sold separately or the price established by management having the relevant authority to do so, for an element not yet sold separately. If evidence of fair value of all undelivered elements exists but evidence does not exist for one or more delivered elements, then revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue.

The Company records deferred revenue for software license agreements when cash has been received from the customer and the agreement does not qualify for revenue recognition under the Company’s revenue recognition policy. The Company records accounts receivable for software license agreements when the agreement qualifies for revenue recognition but cash or other consideration has not been received from the customer.

Services, Maintenance and Other Revenue

Consulting services revenues and customer training revenues are recognized as such services are performed, as they are incidental to the functionality of the software. Maintenance revenues, which include revenues bundled with software license agreements that entitle the customers to technical support and future unspecified enhancements to the Company’s products, are deferred and recognized ratably over the related agreement period, generally twelve months. In accordance with Emerging Issues Task Force release 01-14, “Income Statement Characterization of Reimbursements Received for Out of Pocket Expenses Incurred”, the Company recognizes reimbursable expenses as revenue and as an expense in cost of revenue in all periods presented.

Note Receivable

Optio holds a note from M2 Systems as partial consideration for the sale of Muscato and TransLink. Under the terms of this note, M2 Systems was required to make payments of $100,000 each on September 1, 2003 and December 1, 2003 and a payment of $115,000 on June 1, 2004. M2 Systems failed to make these payments on their respective due dates; however, payment was made prior to an event of default. The payment of $115,000 due on September 1, 2004, was made when due.

During the third quarter of 2004, as a result of M2 Systems’ failure to make timely payments, management determined that this was an indication that it was probable that Optio would be unable to collect all amounts due according to the contractual terms of the note. At that time, the loan was considered impaired and was written down to the assessed fair value of the collateral. As of October 31, 2003, the collateral, including technology, accounts receivable, fixed assets and the discounted net cash flows of maintenance contracts was estimated to have an approximate fair value of $2.8 million, substantially less than the $3.7 million note receivable balance as of October 31, 2003. Thus Optio recorded an impairment charge of $900,000 during the year ended January 31, 2004. Optio continues to reassess the value of the collateral on an ongoing basis. The amount of the note receivable recorded could be materially different under different conditions or using different assumptions, including the varying assumptions regarding the fair value of the collateral. In Optio’s assessment of the collateral, varying assumptions, including the length of time of which customers would continue on maintenance, resulted in estimates of the value of the collateral ranging from $1.8 million to $3.5 million, which could have resulted in an impairment charge ranging from $200,000 to $1.9 million. If M2 Systems defaults on the note and the collateral proves to be of no value to Optio, Optio would incur an additional loss of approximately $2.5 million.

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Accounts Receivable

Optio maintains allowances for doubtful accounts for estimated losses resulting from customers’ inability to make payments required under their contracts. The amount of Optio’s reserve is based on historical experience and Optio’s specific review and analysis of the receivables outstanding. Management reviews its accounts receivable on a regular basis to determine if any such amounts may be potentially uncollectible. The Company includes any balances that are determined to be uncollectible, along with a general reserve at varying percentages of 3% to 20% of each aging category of the accounts receivable, in its overall allowance for doubtful accounts. Based on management’s best estimate it believes the Company’s allowance for doubtful accounts is adequate as presented; however, the amount of the reserve could be different under different conditions or using varying assumptions. If the percentage of the general reserve were to increase by 1%, an additional reserve of approximately $50,000 would be required. If the financial condition of Optio’s customers were to deteriorate, resulting in their inability to make payments, additional reserves would be required, increasing Optio’s bad debt expense included in general and administrative expenses.

RESULTS OF OPERATIONS

Three Months Ended July 31, 2004 Compared to Three Months Ended July 31, 2003

Revenues

The following table sets forth certain items from Optio’s statements of operations as a percentage of total revenue for the periods indicated.

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Revenues

Total revenues increased 1% to $6.8 million from $6.7 million for the three months ended July 31, 2004 and 2003, respectively.

License fees

Revenues from software licenses increased 3% to $2.6 million from $2.5 million for the three months ended July 31, 2004 and 2003, respectively. While license revenue only slightly increased, we have seen a change in the source of license revenue. In the three months ended July 31, 2003 healthcare sales represented 32% of Optio’s domestic software sales. In the three months ended July 31, 2004 only 16% of Optio’s domestic revenues came from healthcare. This decline was primarily the result of turnover in Optio’s healthcare sales team. Alternatively, Optio experienced a significant increase in software sales in our ERP business, from 48% of domestic software revenues in the three months ended July 31, 2003 to 61% of domestic software revenues in the three months ended July 31, 2004. Although the total number of software contracts to new customers declined slightly, Optio’s average sales price improved quarter over quarter, largely the result of the introduction of new products such as Print Manager. In addition, Optio increased our license revenue to our existing customer base, partially as the result of the introduction of new products, but also through the expansion of additional licenses to existing customers. License fee revenues from Optio’s European division increased from $283,000 in the three months ended July 31, 2003, to $506,000 in the three months ended July 31, 2004, largely as a result of our efforts to build upon existing partnerships, for example, Oracle, in the European marketplace.

Approximately $695,000 of Optio’s software license revenue during the three months ended July 31, 2004 was derived from partners, such as resellers, value-added distributors or OEM relationships, representing 27% of license revenue for Optio. During the three months ended July 31, 2003, Optio generated $775,000 of its software license revenue through partners, representing 31% of Optio’s license revenue.

Services, maintenance and other

Revenues from services, maintenance and other remained constant at $4.2 million during the three months ended July 31, 2004 and 2003. Services revenue decreased to $1.3 million for the three months ended July 31, 2004 from $1.5 million in the three months ended July 31, 2003. In the three months ended July 31, 2003, Optio was involved in large consulting engagements with specific large integrators, contributing an additional $90,000 to services revenue in that quarter. These projects were completed during the second quarter of fiscal year 2004. Maintenance revenue increased $200,000 to $2.9 million in the three months ended July 31, 2004 from $2.7 million in the three months ended July 31, 2003. Maintenance revenue continues to increase as Optio adds to its customer base and increases the price of its annual maintenance fees.

Revenue Mix

Revenues from licenses has remained relatively constant at 38% of total revenue in the three months ended July 31, 2004 and 37% of total revenue in the three months ended July 31, 2003.

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Costs of Revenues

Total costs of revenues decreased 2% to $1.5 million in the three months ended July 31, 2004 from $1.6 million in the three months ended July 31, 2003.

Licenses

Costs of revenues from licenses consist of costs related to the packaging and distribution of the products, fees paid for integration of third-party software products and fees paid to referral partners. Costs of revenues from licenses increased to $174,000 in the three months ended July 31, 2004 from $108,000 in the three months ended July 31, 2003, primarily the result of royalties due to OEM partners for products introduced in the third quarter of last year.

Services, maintenance and other

Costs of revenues from services, maintenance and other consist of personnel, subcontracting and other expenses relating to the cost of providing customer support, education and consulting and implementation services. Costs of revenues from services, maintenance and other decreased to $1.4 million in the three months ended July 31, 2004 from $1.5 million in the three months ended July 31, 2003. The cost of outsourcers, often used in the implementation of Optio’s products at customer sites, remained constant at approximately $315,000 in both periods. Optio’s internal headcount for its support department declined, accounting for the reduction in expense.

Operating Expenses

Sales and Marketing

Sales and marketing expenses consist primarily of salaries, commissions, bonuses and benefits earned by sales and marketing personnel, direct expenditures such as travel, communication and occupancy and marketing expenditures related to direct mail, trade shows and other advertising.

Sales and marketing expenses increased 11% to $2.6 million from $2.4 million for the three months ended July 31, 2004 and 2003, respectively. Sales and marketing expenses were 38% and 35%, respectively, of total revenue for the same periods. While direct marketing expenditures declined by less than $50,000 between the two quarters, Optio increased its sales and marketing headcount by three individuals over the previous year, resulting in an additional $100,000 in salaries. In addition, commissions and bonuses were increased approximately $90,000, resulting from improved software sales.

Research and Development

Research and development expenses consists primarily of salaries, benefits and equipment for software developers, quality assurance personnel, and product managers.

Research and development expenses increased to $1.1 million in the three months ended July 31, 2004 from $1.0 million in the three months ended July 31, 2003. This increase is primarily the result of increased wages and the addition of $40,000 in consulting fees related to the development of future products.

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General and Administrative

General and administrative expenses consist primarily of salaries, benefits and related costs for executive, finance, human resources and information services personnel. General and administrative expenses also include legal, accounting, insurance and other professional services.

General and administrative expenses decreased to $1.1 million in the three months ended July 31, 2004 from $1.2 million in the three months ended July 31, 2003. While overall, general and administrative expenses remained relatively constant, Optio was able to save $173,000 in legal fees and $147,000 in insurance premiums. This was offset by increased salaries of $75,000 and bad debt expense of $45,000.

Depreciation and Amortization

Depreciation and amortization expense decreased to $106,000 from $142,000 for the three months ended July 31, 2004 and 2003, respectively. This decrease is due to a greater number of Optio’s fixed assets becoming fully depreciated during the three months ended July 31, 2004.

Interest Income

Interest income remained constant at approximately $40,000 in the three months ended July 31, 2004 and 2003. Interest income primarily represents interest earned on the principal of the M2 Systems note receivable.

Interest Expense

Interest expense decreased to $4,000 from $5,000 in the three months ended July 31, 2004 and 2003, respectively. Interest expense primarily represents the interest paid on Optio’s capital leases.

Six Months Ended July 31, 2004 Compared to Three Months Ended July 31, 2003

Revenues

The following table sets forth certain items from Optio’s statements of operations as a percentage of total revenue for the periods indicated.